Investing in 'alternatives'
Investors typically regard equities, bonds and cash as the primary asset classes. But there are a number of other peripheral assets which fall under the “alternatives” catch-all. In this commentary John Berry from Pathfinder looks at PIE managed fund “alternatives” that New Zealand investors can include in portfolios.
Tuesday, March 1st 2016, 11:28AM 
5 Comments
by Pathfinder Asset Management
The 'what' and 'why' of alternatives
A recent international study by Willis Towers Watson focused on US$33 trillion of pension fund assets in 7 countries (Australia, Canada, Japan, Netherlands, Switzerland, US and UK). They found that across portfolios an average of 24% was invested in assets classified as “other/alternative” - a staggering jump from 7% in 1996. By contrast equity allocations have gone down from 52% to 44% over the same 19-year period. The rationale for alternatives is well understood, it is about risk and return:
- Portfolio diversification across asset classes reduces risk (by introducing assets not expected to be correlated with equities or bonds)
- Higher returns may be achieved from difficult to access markets or through more complex alternative strategies
Below we look at PIE fund options for NZ investors in alternative assets by reviewing hedge funds, private equity, commodities and other 'alternative strategies (we will save real estate for a future commentary)'.
Multi-asset hedge funds
Multi-asset hedge funds invest across a range of asset classes – equities, fixed income, commodities and credit. They can also cover a broad geography (i.e. both developed and emerging markets).
Their returns are not benchmarked to equity markets. The intention is to generate positive returns in all conditions, whether markets are going up or down. These funds are likely to include unconventional strategies like long / short exposures and leverage. Unfortunately the proprietary nature of hedge fund investing often means limited transparency to the underlying assets (although this is improving).
The NZ fund manager will typically “repackage” one or more offshore hedge funds through a PIE fund with currency hedging. For example the GSR fund mentioned below invests in the Blackrock Multi-Opportunity Fund, the Nikko fund in JP Morgan’s Multi Strategy II fund, the AMP fund invests with both AMP and Schroders and the NZAM fund invests in a “diverse group of managers”.
There are advantages of using a PIE fund rather than trying to access the offshore hedge fund managers directly. These advantages include:
- Most hedge funds are not accessible to smaller investors (or where accessible the NZ PIE will typically benefit from preferential fees)
- The NZ manager can undertake due diligence and choose what they see as the best managers
- The PIE fund structure has a management fee (i.e. a cost) but this is balanced by structural benefits such as the ability to currency hedge and simpler tax compliance
Here are hedge fund PIE options available in NZ:
Hedge funds have been a tough space for NZ fund managers. Several specialist funds in this area have subsequently disappeared – largely because it has been difficult raising investor money (Elevation, Richmond and Savings & Investments have generally had good underlying hedge fund managers but limited traction with NZ investors).
These hedge fund PIE products seem to succeed in their mission of producing returns uncorrelated to equity markets. For example, the correlation of NZAM’s fund to global equity markets is close to zero (-0.06). In recent years this class of funds has helped diversify portfolio risk, with positive (but largely unspectacular) returns.
Private equity
Private equity has proven itself by generating solid absolute returns in NZ – fund returns exceeding 20% p.a. are common. While it is a lucrative asset class, the problem for most investors is finding access to these investments.
For sophisticated investors who can write large cheques there are occasionally private equity managers raising new funds. Names include Maui, Knox, Pencarrow, Waterman and Direct Capital (the NZ Super Fund has invested with these last 3 managers). However these investments are only available to wholesale investors with minimum applications of $100,000, $250,000 or more.
There have been a few attempts to make private equity funds accessible to retail investors, namely:
- Pohutukawa Funds: their 2 funds raised $135m under retail offer documents (this is a joint venture between Craigs and Direct Capital)
- Punakaiki Fund: focuses on wholesale investors and used the Snowball crowd funding platform in 2015 to raise $2m from retail investors. This was followed by Powerhouse Ventures raising $1.8m through Snowball in early 2016.
- Milford Active Growth Fund: this is unique as a diversified growth fund that includes a small allocation to direct private equity assets. More fund managers, especially in KiwiSaver, should take note of this.
The challenge with private equity is liquidity. The underlying assets cannot be sold easily so typically investors must hold for 7-10 years until the fund is wound up. The funds do not offer redemptions and there is no developed secondary market. In summary private equity offers good returns for investors, but limited access and very restricted exit options. The higher returns reflect a premium for very limited liquidity.
Commodities
Commodities are the basic building blocks of economies – things that are grown in the ground (like corn and wheat) or extracted from the ground (like oil, copper or gold). Commodity markets have been through tough times in recent years. Oil for example was close to US$100 a barrel less than 2 years ago (now 70% lower). Gold hit an all-time high of US$1,921 an ounce in August 2011 (now 35% lower). Whether prices have stabilised or will continue to be volatile is widely debated.
There are several PIE fund options for commodities in NZ. However, the difficult environment for commodities is reflected in fund returns:
Alternative strategies
The managers in this category may employ strategies similar to “hedge funds” (discussed above) but they are not multi-asset funds. For this reason we regard “alternative strategies” as a separate grouping. There are some interesting and quite varied NZ PIE funds in this category:
It is worth noting that we could have included concentrated equity funds like Castle Point’s Ranger Fund and Devon’s Alpha Fund (closed to new investors) in the table. They do not track equity benchmarks but as concentrated active funds that cannot go “net short”, they are not quite “alternative” enough to include. By contrast the net market exposure of Salt’s Long Short Fund can be anywhere between 30% short and 60% long.
Closing thoughts
There are a range of PIE fund options that give access to alternative asset classes and strategies. These include hedge funds, commodities and alternative strategies (but unfortunately limited options in private equity).
Are these useful for NZ investors? “Alternatives” may enhance returns or diversify portfolio risk (in a perfect world they would do both!). In particular, they often help portfolios with their low correlation to equity and bond markets.
Be sure to do very thorough research before including alternatives in a portfolio. Here are some points to ponder:
- Take time to understand the real investment risk – what are the underlying assets (and are they fully disclosed)? What is the risk of the strategy? For example, are there any unusual features, such as high leverage or illiquid assets?
- Keep the allocation to alternatives at an appropriate size in the portfolio. It is not uncommon for sophisticated investors offshore to have alternatives at 20% of a portfolio. By contrast the rule of thumb in NZ seems to be no more than 10% (having said that, AON’s January fund manager survey shows an allocation to “alternatives” in balanced funds ranging from 0% to 20%).
- While it is not always the case, alternative strategies can involve higher costs. Be aware that “fund of fund” structures layer fees on fees (and even performance fees on performance fees). But with alternatives think of post fee returns – you can afford to pay higher fees if a manager consistently delivers outstanding absolute returns.
In summary, there are a range of alternative asset funds available in NZ. They cover hedge funds, commodities, alternative strategies and private equity. Depending on investor risk profiles, one or more could be a useful addition to portfolios.
John Berry, Director
Pathfinder Asset Management Limited
Seek advice: Pathfinder is a fund manager and does not give financial advice. Seek professional investment and tax advice before making investment decisions.
Disclosure of interest: John is a founder of Pathfinder and invests in its Commodity Plus Fund. He is also an independent director of (and invests in) Punakaiki Fund Limited.
Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz
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Comments from our readers
Whichever way you slice it there has been significant growth in the allocation to non-real estate alternatives. This has mostly happened post-GFC, suggesting global asset consultants and pension funds have looked at how these strategies performed in the GFC and seen something they like.
Taking equity long/short as an example, while there was correlation in the GFC (i.e. long/short funds also fell), the long/short funds fell about half of long only funds (around -20% vs -40%). That is extremely meaningful for long term returns (and advisers' conversations with their clients).
That was exactly my point. Mr Berry started off by saying investors typically regard equities, bonds and property as primary asset classes and that there are other peripheral assets known as alternatives. He then says that alternatives are 24% of portfolios according to Willis Towers but neglected to say that the 24% includes property. That was misleading in my view.
As regards your point that there has been significant growth in non-property alternatives that may be so over the longer term but the Financial Times this year is full of stories of institutional investors dissatisfied with alternatives and withdrawing their money.
Regards
Brent
Thanks for your comments. You are right that the Willis Towers study included property. To avoid confusion, the simplest fix is for me to remove the word “property” from the first line of the commentary. Apologies for causing grief.
Your second point assumes that all the PIE funds mentioned in fact pay FDR tax, which of course they don’t. In any event the commentary was not intended as a detailed debate of PIE fund structural advantages and disadvantages over choosing other options like ETFs or Australian Unit Trusts. It is simply a summary of what PIE products are available in the alternatives space.
Your final point is a good one in that I could have included the question of correlation in the “points to ponder” at the end (particularly the experience in 2008 when the only thing that went up was asset correlation!).
Regards, John
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Secondly in his promotion of PIE funds Mr Berry neglects to mention that PIE funds have a disadvantage in that they cannot use comparative value to reduce their tax liability in falling markets.
Thirdly Mr Berry forgets to add that most investors recent experience of alternative assets is that they frequently become correlated with equity markets whenever equity markets fall thus lose their much vaunted diversification benefits at just the time they are needed.