Alternatives becoming the new core

In recent years, the investing public has been taught that the core of any portfolio is nearly, by definition, a passive beta strategy, with the potential for alpha generated by a smaller layer of active management and alternative assets.

In the wake of the global credit crisis, many institutional and HNW clients are asking for more tactical asset allocation and have shifted their focus to risk management—the central theme of the original hedge fund mentality.

For institutional and HNW clients, there is no reason why alternative strategies cannot form the core of their portfolio; alternative mandates simply allow the manager to use all of the strategic tools at his or her disposal.

It is somewhat ironic that a do-it-yourself investor is able to use alternative strategies—such as short selling—while those who rely on professional management must meet regulatory hurdles to access these same strategies. Retail mutual funds can obtain regulatory permission to take small short positions, but these are relatively rare in the Canadian market.

For institutional investors, the shift to alternatives has been sudden; in 2009, the most common manager search was for international/global equity, while hedge fund managers ranked fourth. In 2011, hedge funds were the most sought-after asset managers.

Many institutional investors want a base return of 5%, plus 3% to cover off inflation and another 1% in “real return.” Add in operating costs of between 50 and 100 basis points, and the overall portfolio is targeting a nominal return of between 9.5% and 10%.

This is a tricky proposition with a traditional long-only stock and bond portfolio, especially with the long-term bull market in bonds coming to an end, he said. Shooting for a 10% return in a long-only stock portfolio is simply too risky, so institutional investors have embraced alternative strategies.

Alternatives are not in every portfolio, largely because hedge funds are restricted to the wealthy, Cortez pointed out. But for large institutional investors like the Harvard and Yale endowment funds, alternatives are already the new core.

The same shift is occurring among ultra-HNW individuals; the wealthier the client, the larger their allocation to alternatives, Cortez said.

Equity-based hedge funds—such as long-short, private equity and arbitrage strategies—are being treated as part of the overall equity bucket, while bond-based hedge funds are seen as a natural portion of the fixed income portfolio.

Not all alternative assets have a home in these traditional baskets, however. These are being broken out as liquid (such as commodity trading advisor funds) and illiquid (such as managed timberland) assets.

At the depth of the downturn, passive index-tracking strategies did precisely what they were supposed to do and tracked the S&P 500’s 40% decline, illustrating the hazard of holding a passive core in a portfolio.

“If your core can drop that much, it’s not the core you want. The core is supposed to be the safer money,” Cortez pointed out.

Just as tracking a traditional stock index is fraught with peril. Cortez does not believe investors should buy into a passive alternative investment index, as these have far too much survivorship bias. To get a more accurate picture of how the industry is performing, he says investors should deduct up to 200 basis points from the reported return of an alt index.

When the market was melting down, many hedge fund investors stampeded for the doors as well, only to find they were locked; the majority of the funds have limited liquidity, as it would be impossible to manage private equity (as one example) while providing daily liquidity.

But Cortez said the industry learned from this episode, and many investors are now providing improved liquidity. There are now roughly 300 alt-strategy retail mutual funds in the U.S., with assets in excess of $100 billion.

These new funds have been able to provide lower entry points, although Cortez pointed out that some strategies still do not lend themselves to daily liquidity.

To provide these retail vehicles, managers have voluntarily subjected themselves to the same SEC regulations as traditional mutual funds, but this, too, is a good thing for the industry, Cortez contended. In the post-Madoff world, individual and institutional investors alike have sought out investments with closer regulatory oversight.

The market collapse of 2008 proved that the idea that hedge funds could do well in any market was false. Most managers would have admitted this ahead of the collapse, but many supposedly sophisticated investors seemed unaware that they could lose 28%, even as the overall market fell 50%.

As the focus shifts from returns to risk management, investors are seeking new asset classes and new methods for carving up their asset allocation.

Institutional and HNW investors are increasingly using a risk budgeting model for asset allocation, according to Michael Underhill, chief investment officer of Capital Innovations. The safer the “safe” part of the portfolio is, the more risk investors can take in the rest of the portfolio.

Such an approach can place a premium on stability, as it allows investors to take more risk elsewhere. Among alternative assets, one of the most stable subclasses is infrastructure, the niche served by Underhill’s firm.

The market is vast, with about $4 trillion in global listed infrastructure assets, ranging from utilities and toll roads, to water and hospitals. Given the importance of these services and the relatively benign nature of their operations, infrastructure will usually survive social investment screens, which have become more common in the past decade.

Because infrastructure provides stable cash flow with the potential for inflation hedging, it can be seen as a hybrid of both fixed income and equity. Agreements tend to fall into the mid-term range of seven to 10 years, often with built-in indexing.

Underhill says most institutional investors fund their infrastructure allocation with assets drawn out of their real asset and fixed income portfolios. As little as a 5% allocation can be enough to “move the needle,” he said.

Perhaps one of the best attributes of infrastructure, though, is that it can be relatively impervious to recession.

“When you look at things like telecommunication and waste water, those things are a little bit more inelastic,” Underhill said. “In 2008, when everything correlates to 1, people are more inclined to take showers and flush their toilets and less inclined to go to Starbucks.”

As regulated monopolies, most of these services have the ability to pass rising costs on to the consumer. Other real assets commonly held by institutional investors may not enjoy this luxury—few car washes can raise their prices in a recession, he pointed out.

For instant diversification, smaller investors may opt for pooled funds, which offer fractional ownership of a diversified portfolio of infrastructure holdings operated by experts. As with all managed investments, though, investors must keep an eye on fees, Underhill warned; some pools will charge their management fees on undeployed capital.

While institutional investors have access to direct holdings and private equity, many have started to move away from these vehicles in favour of publicly traded securities, including exchange traded funds, exchange traded notes and master limited partnerships.

While there are costs associated with these structures, their public listing requires regulatory oversight and provides investors with liquidity, T+3 trade settlement and access to global opportunities.

And the opportunities truly are global, especially from a North American perspective, where most infrastructure is viewed as a public good and privatization has been slow in coming.

Despite its reputation as the bastion of capitalism, the U.S. lags Europe, Asia and Australia in implementation of infrastructure investing. The U.K. and Australia really got the ball rolling about 20 years ago, as market-friendly politicians sought to move infrastructure off of the government’s balance sheet.

But the North American market is set to explode, Underhill believes, as much of America’s infrastructure has been allowed to decay and the current political climate is far more conducive to privatization than tax increases.

“In the U.S., it’s beyond broken. Several states are tragic in their deficit/infrastructure problems,” Underhill said. “We’re into another election cycle already, which muddies the waters. Like politics, all infrastructure is local.”

Never mind the crumbling bridges; he believes the most logical area for investment is the energy sector, as the U.S. is the only developed country without a “real energy policy.”

Public-private partnerships are unlikely to gain traction, he said, so investment banks are focusing on private-to-private deals.

Globally, there has been a trend toward more publicly traded securities in the fields of transportation and telecom. Irrigation projects are also desperate for capital, as global climate change is threatening to halve the growing season in much of Africa to just 61 days.