Beyond Bonds

Locked or liquid: which alternatives have a future?

“History is moving pretty quickly these days, and the heroes and villains keep on changing parts.” ― Ian Fleming

Shaken but not stirred is for James Bond’s martinis, not the average investor’s portfolio. This is why hedge funds, and other alternatives, have been ‘sold’ as path to smoother, uncorrelated returns.

The growth in alternatives—real assets, hedge funds and private equity—has been trending upwards, reaching $7.2 trillion at the end of 2013, according to McKinsey. The report sees alternatives comprising more than 15% of global assets and contributing 40% of industry revenues by 2020 because of disillusionment with traditional asset classes and products, as well a need to close gaps in defined benefit pension plans among some of the reasons.

That said the primary driver, McKinsey believes, will be the retail segment of the market particularly in the US. And this is despite hedge fund performance being lacklustre; up 1.65% year to date, according to HedgeFund Intelligence. Hedge funds only returned 4.13% in 2014, according to the Credit Suisse Hedge Fund Index, which shows that 18.37% came from managed futures, the robots of the hedge fund industry.

But it is less the weak performance and the complexity of the structures than the high expenses that has led to some high profile hedge fund investors, such as the California Public Employees’ Retirement System and the Dutch healthcare workers’ fund PFZW, to announce plans to exit their hedge fund holdings.

Howard Marks, founder of Oaktree Capital predicted that investors would question the two and 20 fee model more than a decade ago and yet hedge fund fees seem to have only really fallen for newer entrants to 1.4% and 17%. For some investors, it is less the size of the fee, but the alignment that needs to change. In Asset management 2020 – A Brave New World, PWC states that by 2020, global regulation on fee transparency will mean better alignment of interests.

Globally, it seems to be politics that is driving some investors such as CalPERs to sell its alternative portfolios. In the US public pension fund world, the political pressure to justify fees has led CalPERs to announce plans to axe at least two thirds of its ‘costly’ private equity managers as well, while in Australia the superannuation funds too have to cut fees.

Does this mean that the glory days are behind them for the chino-clad hedge fund crowd and their sharper suited (but arguably more rapacious) cousins, the private equity fraternity? The Volcker rule is forcing proprietary trading and stakes in hedge funds and private equity firms out of banks by 2017, and Basel III is making the cost of capital expensive for hedge fund start-ups as banks are getting picky about their clients.

So where do investors turn to in a low interest rate environment that is punctuated by bursts of high volatility? The answer seems to depend who you are. Larry Fink, chairman and chief executive of BlackRock, highlighted the fact that public policy does not encourage long-term investing and in its 2015 Investment Outlook, BlackRock asks if investors are getting adequate compensation for taking liquidity risk in certain longer lock up assets such as private equity and infrastructure.

It is in this area in which, according to McKinsey’s The $64 trillion question: Convergence in asset management, institutions managing more than $2 billion are heading with their ability to access specialised private-market exposures such as agriculture, energy, infrastructure, real estate and timber.

For this reason, the alternatives industry will continue to grow although whether the majority of the allocations will go to real estate, private equity or hedge funds has yet to be seen as the alternatives market is highly fragmented. Going forward, however, the retail buyer will start to get more access to the alternatives via liquid structures.

From this, it would seem that the hedge fund industry is pursuing ever-more liquid vehicles, which will exacerbate issues should there be (as there inevitably will be) a market ‘event’. Going main stream in liquid alternative formats such UCITS for Europe and Asia and open-ended ’40 Act alternative mutual funds in the US seems to be one of the preferred business development strategies for hedge funds, 

In what looks like modern remake of the hedge fund story, potentially inappropriate hedge fund-like strategies, along with leveraged exchange traded funds, are being shoe horned into mutual fund structures with higher total expense ratios than those offered by long only players, in the hope that retail and future defined contribution assets will keep them in business.

Those that have been around the block a few times know that it will be the investors that may suffer if liquidity dries up. It would seem that Massachusetts securities regulator William Galvin had a similar thought over the summer when launched a review of state registered advisers’ sales of alternative mutual funds offered by some of the largest money managers, as these products “can be accidents waiting to happen.”