Bolder portfolios ready to re-embrace alternatives

While the overarching theme for wealthy investors both in Europe and the US appears to be the quest for yield in a low interest rate environment, where bonds are being increasingly mistrusted, alternative investments, in the broader sense, are once again beginning to rear their heads in some more adventurously-tilted portfolios.

However, the way alternatives are being positioned has now been revised, particularly in their politically correct North American heartlands.

“If there is such as thing as the balanced investor, we are now recommending 20 to 25 per cent exposure for them to alternatives,” says Leo Grohowski, New York-based chief investment officer at BNY Mellon Wealth Management. “But today, we refer to them as ‘diversifiers’.”

This understandable renaming, in order not to further frighten the horses, is currently focusing on private equity rather than the controversial hedge funds which once powered the performance of some of the US’s largest endowments and public pension funds.

“I think this will turn out to be a very good period for private equity investing, though we will not really know the results for another five, seven or 10 years,” says Mr Grohowski. “Times of economic distress tend to be vintage periods for private equity, like 2009 to 2012.”

Currently, BNY Mellon is allocating between five and 10 per cent of wealthy investors’ portfolios to this asset class, provided they are able to lock up capital for a period of five to 10 years. Vast allocations of US investors to money market funds suggests a reluctance to buy into illiquid assets, although “savvy investors” are turning to more interesting areas of the market.

“If you look at distressed opportunities, you can invest on terms which can prove rewarding in years to come,” says Mr Grohowski.

A DIFFICULT YEAR

With disappointing hedge fund returns in 2011 in a high correlation environment, when “many hedge fund managers got whipsawed even more than long-only managers in an effort to be more nimble,” according to Mr Grohowski, selectivity of providers is becoming more important.

“Many of us were expecting a bigger shakeout of managers, with fewer players left,” he says. “But there are still 9,000 hedge funds out there. There will now be an even greater premium on due diligence and hedge fund manager selection.”

He expects shifts in the alternatives market which will expand available capital, although much of this will come from institutions. “The high net worth investor took the lead in the early stages of the industry. Now we are seeing a broadening of that pool.”

Commodity exposure is also going to be increasingly important for investors’ portfolios for the next 10 years, he says. “But I get nervous when investors define this exposure purely through gold exchange traded funds (ETFs). We have been pretty consistent in warning investors that gold should be part of a broadly defined commodity exposure – it shouldn’t dominate the exposure entirely.”

He says many clients became a “little wiser” after witnessing last year’s correction. BNY Mellon prefers a managed exposure to this asset class through its hedge fund of funds, which includes two specialist managers in the commodities sector.

“At the other end of the spectrum, I don’t have a problem with buying ETFs, although some of them tend to be overweight energy,” believes Mr Grohowski. That said, he sees energy exposure as a crucial position of private portfolios for the next decade or so.

HIGHER LEVELS

At JP Morgan Private Bank, the alternative allocations are if anything slightly higher than their global rivals, with a broad one third in each allocation between equities, fixed income and alternatives buckets recommended for wealthy clients.

“In our portfolios we are significantly underweight equities and are in the bottom decile in the peer group of 40 wealth managers in the US in terms of equity allocation,” suggests Archan Basu, global head of portfolio construction at JP Morgan.

But there are other equity-like assets which are heavily represented in client portfolios. “If you look past the headlines, down a level and add the back alleys of private equity, high octane hedge funds and high yield bonds, we would be in the top decile,” he explains. “There is a difference in how you ask the question.”

Asset allocation is more about looking at the underlying risk of investments and judging their exposure to the market and broader economy rather than a simple comparison of weights afforded to equities, bonds and alternatives, believes Mr Basu.

“We are looking to out-think the markets with thoughtful risk-taking. We are taking risk, but taking it carefully, not just going into equity markets.”

Indeed hedge funds have been very beneficial to the performance of portfolios, says Mr Basu, particularly macro-based funds able to take advantage of volatile environments.

“Risk in markets has been macro risk. Investors are asking if the euro is going to hold together or fall apart, if Greece is in or out and whether Italy is next,” he explains.

“This is a very different set of issues than whether this or that sector can achieve earnings targets. Macro hedge funds are poised to do better and many have done particularly well during this recent period.”

Again, the JP Morgan line is that anybody can invest in hedge funds, but the private bank delivers the best selection of vehicles to clients. “We are not investing in alternatives just to get the average performance of alternative managers,” says Mr Basu. “The day we lose the ability to pick the better ones is the day we will exit that asset class altogether.”

As important as the selection and mix of alternative strategies is their number, with excessive numbers of underlying funds inevitably leading to market returns or worse.

“I recently met one investor with 86 lines in his fund of hedge funds,” said an incredulous Stefan Keller, head of managed account platform research at Lyxor Asset Management during a recent Hedge Fund Insights seminar in New York. Mr Keller’s research suggests that a combination of somewhere between 15 and 20 underlying hedge funds offers the most attractive potential portfolio return.

“A small number of funds is generally sufficient to reap most of the diversification benefits,” confirms Mr Keller. “The more you increase the number of funds, the better diversified you are, but also the more ‘industry average’ your risk exposure becomes. Average return is something normally obtained by uninformed investors.”

Currently, BNY Mellon is allocating between five and 10 per cent of wealthy investors’ portfolios to private equity, provided they are able to lock up capital for a period of five to 10 years

Insights from across the pond

Some of North America’s legendary hedge fund investors shared insights with the audience at a recent event in New York, held by PWM in conjunction with Lyxor Asset Management.

“I am pretty well loaded up in US technology,” confirmed Barton Biggs, founder of Traxis Partners, former chief global strategist and 30-year veteran at Morgan Stanley, where he was known as “the ultimate big picture man”.

New technology continues to be an exciting investment area, he says, singling out flash memory card and data storage provider SanDisk. He also mentions the “old tech” trio of Cisco, Intel and Microsoft as “not the fastest growers, but very cheap and growing faster and with a lower P/E than the rest of the market”.

Marathon Asset Management’s CEO Bruce Richards talked about the 2 per cent default rate which should still be able to generate returns of more than 6 per cent in distressed, high yield opportunities. He also drew attention to collateralised loan obligations. “I have never seen so many clients knocking on our door saying they want to look at this asset class for a small piece of their portfolio, on a diversified basis, to perform well,” said Mr Richards.

Jordi Visser, CIO at Weiss Multi-Strategy Advisers, pointed to the 5 to 7m students graduating each year in China, leading to greater risk appetite and a more advanced business culture in the country. “People will take more risk if they are educated,” he said.

He advocates playing this theme through buying foreign companies doing business in China, or through investing in Hong Kong’s Hang Seng index, up 12 per cent in the first three months of 2012, its best first quarter rise since 1993. “People are worried about what is happening in China, but it is still very low risk,” insisted Mr Visser.