Alternative investments

Attractive opportunity puts demands on your operating model

Read this article and learn about:

  • What alternative investments mean for your operating model
  • How alternatives represent an opportunity and a challenge
  • Viewing alternatives in a holistic portfolio context
  • How to prepare for the challenge of alternatives in your portfolio
  • What operational framework best suits alternatives

About the author:

Jørgen Vuust Jensen, CFA, is Domain Manager for Financial Instruments at SimCorp, Copenhagen, Denmark.

 

An alternative investments specialist, Jørgen Vuust Jensen has more than 15 years’ experience in financial technology, most of which have been spent with SimCorp in various roles. In his current position, he oversees the strategic direction and development of financial instrument support in SimCorp Dimension, ranging from bonds over derivatives to alternative investments. Jørgen Vuust Jensen holds an MSc in Business and Economics from the University of Southern Denmark.

In the current market environment, more and more investment managers see alternative investments as an attractive investment opportunity for alpha generation. However, to reap the promised potential, you must view them in a holistic portfolio context and be prepared for the challenges and pitfalls entailed. Alternative investments differ markedly from traditional investments in fixed income, equities, and derivatives – and this could challenge your operations and operating model.

Alternative investments are the talk of the town these days. As a substitute for traditional investments, asset owners have been gearing up on various forms of alternative investments for some years now. Declining, and currently extremely low, interest rates and a stock-market rally that might be at its peak are forcing asset owners to seek new investment opportunities. Alternative investments represent just such an opportunity for alpha generation.

We often hear that alternative investments possess the following four desirable qualities:

  • superior returns
  • low correlation
  • inflation protection
  • long-term investment horizon

Alternative investments are, however, not an easily defined, homogenous type of investment. If we consider alternative investments as covering Private Equity, Direct Investments, and Hedge Funds (See Figure 1), we obtain some similarities but certainly also differences.

What are Alternative Investments?

Everyone talks about alternative investments these days, but the meaning can differ. Here we define alternative investments rather narrowly to include primarily Private Equity, Direct Investments, and Hedge Funds, focusing more on the differences in managing these investments than on the differences in the underlying investment object.

Examples of typical investment objects in the alternative investment segment include:

  •  Private Equity (Leveraged Buyout)
  •  Direct Investments (Real Estate, Infrastructure, Renewable Energy, Wine, Music, Art Patents)
  •  Hedge Funds (Long/Short, Global Macro, Quantitative)

Figure 1: Definition of alternative investments

 

 

Superior returns

We will not attempt here to provide proof whether this is correct or not, but illustrate that the truth is a bit more complex. Taking Private Equity performance as an example, data reveals that in recent years, the performance of the S&P 500 Index has been on par with or outperformed (3-Year horizon) most Private Equity benchmarks (See Figure 2). However, on a 10-year horizon, Private Equity outperforms S&P 500 significantly, as shown in the dataset.

Performance data collected by Private Equity Growth Capital Council Journal 740x468

Performance data collected by Private Equity Growth Capital Council, March 2014, http://www.pegcc.org

A comparable dataset for Q4 2011 puts Private Equity in a more favorable position as it outperforms S&P 500 on one-, five- and 10-year horizons with 5-7% points (see Figure 3). Only on the three-year horizon does S&P 500 fare much better.

Performance data collected by Private Equity Growth Capital Council Q4 Journal 740x468

Performance data collected by Private Equity Growth Capital Council, Q4 2011, http://www.pegcc.org

The example clearly illustrates that returns depend on the time period examined, and that Private Equity does not always emerge as the winner.

It is also worthwhile observing that performance seems to be persistent – at least in Private Equity funds. High-performing funds continue to perform well and vice versa (see Kaplan and Schoar, 2005).1 This sounds intuitively correct. The big successful funds get to choose first – the smaller players get what is left.

Low correlation

This might be true for some types of alternative investments but not necessarily all. A solar park with a government-guaranteed feed-in-tariff will produce a steady revenue stream as long as the sun shines – and the government does not change its mind. However, other direct investments, such as real estate or infrastructure, can exhibit higher correlation with other more traditional investments, as global and local economies play a role, and investing in a long/short hedge fund might effectively just change the composition of your equity portfolio.

Inflation protection and long horizon

Investments in certain types of tangible assets such as real estate, for example, will often have cash flows linked to inflation and the asset value itself increases with inflation. This is a nice quality for long-term investors like pension funds. Similarly, the fact that many types of alternative investments (i.e. toll roads, renewable energy, etc.) will generate a steady long-term income stream is attractive to many asset owners.

For the asset management industry, alternatives represent a high margin product for alpha generation, as depicted in the graph from Boston Consulting Group (see Figure 4), and we have seen an increasing interest and concrete initiatives among traditional asset managers to offer various types of alternative investment products. For the asset owners, the question is of course whether the evidently superior returns and other desirable qualities justify the higher cost.

Global Asset Management 2014 Steering the Course to Growth Journal 740x610

Global Asset Management 2014: Steering the Course to Growth’, Boston Consulting Group, 2014

There are certainly qualities that count in favor of alternative investments, but it is always worth questioning whether these qualities really apply to the specific investments considered.

Alternatives in a holistic portfolio perspective

Asset managers have traditionally viewed alternative investments as a separate investment from the remaining portfolio. A fixed share of funds was allocated to alternatives, and these were managed more or less independently from the rest of the portfolio. However, alternative investments should, as all other investments, be viewed in a holistic portfolio perspective to gauge correlations, exposures, concentration risks, and expected returns.

Risk assessment

There are numerous cases where alternatives affect the portfolio’s risk profile – some obvious and some more subtle and difficult to identify. It is a challenge to discover all these related risks and exposures. Doing so requires state-of-the-art data management and risk analytics capabilities.

Such capabilities are generally available when it comes to looking at traditional investments, where for example the equity portfolio can be sliced, diced, and analyzed for numerous attributes. However, similar capabilities are not always available for alternatives. It is very common to find these investments represented in the portfolio overview as a single record, i.e.: ‘Invested EUR100 million in Private Equity Fund ABC’.

Data on alternative investments can be scarce or a long time materializing. This is gradually improving though, as asset owners require more detailed and timely information. One requirement has its roots in the need to consolidate risks and exposures across the portfolio. Keeping positions together in the same system, trying to maintain the same data attributes and structures, decomposing investments where the content is available, etc. are all essential to obtain the consolidated portfolio view and insights from the data.

Cash and liquidity

Similarly, cash and liquidity should be viewed in a holistic portfolio context. Optimal utilization of cash requires that all cash flows be taken into account, and alternative investments add some complexity to this. First, alternative investments are typically illiquid investments, so cash must be available to fund these investments over a long time horizon.

Second, it must be possible to free cash to support commitments when demanded. Third, for some investments it will be virtually impossible to predict cash flows, whereas others have quite steady predictable cash-flow streams.

Managing alternative investments – a different game

Managing a book of alternative investments differs from managing a book of equities, or other traditional investment objects. Skills, competences, people, processes, timing, risk management, and systems are issues to consider.

The first question could be: “Do we have the right contacts and size to seize the right investment opportunities? Do we have the right people with the skills and competences to analyze and manage these investments?”

It starts with the selection process. Who do we want to invest with? Who do we know? Who do we trust? Who will allow us to participate? The largest and most successful private equity and hedge funds are not open to everybody and here it might be worth remembering Groucho Marx’s words: “I don't want to belong to any club that will accept me as a member.”

With respect to people and skills, it might be that you have a great fixed-income team, but do they know about toll roads, renewable energy, or selecting the best hedge funds to invest in? Alternative investments tend to be more like stock-picking, i.e. performing numbers and data crunching to pick the best opportunities.

The second question could be: “How do we assess the risks in a portfolio context and take all risk factors into consideration?”

To answer this, you need to be able to decompose the investments considered in risks and exposures and view this in the context of the existing portfolio. In other words, you need a system where all positions are maintained and available for analysis to get the full picture and identify areas of concentration risk, etc.

However, you also need to consider the risks and exposures specific to the alternative investment under scrutiny. For example, investments in renewable energy are often highly dependent on existing legislation and government pledges to pay a high feed-in-tariff for a number of years. How do you quantify the risk of the government changing its mind? There seems to have been a tendency to ignore such risks, but as Spain has shown us, they are very real. Your processes and systems should support tracking such risks and allow you to quantify them in scenario analyses and similar.

Liquidity is another risk factor to consider. Because alternative investments are generally illiquid, it is imperative that liquidity is available to support the investment – also in times of market turmoil or outright crashes. Trying to sell off such investments to obtain liquidity at the wrong time can be costly.

The third question could be: “Do we have the system support and processes required?”

Now that you have selected one or more investments, you need to manage them. Excel works fine as long as there are only one or two investments to track. When more is added, Excel starts to become an obstacle and you need to start looking for better system support.

Look for flexibility, analytics capabilities, and a holistic portfolio view. It is essentially all about data. As you might choose to move into other investment types and objects, you will need system flexibility, as the data needed to track, manage, and monitor these investments differs. You will want the flexibility to model and customize data structures, financial models, budgets, etc.

When it comes to analysis, all data must be available. As an example, your asset management system should be able to answer questions like: “Which vendor provided the solar panels across my 20 solar parks?” This is certainly a relevant question to ask if problems arise with the panel from a specific vendor in one park. While the portfolio manager might not be involved in the daily operation, detailed information on the investment is needed to manage it in a portfolio perspective.

An asset management system that supports a holistic portfolio view is imperative to gauge the concentration and correlation risks that might appear in a portfolio, but also to manage such risks. Hedging unwanted FX exposure is much easier, for example, if both the FX hedge and alternative investment are maintained in the same system and the effectiveness of the hedge is readily visible.

Having a flexible and agile asset management system in place gives you a better chance of reaping investment opportunities when they appear. A high feed-in-tariff, tax subsidy, or other legislation that favors various investments might only exist for a limited period.

Conclusion

Alternative investments represent an attractive investment opportunity for alpha generation in the current market environment. The promise of a non-correlated superior risk-adjusted return on the one hand, and inflation protection and long-term sustainable cash flows from certain investment types on the other, are attractive qualities.

However, alternative investments comprise a diverse set of investment types based on different investment objects and do not necessarily share all these favorable attributes. The attractiveness of each investment opportunity should be considered in a holistic portfolio perspective.

Joining the alternative investments bandwagon might not seem an overwhelming prospect at first glance, but flexible support from your operating model becomes imperative once the investments increase. You need system capabilities to hold and analyze data from various investments, to view and analyze in a portfolio perspective, and to manage and hedge unwanted exposures and risks in the same system as all your other assets, your counterparty data, etc.

Your operating model and IT infrastructure should allow you to focus on analyzing and managing your investments – not just obliging you to spend all your precious time on data management.


1. http://www.mit.edu/~aschoar/KaplanSchoar2005.pdf

 

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