Column: The Rise of Liquid Alternatives | Chief Investment Officer

As institutional investors have decreased equity allocations, the biggest investment management trend in recent years has been around systematically capturing alternative risk premia. This has benefited so-called “marketable” and “liquid” alternatives.

Let’s take endowments and foundations (E&Fs) as an example of sophisticated long-term investors and trendsetters, first by examining their exposure to alternatives, and then by breaking down their specific alternative asset allocation.

Our research shows a huge discrepancy in alternatives allocation for E&Fs by size and sophistication. Large endowments with more than $1 billion in assets under management have 60% of their assets allocated to alternative strategy.

Given the resource and research requirements to adequately allocate to alternatives, the allocation drops in linear fashion down to 10% exposure to alternatives for endowments with less than $25 million in assets.

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However, allocations to alternatives overall have grown in recent years for endowments of all sizes, with alternatives accounting for 53% of E&F assets overall.

Importantly though for liquid alternatives, marketable “liquid” alternative strategies account for 60% of alternatives exposure for small endowments. This number decreases to 34% for the largest endowments.

As smaller institutions have to deal with their boards on liquidity and the overall comfort of alternative exposures–and also have less staff and resources to dedicate to alternatives–liquid alternatives have benefited greatly.

This is not only true for E&Fs. Public and corporate pension plans increasingly are looking to capture alternative risk premia at long-only fees, and their trustees and boards are more comfortable to start out with liquid forms of alternatives.

As traditional and alternative investment products are converging globally, the net flows to hybrid vehicles are becoming meaningful. Here are a few examples:

1) AQR in the last few years has amassed $12 billion in liquid ’40 Act funds, close to 15% of total assets. Managed futures and diversified arbitrage each have around $3 billion in assets, but there are now four risk parity funds growing fast.

Standard Life has raised $30 billion in their Global Absolute Return Series since 2008, transforming an internal defined benefit investment strategy first into UK and then a cross-border global product with a majority of assets lately coming through higher fee external assets.

And then there is the PIMCO commodity real return strategy with $20 billion in assets, which has been around in the US for more than a decade with a portable alpha approach.

We will likely see much more activity as alternatives move from satellite to core allocations in institutional, high net worth and even retail portfolios.

Endowments’ Asset Allocation by Size of Institution

Enskat_Endow Allocation

Source: 2011 NCSE survey of 823 endowments

Notable recent examples include Franklin Templeton buying K2 to build alternative investment solutions, GCS in Hong Kong purchasing Dexia in Europe to introduce broad capabilities in Asia with the Industrial and Commercial Bank of China, Legg Mason buying Fauchier Partners, and KKR selling its flagship strategies through Charles Schwab.

Smaller hedge funds and alternative managers will especially be trying to combine their expertise with long-only or more liquid strategies, because they are dealing with fee and other pressures in discussions with clients.

Challenges are mostly around product design, regulatory constraints and finding the right people to implement liquid alternative strategies and manage derivatives. As a result, most of the top liquid alternative funds spend a lot of time on educating clients and advisors on leverage and derivatives.

The top 15 liquid alternative funds both in the US and globally each manage a total of $180 billion in 30 funds, while many other funds have not been able to attract meaningful assets.

In other words, the main trends discussed in my prior columns–the blockbuster phenomenon (winner takes all) and the era of multi-convergence (convergence of products, distribution, regulation and geographies)–very much apply to the liquid alternatives discussion.

A handful of managers will gather large amounts of assets and establish strong brands with institutions, private clients and key consultants, while many others will struggle. The good news is that the secular shift for alternatives from satellite to core allocation is just beginning.

Time to develop a simple story for a complex proposition.

Daniel Enskat is senior advisor to Asset International and founder of Enskat & Associates

Endowments’ Alternatives Allocations by Size of Institution

Source: 2011 NCSE survey of 823 endowments

(July 9, 2013) — The solvency requirements hanging over European insurers have restrained investment into illiquid assets, according to Friends Life’s CIO.

Mark Versey told aiCIO of his frustration at Solvency II’s shadow over the industry, but he remains keen to gain exposure to the asset class, especially loans.

“We’re making sure that when we go into the markets, we’re doing it in as friendly a way to Solvency II as we can,” he explained.

“It’s a bit of an unknown, but for example [with loans] we’ll try and restrict the pre-payment risk. We can also constrain the ratings, the term of loans, and some of the conditions. In the detail, we can give ourselves the flexibility to change that mandate over time. We’re just trying not to take on anything today that we might regret under Solvency II.”

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Versey oversees two major pools of assets–the legacy with-profits funds and the annuity business–in addition to the Friends Life Investment asset management arm. The total number of assets he is responsible for is £95 billion.

The traditional strategy for an annuity business is core fixed income, such as investment grade credit and government bonds. But, as with other insurers, Versey has shifted away from that in recent years, and is looking to more illiquid asset classes for yield.

The annuities side of the business is split into three areas, the short, medium, and long-dated.

“The typical illiquid strategy we might employ for those are infrastructure loans for the long end, commercial real estate loans for the medium term and loans to small and medium enterprises in the short end,” Versey said.

That philosophy can be seen in Friends Life’s recent announcement of a partnership with Pramerica Investment Management: the insurer awarded a £500 million mandate to Pramerica’s commercial mortgage business.

The mandate relates to the investment in commercial real estate (CREs) loans in Friends Life’s annuity funds. The CRE assets will be UK-based, senior secured, fixed rate loans with maturities of between five and 15 years, and originated by Pramerica’s London-based mortgage business, Pricoa Mortgage Capital Company.

CREs aren’t an entirely new venture for Friends Life; it already holds loans in its with-profit fund, but this new mandate is specifically designed for the annuity portfolios. Another mandate is due to be announced for the with-profit fund soon.

Despite his clear liking for illiquid assets, the recent flurry of announcements from fund managers claiming insurers are becoming more risk-on with their asset allocation confused Versey.

“The risk appetite of the insurance sector is very determined by the solvency constraints of the business. I would be very surprised to see the risk appetite of the insurance sector had gone up, because the regulatory environment hasn’t changed at all,” he said.

“Therefore the only reason risk appetite could have gone up is if, as the market rallied in almost all asset classes, it created surplus on the balance sheet of insurers and they decided to say ‘I’m going to use that surplus to increase my risk appetite’.

“That’s not something we’re doing here. I do see a move from insurance land into more illiquid asset classes, and [insurers acting] the potential replacement of banks for some of the loan market, particularly with infrastructure commercial real estate loans.

“But I don’t see that as increased risk, it’s diversification of existing risk. It’s an increase in illiquidity risk I’d guess, but most of the insurers have very illiquid liabilities so they’re in a good place to take those opportunities.”

Spotting opportunities

One of the better opportunities Versey took was to shift from gilts into corporate bonds. He names the decision as both the most challenging and the most rewarding of his job since the advent of the 2008 financial crisis.

Although seemingly a simple decision, Versey said it represented a change in the risk budget for the overall group, making it a difficult one.

But with QE in the UK pushing interest rates down to such low levels meant, he felt he had no choice but to sell gilts.

“Since then credit spreads have tightened quite significantly, which has made the [sale] valuable. Making the decision at the time wasn’t easy, but it seems easy in retrospect,” he added.

Where does Versey see the market going in future? In equities he continues to see value, even though the markets had “overshot somewhat” during the recent spring bull run, prompting him to trim some of his holdings.

“In terms of opportunities in the current market, we’re in a bit of a watch and wait scenario. Everything’s being led by the US government and its monetary policy. Here in the UK we’re waiting to see what Mark Carney will do,” he continued.

“On credit, which has been a great asset class for us, we continue to see value. The widening of spreads recently reflects a bit of an overshoot, and that gives us some opportunities to relook at our exposure, and potentially increase our holdings. It’s quite small beer in some senses though.”

With gilts, Versey’s biggest focus is on interest rate exposure. “We’ve spent a lot of time in the past few years focussing our management information to assess all of our liabilities and assets across the business, and which part of the curve they are exposed to,” he said.

For the with-profits section specifically, Friends Life has a fairly stable equity exposure, forcing Versey’s team to spend a lot of time managing the risks around the guarantees which lot of these products were sold with.

The rest of the asset mix comprises various fixed income and alternative assets, including private equity property, and private loan portfolios. Interestingly, Versey’s not currently an investor in hedge funds.

On the annuities side, Friends Life spends a lot of time on optimising its strategy and getting its risk management information correct, so it can break down liabilities into lots of different buckets.

Focussing on managing interest rate risk has also taken precedence recently, along with a lot of what he calls opportunistic investing.

This includes buying index-linked gilts on an asset swap, looking at illiquid asset classes, shifting ratings of buckets, investing in credit, as well as doing collateral upgrade transactions.

“A lot of [the decisions] in that portfolio has been opportunistic and it’s paid dividends,” he concluded.

Versey’s final focus is on the relatively new asset management arm. Friends Life Investments was launched in July 2012 with $6 billion, and currently has £11 billion under management.

The rise in assets is in part due to those captured from external managers, Versey said.

He continued: “Our core is fixed income, gilts, credit, cash. The direction of travel was to manage those in-house and, a year on, we’ve substantially expanded the amount of assets we’ve captured externally.”

It’s an interesting paradox at a time where we’ve seen rising numbers of insurers outsourcing all of all of their asset management.

The leading pension funds, and latterly sovereign wealth funds, have been bringing their asset management in-house–perhaps Friends Life is the start of insurers doing the same.

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