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For drivers trying to park in Beijing, six out of every seven will be disappointed. This is because only 740,000 parking spaces have been built to accommodate the 5 million cars that enter the city each day—and the number of cars is rising.
There are some of you thinking that’s an interesting statistic. There are some wondering how many spaces there are in London/Manhattan/Sydney that makes your daily commute such a drag. But there are others—the sharpest ones?—considering how they can take advantage of the situation for their investment portfolio, and it is these people who are pushing the boundaries to the New Alternatives.
Time was that breaking off a 2% piece of an institutional investment portfolio to buy a mix of hedge funds, private equity, and/or real estate was seen to be something of a statement. One of the most forward-thinking European investors went on the record-and was hastily taken off by his PR—as saying his portfolio had allocated to hedge funds in late 2008, likening it to conducting an intimate act in public.
Hedge funds used to be exciting; private equity used to have a whimsical charm that enticed and alarmed institutional investors in equal measure. Now they, along with stablemate real estate, enjoy allocations of up to 20% in most sophisticated portfolios. The annual Global Pension Asset Study by consulting firm Towers Watson showed that at the end of 2012, the average allocation to “other”—meaning anything outside bonds, equities, or cash-was 19%, up from 5% in 1996. This average took into account pension fund investors across the globe, including the ends of the spectrum: By the end of last year, Japanese investors—the second largest group in terms of assets—had a 7% allocation to “other”; the Swiss, with one of the smallest combined asset piles, had allocated 30%.
This shows that “alternative” is a misnomer for asset classes that have become mainstream to most sophisticated investors. Labels don’t matter if the performance is there, but sadly, many in this category have failed to exceed expectations in recent years: The Hedge Fund Research Index shows that across this sector, the average return has lagged the S&P 500 over the last decade.
Correlation is also a key point for investors to consider as these asset classes were meant to be “the great diversifiers”; but disappointment is apparent here as well. In September 2011, correlation between hedge funds and the S&P 500 rose to a record 98%, according to analysis by Merrill Lynch. This measure had fallen to 82% a year later and remains in similar territory, which is significantly above the 30% historical average, the investment bank said.
To clarify, this article is not a call for investors to turn on these asset classes and run. Indeed, they are working very well in many institutional portfolios—but they no longer do the job for which they were intended because the diversification benefits are no longer there. Investors need more options.
There are two main tactics to breaking new investment ground. The first is approaching mainstream asset classes in a new way; the second is going completely left field.
For the sake of championing innovation, let’s go with the second theme first.
What was the last song you heard on the radio, an iPod, or in a shopping mall? Chances are, someone in the Netherlands benefitted from you listening to it.
APG, the sole asset manager of Europe’s largest pure-play pension fund ABP, bought the royalty rights to 30,000 songs in 2009, so each time one of them is broadcast, a few cents goes to top up the retirement assets of Dutch civil servants.
“The original idea came from one of our employees,” said Dempsey Gable, the fund manager of APG’s Opportunity Fund. “We ask everyone to come up with new ideas—we have looked at hundreds.”
Gable is based in New York and oversees the fund that was launched when APG was still run in-house at ABP in 2006. “We had 13 other funds that invested in traditional asset classes—real estate, infrastructure, financial instruments—we wanted to create something for new ideas, for unique and unconventional investment concepts,” he said.
The new fund took an approach that APG describes as "tactical, one-off, and opportunistic"—Gable calls it sourcing the "innovation premium"—but is based on looking for investments that offer deep value to the fund and take a long-term view of the macro-economic landscape. "We have themes, but are open to new strategies. If we think something is worth pursuing, we will do so-we don't have to be looking to commit huge amounts to it," he said.
The fund has also been benefiting from our couch potato tendencies. It took stakes in film rights and whole series of popular television shows, most notably crime drama CSI, which is one of the most viewed in the world. The back catalog of the musical theatre legends Rodgers & Hammerstein belongs to the fund too, so you can bet return on investment goes up around Christmas time as we watch Julie Andrews and cast "Climb Every Mountain" amongst other seasonal favourites.
Buying media rights might seem like a simple task compared to hedging out volatility or currency movements, but accessing these investments is not straightforward. "You need someone with experience, who knows what they are doing," said Gable. "Not a banker or analyst who has worked on deals between media companies. You need someone who has actually worked in this area and knows it inside out. And if something is so complex you can't see a way of investigating it thoroughly, you walk away. As attractive as an opportunity may seem, we always remember that we are investing pension fund money."
This is a key point about the New Alternatives. Arguably anyone with a calculator, phone, and Internet connection (plus an appetite for taking risk) can invest in equities—they can even go short or long, and watch for market events given enough time. With a healthy appreciation of the yield curve and access to a Bloomberg terminal, government bond investment is relatively straightforward. Corporate bond investment is trickier, but it does not require in-depth knowledge of each company and sector from which debt is bought. Why else would these functions be the first brought in-house by a pension fund taking control of its own asset management?
The New Alternatives cannot be run by just anyone and it is therefore unlikely they will get overcrowded, which is a criticism that has been levelled at the hedge fund sector. A poll published by SEI Investment Management Services last month showed almost three quarters of institutional investors were put off allocating to hedge funds due to the number of "me too" vehicles being touted in the sector. It seems the most sophisticated institutional investors need innovation to be either more obvious or more eloquently explained to allocate capital to the sector, especially when they are covering the basics in-house.
Private equity investment has not received as much criticism as hedge funds for two main reasons: First, there has been less to criticize. Fundraising ground to a halt during the financial crisis and as investors were looking for new ideas in the aftermath, many private equity houses found they were unable to access the kind of leverage available before the Lehman Brothers collapse. Second, the long-term investment nature of these funds means returns earned over the crisis are only just being released to investors. In some cases, this is being further delayed due to the poor appetite for IPOs, meaning the stockpile of privately owned companies is reaching record levels.
Back to the diversifying tactics. In June 2011, a study from Marquette Associates using data from 1992 to 2010 showed a 70% correlation between a global sample of pooled private equity funds and the S&P 500. During this time, the BarCap Aggregate index of bonds had a 15% negative correlation.
This makes intuitive sense, as many of the companies being bought and sold after a restructure were similar businesses to those available on public stock markets. Over time, the term "private equity" has come to describe a narrow set of operations when it should be a catch all for much more—many of the New Alternatives are private equity investments.
Floating, in its traditional sense rather than being associated with financial markets, has been impressing European investors of late. When asked for their asset class pick to contribute to our Forty Under Forty graphic (see page 8), two out of the 15 Europeans on our list cited shipping as being one of their favored options.
One corporate fund CIO, who allocated to the sector last year, explained the pull of the asset class: "It is your ship, a real asset—it is not a derivative—and you can break a bottle on it and see where it is in the world using satellite navigation. There is no stock market involvement and its value is not dependent on fluctuations in those markets."
Of course, if the global economy is depressed then there is a knock-on effect to the number of ships in service transporting goods. But shipping has the jump on other sectors linked to the import/export cycle, the CIO said. "Unlike other real assets, like property and infrastructure, ships do not have to be stuck in undesirable locations. The smaller ships are like taxis and can easily access some of the emerging market ports that are not as well established as others around the world," he said.
Just like music publishing, or any other esoteric investment, shipping is a multi-billion dollar industry—so knowing where and how to access the market is essential. It is unlikely a pension fund, endowment, or other institutional investor will have the resources in-house to enable it to take the plunge, but that should not be a barrier, according to acolytes of the New Alternatives.
"You don't have to be of a terrific size to access these new markets," said Gable at APG. "You just have to find a manager who has the skill set and a track record—you don't want to be the first ones there—and knows how to report to institutional investors."
Sifting through mailbags full of pitches from these potential new fund managers is Alan Goodman, principal in fund management at the UK's Pension Protection Fund (PPF)—the lifeboat for bankrupt company pension schemes—and head of its 20% allocation to alternatives. (He is also in our Forty Under Forty on page 36.)
The £13 billion fund announced last year that it was allocating to timber and agricultural land (which we will come to later), but Goodman has been presented with a much wider range of options in his three years at the PPF. "We receive lots of new ideas each week—some of them are really different—but we just don't have the time and resources, like many of the larger institutions do, to look into it all as closely as we would like," he said.
What the fund has been doing, however, is looking at traditional asset classes in a new way, which brings us to the other prong of the New Alternatives approach that investors are beginning to embrace. "Some alternatives, private equity for example, are not really alternatives," said Goodman. "We are approaching traditional asset classes in innovative ways, which creates novel ideas. In fixed income, we have looked at asset-backed securities and senior loans, credit and mezzanine debt where long-term investors have been relatively smaller players. Now that many links with banks have been broken, this sector is evolving much faster than ever before."
Nick Spencer, director of consulting at Russell Investments, noted that there had been an evolutionary shift in credit markets since the financial crisis as banks had seen regulators force them to wind down lending and improve their balance sheets. This had left a gap where long-term investors (what aiCIO calls Secret Capital) can step in. "Opportunities are there if you know where to look and how to access them," said Spencer. "These opportunities were once just available to banks, hedge funds, and other sophisticated financial institutions—it was very much a relationship-driven business."
Since cheap credit dried up, the doors of this closed world have been pried apart a few inches—rather than flung wide open—and only the very sophisticated should get involved directly, warns Spencer. "These deals are sometimes only open for a matter of hours," he said, "so a co-investment strategy is often an option, and investors have to have completed full due diligence before taking part. Some managers have created innovative structures and vehicles that make some of the more exclusive opportunities available to a broader set of investors."
By taking part in these deals, institutional investors are replacing investment banks with pools of assets sitting ready to be put to work. Therefore pipelines of capital have to be made available by the new entrants to these situations, and investors may have to be willing to wait four to five years before they see any action—or returns.
Pension Corporation, the specialist pension reinsurer, has been banging the drum about long-term investors stepping into the direct lending market where banks have had to pull back. Mark Gull, co-head of asset-liability management at the firm, told aiCIO last year that unwinding bank balance sheets made happy hunting grounds for institutional investors, then announced it had bought a £50 million bond issued by a social trust, Raglan Housing Association, in September.
A week earlier, Dutch pension fund investor PGGM revealed it had bought a 60% stake in the UK's largest student housing landlord, University Partnerships, from bulge-bracket bank Barclays. The deal was estimated to be worth £840 million and marked a new type of real estate investment that was additionally taking advantage of the breakdown in the banking sector.
Taking assets off banks' balance sheets is just one side of the equation. The New Alternatives consider another: investing in their equity—and rely on the belief that they are not completely rotten.
In September 2008, the collapse of Lehman Brothers confounded many thousands of people working in the bank around the world. Why? Their units had been hugely profitable for years. Third-party investors in the bank lost everything, or so much that it was uneconomical to figure out the exact details, as they were exposed to the whole banking giant. Banks have since bounced bank and many are reporting record profits. So what if there was a way to get exposure to the parts of the bank that are doing well and insulate investment from the parts that look risky? It seems there is—and pension fund money is looking at it.
There are two main ways of making a bank compliant with Basel II regulations: trim its balance sheet or boost its equity component. Most banks' cost of capital has made it too expensive to hit up equity markets, and with an estimated $2.5 trillion shortfall, it is unlikely that investors will be willing to put up the total cash required.
A new idea being touted by a partnership of former bankers is to post equity against a profitable unit of the bank in a watertight contract. This contract sees the investor act as guarantor and reap a slice of any profits made by the section. The capital would be drawn upon only in the event of a loss being made by the section creating a "risk transfer" arrangement. This enables the bank to spread the capital it already holds around to its more needy units and strengthen itself to Basel II standards. Importantly, the posted equity is held in US Treasuries in an escrow account and even if the bank collapses under the weight of its loan book, the investor's capital is not touched.
For those still smarting from the financial crisis, or are unconvinced by the great banking turnaround in recent years, a more digestible idea has been gathering pace recently. Money may make the world go around, but those living on it will always need food, and agricultural land—a real estate derivative—has become a popular theme.
Legendary investor Jim Rogers said he was buying farmland at the turn of last year, and stepped alongside many larger institutions. Railpen, one of the largest pension fund investors in the UK, -allocated to agricultural land last year along with the aforementioned PPF.
And the numbers are compelling. Between 1964 and 1966, the average person (geographical situation averaged out) consumed 2,358 calories a day, according to the Food and Agriculture Association of the United Nations. By 2015, this is estimated to jump to 2,940 a day, eventually rising to 3,050 by 2030. The breakdown of these calories has leant increasingly toward to animal products, which require huge quantities of feed to be cultivated—which in turn requires lots of land.
More widely, commodities need reinvestigation, as the world is unrepentant in its appetite to consume (in all senses of the word). This sector was often lumped beside hedge funds, private equity, and real estate as a good diversifier, but tremendous shock waves that hit some headline investments convinced many that the sector was too unreliable for them.
The world continues to turn, however, and its resources are needed more than ever. As oil reserves dwindle, renewable energy comes to the fore; as developing nations industrialize, their citizens need waste water facilities. This all falls under the commodity banner. The task, however, is accessing these markets. Like the other New Alternatives, it's also about finding the right person to do it, for regulation and popular sentiment may have an impact that only an expert could recognize and pre-empt.
"Commodities are an interesting, challenging, and vast category," said Peter Tobeason, partner at Silvercrest Asset Management, a specialist in the field. "Investors start out with an index, which is an appropriate first step, but the next step is to figure out how to get specific exposures." Many investors were burned by commodities in years past, either by holding too broad a basket or not being prepared for the volatility the asset class contained. By taking a long-term view and actively managing exposure, Tobeason says risk can be reduced by more than 50%.
Once again, the banks that once traded these goods have shrunk away from all but the most solid of markets, according to Tobeason, and while gold and other mainstream commodities react to macro-economic influences, others remain disconnected from market sentiment. This disconnection is the key to diversifying—to which hedge funds, private equity, and real estate can no longer lay claim.
APG's Gable refers to the innovation premium, something only those willing to dare to be different can achieve. In the post-crisis search for assets that can truly diversify portfolios, we might soon all be wondering how we got by without an allocation to Chinese car parking, the musical Oklahoma!, or pharmaceutical patents—or at least be thanking the Dutch for investing in them.