SPONSORED CONTENT | A demanding market and a better selection of high-quality products are leading more institutional investors to take up this maturing asset class, to fill a variety of needs.
Ten years on from the global financial crisis, institutional investors are grappling with how to ensure their portfolios are sufficiently diversified to be resilient in the event of another liquidity crisis or major market downturn.
For Australian superannuation funds, the challenge comes amid increased pressure to improve transparency and reduce the costs that make traditional hedge funds and private equity funds less attractive.
In this context, liquid alternatives-style strategies are finding favour with a number of leading funds, attracted to their liquidity, transparency and simple fee structures.
At a recent roundtable, hosted by Investment Magazine and sponsored by QIC, experts from a range of institutions exchanged insights into how they are using liquid alternatives and managing the associated risks.
It became clear that the phrase ‘liquid alternatives’ means different things at different funds.
Colonial First State senior investment manager Guneet Rana is responsible for the $44 billion multimanager’s roughly $1 billion alternatives portfolio. This includes alternative risk-premia, volatility, and macro strategies. The fund’s mandate prohibits investing in illiquid assets.
“To define what we mean by liquid, assets have to have a price valuation that is available daily,” Rana said.
Liquidity
The main role of Colonial First State’s liquid alternatives strategy is to diversify against traditional equity risk. Rana noted that genuine diversification is difficult to observe in benign equity markets.
“Although people might say they understand that the role of the strategy is a diversifier, when they see a negative return over a short period, they do question it,” Rana said. “You have to remain true to the objective the allocation is trying to achieve.”
At Statewide Super, an $8 billion Adelaide-based industry fund, the investment team is less concerned with short-term liquidity and tends to think in terms of growth alternatives and defensive alternatives.
“Liquidity is nice but it’s not really a focus of what we do,” Statewide Super investment manager Chris Williams said.
On the defensive side, Statewide is seeking out bond proxies, while on the growth side it is looking for ways to replace some equity risk via alternative sources of return.
QIC head of liquid alternatives Robert Swan explained that the $85 billion Brisbane-based alternatives house’s approach to building liquid alternatives strategies is to find systematic, factor-based exposures that offer excellent transparency.
“We’re looking for equity-like returns that are largely uncorrelated from equity risk,” Swan said.
The liquid alternatives strategies QIC manages are typically long-short funds, although they do offer long-only solutions for clients with mandates that preclude shorting.
The systemic risk factors that can be isolated and targeted include quality, value, carry, momentum, trend-following and volatility, across a wide range of liquid markets.
QIC was founded as the Queensland Government’s investment corporation, and the state is still the now-independent-firm’s biggest client. But QIC also manages external mandates for a range of institutional clients, including super funds and insurance companies – a growing number of which are adding to their liquid alternatives exposures.
Diversification
Mine Wealth + Wellbeing is a $10 billion Newcastle-based industry fund that is actively researching and investing in the liquid alternatives space.
“We’re actively in due diligence across a range of liquid alternatives strategies under our competition for capital model,” Mine Wealth + Wellbeing senior investment analyst Robert Graham-Smith said.
The fund’s liquid alternatives universe includes non-benchmark, absolute return-oriented investments, Graham-Smith said. These can be implemented via non-traditional asset classes; however, they can also include strategies that apply a long-short approach to a traditional asset class, or multi-asset funds that include a combination of alternative assets and long-short exposures to equity or debt. Typically, an offering needs to be accessible via readily traded securities to be considered for the liquid alternatives portfolio.
Cbus Super hired Scott Pappas last year as a senior portfolio manager with responsibility for building out the $40 billion construction industry fund’s liquid alternatives portfolio via mandates to specialist external managers.
“At Cbus, we define liquid alts as dynamic, long-short strategies that are implemented in exchange-traded or over-the-counter markets…so it’s a pretty broad church,” Pappas said. “The main goal is to provide diversified returns, particularly in relation to equity beta and fixed income duration.”
Over time, Cbus has a target to allocate roughly 5 per cent of its overall portfolio to liquid alternatives, he said.
The goal of the liquid alternatives portfolio is not to outstrip returns from the equity portfolio, but to diversify the overall portfolio and reduce sensitivity to equity market risk without dampening fund-level returns, Pappas explained.
Equip Super is also lifting its allocation to liquid alternatives assets. The $15 billion Melbourne-based industry fund’s executive officer, investment strategy, Troy Rieck, said the big challenge in picking liquid alternatives strategies is finding products that will prove their worth in down markets.
“You actually want this stuff to be liquid, which is easy in good times and quiet times, but what really matters is whether it will be liquid during distressed times and act as a genuine alternative to the other things you’ve already got in the portfolio,” Rieck said.
Cost control
Over the last five years, Equip has been a big investor in bank loans, high-yield credit, distressed credit and macro-strategy hedge funds; however, it is harder today to find value in those areas, so the fund is searching for new risk factors to target.
Rieck is open to lifting Equip’s liquid alternatives allocation to potentially as much as 25 per cent of the overall portfolio, if he finds the right strategies with low enough fees.
“If you are thinking of making a 2 or 3 per cent allocation to alternatives, then you probably shouldn’t bother, because it isn’t going to make any difference to the bottom line risk-return profile of your fund,” he said.
Sunsuper is a $50 billion Brisbane-based superannuation fund with an established allocation to liquid alternatives within its hedge funds portfolio, but unlike the other investors participating in the roundtable, recent trends have led it to reduce its exposure to liquid alternatives.
“At this stage of the cycle, we think illiquid alternative strategies are more attractive than liquid ones,” Sunsuper portfolio manager Andrew Fisher said. “Our strategy will adapt as market conditions change, and we continue to invest in liquid alternatives; however, the current focus is definitely on finding more illiquid opportunities.”
Frontier Advisors consultant Michael Sommers works with super funds and other institutional clients on developing absolute returns portfolios, the bulk of which are invested via liquid alternatives strategies.
“The type of liquid alternatives strategy we would consider for a client’s portfolio very much has to do with the role they need it to play,” Sommers said. “Sometimes that’s very much about diversification, sometimes it’s about diversification and growth, and sometimes it’s about diversification and adding downside protection.”
Sommers also stressed the importance of investors being clear about the types of risks they are targeting.
“They have to fully understand the type of risk profile they are taking on…if they want to go high-volatility, well then understand the word ‘volatility’ is there for a reason and large monthly P&L swings should be expected, even if they may have diversifying properties for the wider portfolio.”
QIC investment director Neil Williams said one of the main reasons a growing number of institutions are investing in liquid alternatives is the need to ensure their portfolios are more genuinely diversified.
A number of QIC’s clients are using liquid alternatives to address underlying risks in their balanced portfolios, which tend to be dominated by equity risk.
“When designing or choosing a liquid alternatives strategy, it is vital to be clear about what the client is hoping to achieve with it,” QIC’s Williams said.
Liquid alternatives strategies can exhibit vastly different levels of expected return and volatility but a key differentiator is the implicit equity risk in various strategies. It will manifest itself differently, according to the type of equity market environment involved, and clients need to understand that.
Mercer director of portfolio construction research, Nick White, advises the investment management and asset consulting firm’s clients on how to build multi-asset portfolios with liquid alternatives.
He has found the biggest challenge for investment chiefs in building out a liquid alternatives portfolio is to set and communicate realistic expectations of how these types of assets might perform in different market conditions.
This discipline can also help fiduciaries prioritise the types of defensive strategies for which they are prepared to pay a premium, and make the most of their fee budget.
Clear purpose
In White’s view, the rising popularity of liquid alternatives reflects not just increasing demand for unique assets at a time when mainstream assets are more correlated, but also an improvement in what’s available.
“For instance, some of the early alternative risk-premia strategies were pretty unsophisticated,” he explained. “Now there’s a decent universe of sophisticated funds at a decent price point.”
QIC’s Williams, and others at the roundtable, noted that the Australian Securities and Investments Commission’s updated regime for fee and cost disclosure, known colloquially as RG 97, had sharpened many super funds’ focus on fees.
Swan said he hoped the regime wouldn’t lead to trustees becoming so distracted by management fees and transaction costs that they lose sight of the importance of evaluating strategies based on their expected return net of fees and costs.
All roundtable participants agreed that, given the complexity of liquid alternatives, it is particularly important to take extra care when communicating with stakeholders about strategies.
Not only is it critical to manage external stakeholder communications to ensure fund members’ expectations are realistic, but also internal exchanges with the investment committee and board must address their expectations.
Swan said this was because liquid alternatives strategies may exhibit different characteristics to more traditional investments, and are often perceived as more opaque.
Manager presentations to the board, investment committee workshops, concise documents with plenty of informative graphics, and, above all, unflinching honesty about associated risks were among the ways fiduciaries around the table said they ensured they explained liquid alternatives strategies effectively.
