David J. Selbovitz | Associate Product Development Manager, The Boston Company Asset Management, LLC
Adam B. Joffe, CFA | Director of Alternatives and Chief Administrative Officer, The Boston Company Asset Management, LLC
As risk aversion has remained widespread over the past several years, investors have allocated sizable portions of their assets to fixed income, despite prevailing low interest rates. The Boston Company believes that as the appeal of the low-yielding and overcrowded bond market wanes, more investors may choose liquid equity alternative investments. These strategies use equity market exposure to seek greater returns than those available from fixed income while also employing hedging and diversification to mute the volatility that often comes with equities. This class of assets may provide investors with attractive risk-adjusted returns and inflation protection as well as transparency and liquidity.
"Men, it has been well said, think in herds. It will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." — Charles Mackay, Scottish journalist, circa 1841
The financial crisis that began in 2008 brought with it high volatility, global economic uncertainty and widespread skepticism about the health of the financial system. These factors prompted a wide-ranging flight to quality and increased flows out of equities and into fixed income. Since then, fixed income allocations have remained high even as the economy has improved and equities have rallied. But earlier this year, analysts from The Boston Company noted that the fixed-income market now offers very little potential reward and significant downside risk:
"In an environment with improving economic growth prospects, investors should expect low-single-digit nominal returns at best — with a significant risk of negative nominal returns. With inflation close to 2 percent, real returns will likely be negative, even assuming that the inflation rate holds steady.1"
Maintaining large allocations to low-yielding fixed income assets could prevent many institutional investors from meeting their future payout obligations. According to a report from Congress's Joint Economic Committee, state-run pension systems are underfunded by $2.8 trillion.2 Meanwhile, U.S. corporate pension funds are maintaining their highest average allocations to fixed income since 1984, while equity allocations are at their lowest levels since that time.3 (See Figure 1.)
The financial crisis and the volatility that followed have changed how pension plans have allocated their assets, while the underfunded status of many of those plans has shifted their managers' priorities toward avoiding further losses.
"Reducing portfolio volatility has become a driving force for most institutions since the global financial crisis, as the Towers Watson Pension Index has fallen to new lows. Between 2007 and 2012, the assets held by pension plans around the world were only sufficient to cover an average of 74 percent of their obligations.4"
While the focus on risk seems a reasonable response to the events of the past five years, many plans are overdue to revisit their views about return. A recent survey of 126 public funds, sponsored by the National Association of State Retirement Administrators and the National Council on Teacher Retirement, showed that the funds were being managed with an average investment return assumption of 7.8 percent.5 But as Figure 2 shows on the following page, that assumption is at odds with performance. As of December 31, 2012, the median annualized investment return for public pension plans was 7.5 percent over the previous 10 years but only 2.9 percent over the past five years, according to Callan Associates. At current yields, the fixed-income and money-market asset classes cannot produce the returns necessary to fund plans' shortfalls.
As pension plans recognize their needs and seek ways to meet their future obligations, they are likely to move into a broader variety of asset classes. Alternative investments are potential beneficiaries of this shift in asset allocation. By the end of 2013, institutional investors are expected to raise their allocations to alternatives, especially to relatively liquid hedge funds, to an average of 25 percent of their total assets, according to a recent McKinsey & Company study.6
Investors no longer regard alternative strategies as exotic. In fact, a 2012 study of 151 U.S. institutional investors by Natixis Global Asset Management showed that 76 percent called alternatives "essential" for diversifying risk. Sixty-four percent said the time had come to replace traditional diversification and portfolio-construction models.7
Liquid equity alternatives appeal to investors because they provide a "confidence bridge" back into equity markets. By using equity strategies that can take short as well as long positions, these investors are less than fully exposed to the market. That means they can pursue upside total return through equity positions while maintaining a relatively low level of exposure to systematic risk. These strategies also provide some bond-like characteristics such as minimized volatility and a more concentrated distribution of returns made possible by the use of derivative instruments. Of course, these strategies do have their own risks, including the possibility that they may amplify losses under certain market conditions.
The rise of benchmark-agnostic investing mandates which considerably loosen the constraints placed on managers is helping to expand the use of alternatives. High-quality, active, long-only managers with these mandates can pursue alpha and expand their investment universe without being bound by a specific index's allocation weightings. This flexibility may prove particularly desirable in volatile markets. Benchmark-agnostic investing and equity long/short alternatives give skilled managers the freedom to control exposure as market conditions warrant, while making active bets in outperforming stocks.
At its core, active equity alternative management is about entrusting portfolios to managers who have a process and philosophy of managing downside risk and producing alpha without being fully exposed to market factors that impact both passive equities and fixed income. Equity alternatives can offer the potential advantages of attractive risk-adjusted returns, inflation protection, transparency and liquidity.
The past decade has shown the impact volatility can have on portfolios. Many investors believe that fixed-income investments, which offer timely interest payments and relative safety of principal, provide shelter from volatile markets. This view overlooks the risk that an issuer may default or have a trigger event and it presumes the investor will hold the security to maturity. Fixed-income investors also face risk from reinvesting income at today's lower rates and suffering reduced real returns if future inflation erodes purchasing power. Indeed, the value of long-term fixed-income investments (in terms of both risk and opportunity) can fluctuate significantly over the time the investment is held.
Figure 3 shows the return distribution for the equity Long/Short equity universe over the past 30 years. The distribution of monthly returns highlights the limited participation in down markets relative to the fixed-income index, while capturing more positive months. In fact, the Barclays Long U.S. Treasury Index has had 32 percent more negative months than the HFN Long/Short Equity Index, while only experiencing 88 percent as many positive months.
The key difference is total return. Over the past 30 years, the HFN Long/Short Equity Index has returned an annualized 14.7 percent, with a standard deviation of 10.6 percent, while the Barclays Long U.S. Treasury Index has underperformed by five percent on an annualized basis with a similar risk profile. Figure 4 on the following page shows that the nominal interest rate on a 10-year U.S. Treasury note has averaged 6.6 percent over the past 30 years. At the same time, the spread between the yield and inflation as measured by year-over-year change in the Consumer Price Index has averaged 3.6 percent.
|Years||Average 10-Year Treasury Yield (%)||Annual CPI Increase (%)||Real Rate (Required Return) (%)||Standard Deviation (%)|
Source: Federal Reserve, Bureau of Labor Statistics between January 1, 1983 through December 31, 2012
Investors have been settling for historically low real rates of return since 2008, even as the volatility of those returns — as measured by their standard deviation — has spiked. The real rate, a proxy for an investor's required rate of return, has averaged 1.2 percent over the past five years, compared with an average of 3.5 percent since 1983. Simultaneously, volatility has risen to 12 percent from the historical average of 10.5 percent. Over the same five-year time period, the standard deviation of the long/short equity universe has been 9.1 percent, roughly 25 percent less volatile than the 10-year Treasury note.
Like equities in general, equity long/short mandates are not directly impacted by changes in rates of inflation. However, since the financial crisis, there has been a direct correlation between inflation — as measured by the Consumer Price Index — and the Standard & Poor's 500 Index (Figure 5).
In an economic recovery, rising aggregate demand can raise price levels as real output grows. Rising demand and output can, in turn, raise corporate revenue, profitability and equity valuations. Meanwhile, the real return for the 10-year U.S. Treasury note has fallen to an average of only 1.2 percent over the past five years and we believe that in the current environment of "flat" real interest rates, a spike in investor sentiment or inflation expectations — both of which are potentially good news for equities and equity alternatives — could quickly push the required return rate closer toward the historical average of 3.6 percent. The Federal Reserve has attempted to prevent this by vowing to keep interest rates low, likely through mid-2015, though this may change with economic conditions. Not all voting members of the Fed's Open Market Committee have agreed with this policy, as they are under pressure to balance the Fed's twin goals of economic stability and full employment. Investors have already begun to accept that artificially low rates are unlikely to persist and the Fed has said it will taper its bond-buying program. Equity markets are likely to respond positively, regardless of the interest-rate scenarios. If rates rise, it will signal growing demand which benefits equities. If interest rates remain low, fixed income yields will remain unattractive and investors will instead seek out equities and other risk assets.
As alternative products have risen in popularity, so has the demand for transparency. The financial crisis and ensuing market volatility exposed weaknesses in the traditional due-diligence process as well as in assumptions about portfolio liquidity. In response, many innovative product managers have adopted more transparent due-diligence and portfolio-management processes. Highly liquid long/short alternative strategies make desirable 1940 Act vehicles, offering the investment characteristics of long/short strategies with the daily redemption features of open-end mutual funds.
Many financial advisors are recognizing this, as a study by consulting and research firm Practical Perspectives showed. Most advisors using alternatives prefer to use liquid alternatives to diversify portfolios and manage volatility. Many plan to use them more in coming years.8 Highlighting the growing demand for such products, the amount of assets invested in the mutual fund long/short equity category has tripled since the beginning of the financial crisis, with 62 long/short equity funds having been launched, according to data from Morningstar Direct as of March 2013.
Equity long/short strategies are more transparent — and, in our view, more liquid — than more complex alternatives because of the familiar securities in which these strategies invest. Because they trade on active, broad markets, equity securities do not carry as much counterparty and illiquidity risk as other strategies such as private equity. Alternative products from larger asset management firms can offer reduced firm-specific operational and business risk. In many cases they also have compliance requirements that are as rigorous as more traditional asset classes.
Risk management is a top concern for investors in the wake of the financial crisis, as they strictly observe risk limits and demand more customized reporting. Compliance costs often represent a heavy burden in the asset management industry. Thomson Reuters Governance, Risk and Compliance asked more than 800 compliance practitioners from financial-services firms around the world between November 2012 and January 2013 about the costs of compliance and the challenges they face in the year ahead. Sixty-seven percent expected their budgets to increase. Eighty-one percent said they expect the amount of information published by regulators and exchanges to grow.9
Indeed, the costs and demands of regulatory compliance are expected to increase as provisions of the Dodd-Frank financial reforms are implemented in the U.S. and the Alternative Investment Fund Managers Directive takes effect in the European Union. Of the more than 270 asset managers, hedge funds, fund administrators, bankers, wealth managers and custodians polled in Linedata's third annual global asset management industry survey, 48 percent said their biggest concern was adapting to new regulations.10 Larger organizations that can more easily afford the costs of complying with new regulations should fare better in meeting client needs for alternative asset strategies.
While the increase in allocations to alternative investments seems like a sustainable trend, the integrated global economy is fluid and complex. Despite positive signs from housing, employment and consumer confidence, U.S. economic growth could be hindered by Europe's ongoing recession and austerity measures. That could keep U.S. short-term interest rates near zero even past the Fed's stated 2015 target and, in turn, lead to a Japan-style lost decade of zero growth and extended near-zero borrowing costs. Another possibility is that a return of financial-crisis-style volatility could cause another flight-to-quality, resulting in higher bond prices, lower yields and a decreased appetite for risk on the part of investors.
Deflation is another potential risk, albeit a less likely one. An economic environment characterized by a prolonged and steep decline in prices would depress rates to near zero, which is a devastating, difficult-to-escape scenario. Corporate revenues, wages and output would all decline as consumers and businesses wait for lower prices. The Fed's massive balance-sheet expansion serves, in part, to protect against this possibility. These risks, however, can be mitigated by the volatility-dampening effect of shorting within a portfolio. A long/short manager can potentially profit in a falling equity market, as market exposure reflects the manager's view of overall economic conditions.
Active, liquid equity alternatives can play an expanded role in stabilizing pension-plan asset bases by pursuing high total returns, potentially reducing volatility and helping plan sponsors meet their return assumptions and payout obligations. We believe that, regardless of market conditions, equity long/short investments may provide a better balance between risk and return than overexposure to fixed-income and its limited return potential. As the global marketplace evolves, so should investors' portfolios. We believe equity long/short strategies provide access to ideal methods for initiating and increasing alternative allocations while benefiting from greater liquidity and transparency than other alternatives offer.
1 Charles Cook, CFA, and Brian Blongastainer, CFA, "Preparing for the End of the 30-Year Bull Market in Bonds," The Boston Company Asset Management, LLC, May 2013.
2 "The Pending State Pensions Crisis," Joint Economic Committee Republican Staff Commentary, Sept. 26, 2012.
3 "Asset allocations: past, present and future," Pensions and Investments, November 29, 2012.
4 "The Rise of Liquid Alternatives & the Changing Dynamics of Alternative Product Manufacturing & Distribution," Citi Prime Finance, May 2013, p. 15.
5 The Public Fund Survey, January 31, 2013, sponsored by the National Association of State Retirement Administrators and the National Council on Teacher Retirement.
6 "The Mainstreaming of Alternative Investments," McKinsey & Co. Financial Services Practice, June 2012.
7 "U.S. Institutional Investors Say Alternative Investments Are Essential as Volatile Markets Are Here to Stay," Natixis Global Asset Management, Sept. 25, 2012.
8 "Financial Advisors and Liquid Alternatives 2013 — Insights and Opportunities," Practical Perspectives, June 2013.
9 "2013 Cost of Compliance Survey Report," Commodities Now. February 2013.
10 "2013 Global Asset Management Survey," Linedata, January 2013.
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