Michael Howard, Head of Alternative Investments analyses how alternative assets can benefit multi-asset portfolios.
As yields have compressed and forward-looking return expectations have fallen in the last few years investors have sought alternatives to traditional asset class to supplement their income and boost their total return. Please remember that the value of a client's investment can go down as well as up and isn't guaranteed. They could get back less than they paid in.
In the UK, changes to the tax treatment of second homes and buy to let properties has made one of the key alternatives to equity and bond investments less attractive leading investors to consider other alternative asset types.
What are alternative investments?
If you asked ten investors to define the alternatives investment universe you would probably get ten different answers but at Prudential we define it broadly as investments in:
hedge funds and
Alternative investments tend to share some common characteristics in that, to varying degrees, they are:
opaque in terms of pricing,
less well understood and less accessible to investors.
It should also be noted that the opportunity is diverse in nature ranging from aircraft leasing to renewable energy to royalty finance to timber. Given that many of these asset classes can be complex in nature and are less liquid than public markets it is vitally important you carry out thorough due diligence. As an organisation you need to be confident you have sufficient breadth of knowledge and expertise to assess all the risks from an investment, operational and legal point of view before you invest.
Overview of Treasury & Investment Office (T&IO), formerly known as Prudential Portfolio Management Group , alternatives due diligence process:
It is also important that you have the administrative capabilities to deal with cashflows, capital calls and various corporate actions which are part and parcel of investing in private assets.
Why invest in alternative investments?
We believe that alternative assets deliver a 'high quality' return to the portfolio. Returns are high quality in the sense that they are often idiosyncratic in nature, with low volatility and a low correlation with traditional asset classes and as such the rest of the portfolio. The key point here is that alternative assets enhance the returns of the overall portfolio and provide additional diversification, which has been our experience.
What is Prudential's experience of investing in alternative assets?
Prudential has a large and established alternatives programme with over £5bn of invested capital. The private equity programme dates back to the early 80s and we have been deploying capital into infrastructure and hedge funds for many years. This has allowed us to build considerable expertise in-house and develop a dedicated team of investment professionals to manage the programme.
All investments are subject to a thorough three-prong investment approval process which covers investment, operational and legal due diligence before any investment is made. This process is quite involved. For example, we will typically run background checks on all key employees and the company itself using a specialist background checking agency. We will also instruct our lawyers, often with the assistance of external legal counsel, to review all legal documentation and negotiate terms and protections that we are comfortable with before investing.
An important consideration when making an investment in alternative assets is to ensure the structure of the investment vehicle matches the time horizon of the investment and the characteristics of the asset class. Many of our investments are long duration in nature, so it is important to have the flexibility to hold investments to maturity and not be forced to sell at the wrong time. It is also important to be able to deploy capital in areas which offer an attractive long-term upside but may experience near term volatility e.g. stressed corporate credit after the global financial crisis or energy related opportunities after an oil price fall. Prudential look to be opportunistic and take advantage of the long duration of our investments, and to pick up the illiquidity premium (the spread to liquid assets) which in our opinion has increased post the GFC.
What are the risks involved in investing in alternative asset classes?
There are a couple of key considerations when investing in alternatives. First, you must understand the opportunity you are investing in and be properly resourced to due diligence all the investment and non-investment risks. Second, you have to have the duration of capital to match the less liquid nature of these investments, you do not want to be a forced seller. Finally you need to have the size and scope of mandate to take advantage of some of the larger opportunities and negotiate appropriate terms and protections.
What sort of diversification benefits do alternatives provide to a portfolio?
Many people speak about alternatives as being a separate asset class, it is not. It is a collection of different strategies with different sources of return and risks. Some opportunities within our alternatives portfolio, such as private equity, will have a decent level of correlation with public equity markets and provide a premium return to equity markets. Others will be genuinely uncorrelated with traditional asset classes such as catastrophe bonds or renewable energy where returns are more driven by industry specific factors. By building a diversified book of alternative investments we can create a portfolio which is lowly correlated with the main portfolio while being return enhancing.
Have the returns in the alternatives space come down in line with yields in more traditional asset classes?
We have seen some compression in returns. This is natural given that investors have been increasing their allocation to alternative assets as they seek the diversification and return enhancing benefits they offer. That said, many investors have been unable to access these areas for a number of reasons including: regulatory, complexity and liquidity. We continue to see attractive absolute returns and in many areas high spreads to traditional returns. We mitigate some of this compression in returns by seeking new opportunities and by rotating capital into these new areas or by allocating to areas where we see a scarcity of available capital relative to demand for capital. With this in mind we have been deploying capital into: Greenfield infrastructure, renewable energy, Asian private debt, and asset leasing.
In conclusion, alternative assets have benefited our multi-asset portfolios in a variety of ways historically, with the primary benefits being enhanced returns and diversification.
In addition, clients benefit from:
A large, mature and diversified programme
Tailored mandates, access to best opportunities and fee discounts
Potentially attractive returns in an otherwise yield-constrained investment landscape
The highest governance and due diligence standards.
The opportunity set remains attractive on absolute and relative bases.