Alternatives: Asset allocation drivers and investment trends
Definitions, the future size of alternatives allocations and how to benchmark returns in the unlisted space. Those were some of the topics highlighted when Tell Media Group sat down with HSBC Asset Management and JPMorgan Asset Management for an in-depth discussion on alternative investments from an asset allocation perspective.
WHAT HAVE BEEN SOME OF THE MAIN DRIVERS BEHIND INVESTORS’ INCREASED APPETITE FOR ALTERNATIVE ASSETS OVER THE YEARS?
JOANNA MUNRO: “Some people have, of course, been investing in alternative assets for a very long time. I think one reason for why so many have joined them over the recent past has been the search for yield. In the low interest rate environment, the illiquidity premium became a much more important percentage of the total return. I also think it’s partly to do with the recognition that in private markets, there’s an opportunity to identify specific investments and to use the value of research to gain superior returns. There are also parts of the economy that you can reach through private markets that are simply not available in the listed space. I also think the limited diversification benefits in the listed markets have increased appetite for alternatives.”
PRASHANT SHARMA: “In addition to what is already mentioned, I think you can also see that the market structure has changed, meaning there’s greater supply into the alternatives space. One example has been that the scale of lending to corporates has declined because of bank regulation, which has provided opportunities for private debt and direct lending managers to step into the space. Also, from the perspective of sustainability, I think alternatives and private markets provide a much more direct and tangible way to invest in line with your goals rather than trying to do that via public markets.”
JOANNA MUNRO: “I would very much agree with that. Trying to show additionality with impact investments in public markets is very difficult and much more straightforward in private markets.”
WHEN YOU TALK TO INVESTORS ACROSS THE NORDIC REGION, ARE THESE THE SAME DRIVERS YOU SEE AND HAS THIS CHANGED WITH RISING INTEREST RATES?
JESSICA NORMAN: “Nordic clients have of course been allocating to alternatives for a long time but yield was one reason if we look back at the zero interest rate period. Now that interest rates are higher, the bar is of course higher for assets such as private credit so that will affect where investors allocate in that space. We also see interest for inflation protection and therefore continued interest in real assets such as infrastructure. When it comes sustainability, we do see interest in timber as a way to decarbonise portfolios. Themes are of course changing over time.”
FRANCOIS XAVIER DOUIN: “I think control and purity of the allocation decision and how it’s implemented has always been an important driver for investors when it comes to alternatives. Also, the yield advantage or performance advantage of a private market allocation versus its public market equivalent has to be large enough for it to make sense. It takes more of an effort to do the due diligence on a private equity manager or private credit manager and it’s a bigger commitment compared to buying an equity or fixed income ETF.”
JOANNA MUNRO: “We’re talking a lot about the return opportunity here. I was given some statistics from my team and for most institutional investors globally, the main reason to invest in alternatives is diversification. I think that’s interesting because if you come new to this space, it takes a lot of work to do all the due diligence that Francois Xavier just mentioned.”
ALTERNATIVE ASSETS IS VERY MUCH A CATCH-ALL PHRASE. HOW WOULD YOU DEFINE ALTERNATIVES?
PRASHANT SHARMA: “From our point of view, it’s clearly a diverse category but it’s tied into what has traditionally not been public markets, i.e. alternatives are associated with an illiquidity risk. Generally for institutional clients, we would think of them as three different buckets: private equity and private credit, which of course can have their own sub-asset classes, but where there are also public market equivalents with an similar underlying economic risk exposure. The third is real assets, such as real estate and infrastructure, which offer their own distinct risk and return characteristics.”
JOANNA MUNRO: “I think it depends on which lens you’re using. If you’re an institutional investor, your governance process will be important. So, for example, it might make sense to group all listed assets and then work through the alternatives separately because they will need a different level of oversight and reporting. For us as an asset manager, what falls into which bucket depends very much on the ecosystem we need to create: for alternatives that differs a lot from the traditional business – for example, the need for specialist legal and risk management. Also, at HSBC internally we’re organised around three themes – alternative credit, energy transition and Asia. So how you define assets and organise yourself depends on who you’re talking to.”
FRANCOIS XAVIER DOUIN: “We haven’t yet mentioned hedge funds as an alternative asset class, which I think is interesting. When you talk to hedge fund managers, I think most of them would not define themselves as alternatives but rather managers using liquid markets to create alpha. But from a return and diversification perspective. I think it’s fair to think of them as alternatives.”
JOANNA MUNRO: “Our external manager team allocates to hedge funds and to private markets. We have separate teams doing manager research but we have a single team doing the operational due diligence because that work is very similar.”
PRASHANT SHARMA: “Hedge fund managers are generally investing in public markets, so could be viewed as alpha strategies in public markets, but there are structural differences compared to traditional equity or fixed income when it comes to things like leverage and potentially liquidity. We therefore see them as alternatives in our operational set-up.”
DOES IT MAKE SENSE FOR INVESTORS TO VIEW ALTERNATIVES SEPARATELY, ESPECIALLY FOR THOSE INVESTORS WHERE THE SIZE OF THE ALTERNATIVES ALLOCATION IS BECOMING FAIRLY PROMINENT?
PRASHANT SHARMA: “When the allocation is small, it probably makes sense to think of it separately as the organization gets up to speed. But when it’s more prominent you need to think of it holistically within the overall portfolio. There are of course liquidity considerations to take into account but we certainly see alternatives as building blocks sitting side by side with more traditional assets and understanding the relationship between them is important.”
JOANNA MUNRO: “Liquidity will of course have an impact when it comes to allocation. Firstly, if you do allocate to private markets, you need to sit with those allocations for a number of years – so it can’t be a short-term decision. Secondly, the deployment of capital won’t generally happen at the same time as you decide to allocate. So these are structural differences between traditional and alternative asset classes and that will have an impact on your asset allocation decisions.”
IS LIQUIDITY THE MAIN BOUNDARY FOR THE SIZE OF THE ALLOCATION?
PRASHANT SHARMA: “I would say that there are three considerations that will have an impact on the allocation – liquidity, complexity and fees.”
JOANNA MUNRO: “One aspect to consider is that different investors operate within different regulatory frameworks and that will limit the size of the allocation to alternatives. I do, however, think that there’s still scope for growth.”
WOULD YOU SAY THAT THE INTEREST IS AS HIGH TODAY AS PREVIOUSLY? A LOT OF INSTITUTIONAL INVESTORS INCREASED THEIR ALLOCATION TO PRIVATE ASSETS IN SEARCH FOR A FIXED INCOME SUBSTITUTION WHEN RATES WERE LOW. ALSO, THE RETURNS ON SOME PRIVATE MARKET INVESTMENTS HAVE SUFFERED DUE TO THE HIGHER INTEREST RATES.
PRASHANT SHARMA: “I think you’re correct that there’s something of an adjustment for purely mechanical reasons, including portfolio rebalancing. There’s less allocation to higher yielding assets because of the higher interest rates. However, I think we must remember two things. Firstly, these are long-term investments and investors make commitments across cycles and secondly, investors have invested time and resources to handle private market investments. At the end of the day, allocations may shift but I don’t think they will necessarily shrink.”
JESSICA NORMAN: “We absolutely continue to see an interest in alternatives from institutional investors. But, as I mentioned earlier, the themes and which areas that investors focus on do change over time.”
FRANCOIS XAVIER DOUIN: “If we look historically, the increased allocations to alternatives have come in big steps so on the surface, most of it is behind us. Therefore when you only look at top-down asset allocation numbers, not much seems to be happening but actually there’s a lot of movement within each sub-asset class.”
WHAT WOULD YOU SAY ARE THE MAIN DRIVERS FOR ALLOCATIONS TO ALTERNATIVES TODAY? AND HOW IMPORTANT OF A DRIVER IS THE CLIMATE TRANSITION?
PRASHANT SHARMA: “Climate and sustainability is absolutely a driver because of what we touched on in the beginning – that there’s this tangible impact that you can have through private market investments. Another driver, which we also touched on earlier, is the structural changes to markets and that will also continue to drive allocations. Also, even if there has been challenges in the private equity market in more recent vintages, that’s not an asset class that’s going away. Right now there are also interesting opportunities in certain parts of the real estate market.”
JOANNA MUNRO: “One aspect of this is of course supply and demand and there’s clearly demand for private credit to expand due to limits in bank appetite. However, in terms of investors putting money into private credit, there needs to be the right risk/reward trade-off. It must make sense for both the borrower and the investor and that’s valid for each sub-asset class. Ahead of a significant step change, each sub-asset class needs to build out the full ecosystem of specialist managers, risk management, investor education etc. That’s when the mainstream institutional investors will be comfortable allocating.”
ARE WE SEEING SIGNS OF NEW SUB-ASSET CLASSES BECOMING INSTITUTIONAL ENOUGH AND IS THAT AN IMPORTANT GROWTH DRIVER OR WILL THE GROWTH RATHER COME FROM SEMI-LIQUID STRUCTURES OFFERED TO RETAIL INVESTORS?
JOANNA MUNRO: “The democratisation of alternatives is an important driver but as important is the way that happens. There’s a trend towards what’s referred to as semi-liquid, evergreen or open-ended investments. We see demand from investors and managers are keen to provide these structures. I do, however, think that there’s sometimes a lack of clarity as to what investors are actually getting. I don’t really like the term semi-liquid because they’re not really semi-liquid. They’re open ended so it can be more convenient to invest than dealing with the closed-end fund cycle. But it’s important to understand that we’re not really changing an illiquid asset into a liquid one just because we put it into an open-ended fund.”
PRASHANT SHARMA: “I’m not really an expert on the semi-liquid structures but rather an observer. I think it’s interesting what we see with for example ELTIF structures and their potential to broaden access to alternatives. More broadly, I do think that we see market structures changing that in turn will open up for new sub-asset classes, not least in the private credit space. Also, as we’re investing institutional assets, we’re a fiduciary and therefore hesitant to allocate to things that are too niche or to assets that have not been stress tested.”
JOANNA MUNRO: “When we’re talking about new asset classes, natural capital is growing and that’s an opportunity for institutional investors linked to sustainability and impact. Generally, I think it’s fair to say that the world of alternatives is always changing. It’s always evolving. If there are opportunities out there, you will have managers looking to package that for investors. Whether every initiative work out is of course another question. We’ve seen huge developments over the last 10 years and I’m sure that we will see further developments going forward as well.”
PRASHANT SHARMA: “I also think there’s a human element to this. I grew up in the fixed income space and I think it’s fair to say that the alternatives space is much more interesting compared to public markets.”
FRANCOIS XAVIER DOUIN: “The obstacle we face when reaching out to clients is that there are resource constraints that we need to deal with. Even if we come with something that clients think looks super interesting on paper, they have their internal pipeline of priorities. Also, there’s a finite level of complexity that even large institutional investors can absorb and they only start the due diligence process if they think it has a good chance of leading to an investment.”
PRASHANT SHARMA: “When it comes to implementation of investments into the portfolio, there are a couple of things to keep in mind. If we take an overall equity allocation as an example, I think two things are important. First is to make sure we can rebalance our public equity allocation if markets fall in order to catch the rebound. Then on the private side, some of the best opportunities comes when markets are dislocated and then you need to have liquidity in place to put to work. You simply need to manage the allocations over time.”
JOANNA MUNRO: “This is interesting. You can have the best investment idea but if you don’t get the cash back from prior investments, you can’t act on your ideas. You talked about real estate earlier and I think that’s a super interesting asset class right now. But the amount of cash that’s ready to go into those markets is limited right now because investors don’t have visibility on when cash from previous investments will be returned to them.”
WHAT ARE SOME OF THE LEAST INTERESTING AREAS WITHIN ALTERNATIVES RIGHT NOW?
JOANNA MUNRO: “Being with the right manager makes more of a difference when it comes to alternative strategies than with traditional. That’s partly because the spreads between good and bad managers are bigger but it’s also because it’s more difficult to change managers in alternatives. In general, I would say that it’s difficult to time investments into alternatives. If you have a program going, you need to stick with it over the years to get the benefit of vintage diversification.”
PRASHANT SHARMA: “When we decide what’s more or less interesting, we always compare the cost/benefit of alternatives investments with corresponding public markets. That said, I would agree with Joanna on the importance of investing across the cycle.”
HOW DO YOU BEST BENCHMARK THE RETURNS IN THE UNLISTED SPACE? HOW CAN YOU KNOW AS AN INVESTOR IF YOU HAVE DONE A GOOD JOB OR NOT?
PRASHANT SHARMA: “It’s a complex and fair question. What we’ve traditionally done is used public market benchmarks because that’s investable for the investors, especially for private credit and private equity. We’re not saying that we’ve done a good job just because we beat the public market benchmark but it’s a starting point. There are more private market benchmarks available from data providers and we’re looking at that. The challenge is of course cashflows – so when did you invest your money compared to what the benchmark is showing.”
JOANNA MUNRO: “We have three things that we would look at. In private credit, we would first look at the equivalent credit in public markets and then we would look at our deployment compared to our competitors because we don’t want to deploy capital into expected bad returns. Finally, we would look if we have delivered what we set out to do and that’s very client specific.”
WHAT ARE SOME OF THE POTENTIAL RISKS IN ALTERNATIVES THAT CLIENTS SHOULD PAY MORE ATTENTION TO?
PRASHANT SHARMA: “Due diligence of managers is absolutely a top priority. You hold them for very long times, so you need to do the homework. You need to understand what you invest in – both in terms of the managers you select but also the underlying risks of the investments.
JOANNA MUNRO: “For our external manager business, we have separate due diligence teams for investments and operations and we’ve seen a number of times when we would be comfortable going ahead from an investment point of view but where we say no because of operational issues. It doesn’t matter how good the investment case is if we’re not comfortable with the operational side of things because that’s what will hurt you in difficult times.”
// PARTICIPANTS
- JOANNA MUNRO, CEO Alternatives at HSBC Asset Management
- PRASHANT SHARMA, portfolio manager, multi-asset solutions team at JPMorgan Asset Management
- FRANCOIS XAVIER DOUIN, head of sales, Nordic institutional business, HSBC Asset Management
- JESSICA NORMAN, institutional client advisor, Nordics at JPMorgan Asset Management
The discussion was originally published in issue 05, 2024 of Nordic Fund Selection Journal.
