Demystifying Alternatives

By Pawan Singh, head of Multi Strategy, Alternatives at Sanlam Investments

As advisers we are constantly pondering the environment of ‘lower returns for longer’ that investment managers and retirement fund trustees are currently faced with. A popular and recurring solution to the problem is to look further afield at what the rest of the investments universe has to offer; to seek out alternative investment options.

Alternatives include private equity (buy-outs and venture capital), private debt (loans), infrastructure-funding debt vehicles, hedge funds, unlisted credit and derivatives. These all have the potential to provide higher than average, risk-adjusted real returns. Moreover, alternatives do not only yield financial returns, but social returns as well. By investing in alternatives you can play an active role in uplifting the economy for your future members in turn.

Debunking the myths

As children we were taught by our parents not to trust things we don’t understand and we often carry this philosophy with us well into adulthood. By the time we are approached with new information about a subject, we have often allowed many misinformed myths to feed our hesitation, even though technological advances have made sharing information on such subjects easier and more accessible. Similarly for trustees, many misperceptions may have kept us from allocating towards alternatives, as on average alternatives only receive a 2% allocation from pension funds – noted recently by the Southern African Venture Capital and Private Equity Association (SAVCA) report. This may have made sense during a time when Regulation 28 only allowed for a 5% allocation to alternatives (meaning that by allocating 2% you were in fact making use of just under half of the available allocation). But since 2011, this regulation has been amended to allow for a three times higher allocation, at 15%! And yet, many South African retirement portfolios remain reluctantly behind the trend, clinging onto the wisps and slivers of myths surrounding alternatives.

One of the pioneers for the use of alternatives in the international space is Yale University. Yale has an endowment fund which manages money with a long term investment horizon, similar to a pension fund. In 1985 David Swensen became the Chief Investment Officer (CIO) of this endowment and the first thing he rightfully asked himself was “With a multi-generational investment horizon, why should I not increase alternatives in my portfolio?” In 1985 Swensen introduced alternatives into the endowment fund at about 10%, and in 2017 this allocation to alternatives is sitting at a striking 70%, with only 30% in liquid assets. This hypothesis was further supported by Harvard University, who follow a similar policy with their endowment fund. There is also evidence of an increasingly higher allocation to alternatives in emerging markets, especially by Sovereign Wealth Funds, where the average exposure to alternatives is close to 23%.

Why has this thinking not been adopted sooner in South Africa?

Several reasons for this exist. For many decades pension funds did extremely well by simply investing into traditional asset classes, so there was no compelling reason to look any further. However, over the past five years these traditional (listed) asset classes have no longer been yielding as attractive real returns, and therefore trustees have been forced to look deeper, and explore alternative investment options.

But there has also been a negative perception of alternatives as “high risk’, which hasn’t helped. If anything, it has shrouded alternatives further in mystery. When trustees start looking at investment decisions, we generally have a mind-set of measuring risk as volatility: if my investment horizon is long term then I put more money into equities, or if I have income needs, more must go into fixed interest and bonds. But with alternatives, conversations usually start with the topic of liquidity, or the lack of liquidity. The irony is that the most illiquid asset classes happen to be the most stable asset classes, because of their contractual-return nature. A simple example of this is infrastructure assets that typically have a term of 15 to 20 years with offtake agreements that are contractual in nature and have very little market risk. So in this case a high level of illiquidity does not mean a high level of risk. If anything it means low risk, and from a portfolio construction perspective such assets are a very stable component of a portfolio, that can be used to match long-term liabilities.

A general lack of education also appears to be one of the most common reasons for the resistance to alternatives. This was further enhanced by the difficulty in scheduled robust reporting on alternatives. The performance of more traditional assets such as stocks is easy to track; just log onto Bloomberg and you can pour over the daily changes for hours. But alternatives are subject to what is known as ‘stale pricing’ (a time-lag in pricing due to quarterly, less frequent reporting and subjectivity in valuation for asset classes like private equity). This time lag creates a degree of ambiguity as returns and volatility are not as easy to quantify. Fortunately, investment companies such as Sanlam Investments have developed robust approaches which combine real world and academic research to accurately evaluate alternatives to approximate ‘real time’ pricing, to deal with this problem.

Instead of shying away from the world of alternatives, trustees should be encouraged to request more information on the matter from their industry partners.

Longer term, less liquid alternatives provide significant returns

The long investment horizons of alternatives actually align better with pension funds (which also have longer investment horizons) than several of the more traditional assets. And given that the average retirement fund has a long-term investment horizon, the need for high liquidity (or access to cash) should not be a factor at all. Furthermore, in the current low-return environment we can all benefit from the significant ‘illiquidity premium’ that you get as added compensation when you invest in an asset class that cannot as quickly be converted into cash.

Shake off the myths!

It is essential that as an industry we actively move to demystify the perception that alternatives are high risk when in fact they could provide fruitful returns over the long term as a stable counterpart to more traditional assets. We must upskill ourselves to realise that alternatives operate in the real economy and can go a fair way in helping towards Cyril Ramaphosa’s plan of raising $100 billion through investment to create jobs, solve infrastructure problems and create financial inclusion.­­­­

It is time to shake off the myths, and move to benefit investors by offering more diversified portfolios, that provide incremental risk-adjusted returns by blending alternatives in traditional portfolios.