What are the tools of modern finance?

By Selwyn Pillay, Chief Investment Officer, Sanlam Investments multi-manager business

How can we exploit these alternative growth options to benefit retirement fund members?

Says CIO of Sanlam Investments’ multi-manager business, Selwyn Pillay, we agree with the consensus sentiment that investing in equities is one of the simplest and best solutions for maximising returns over the long term. Moreover, risk of capital losses reduces as time goes by.

One additional comment to this is, however:

“What other growth options are there at our disposal? Where else could we invest?”

This is where we often refer to the concept ‘the tools of modern finance’. These allow us to take advantage of alternative investment tools and exploit them for the best possible investment outcomes.

The rise of alternative investments
Alternative investments offer pension funds the opportunity to potentially get equity-like returns but with less volatility. Pillay says currently while local pension funds are generally under-invested in these strategies, he recognises that these investors have recently started to become more open to these considerations as we enter a period of lower investment returns.

A lot of responsibility has been placed on trustees, not only to limit losses, but also to make sure that there is sufficient growth in members’ retirement fund investment portfolios. Allocations to private equity, hedge funds and Africa are useful tools in this regard – tools that historically have been under-utilised and seen as too ‘risky’ because they are seen to be not part of traditional asset management thinking. It is worth remembering, however, that both equities and bonds were once seen as ‘alternative’. More importantly, utilising these opportunities is an important tool to provide investors with increased options for sustainable and risk-managed investment growth, with lower levels of volatility.

The revised Regulation 28 that came into effect in 2011 allows trustees to also consider additional sources of return, bringing greater credibility and opening the landscape to alternative asset classes including private equity funds, hedge funds and unlisted credit.

What are the common types of alternative investments?
The most common investment strategies that are grouped under this alternative investments banner include:

Private equity: Private equity allows you to invest in growth assets that are not actively traded on markets and may offer more opportunities that the investor can benefit from. On the down side, as a non-mainstream investment it may offer a reduced liquidity and be difficult to model.

Investing in frontier markets: This is investing in the greater continent of Africa or India, where there are high growth prospects plus the added advantage of a rand hedge. Investing in Africa is now regarded as the ‘last frontier market’ following on from China, which until recently offered the biggest growth market in the world. Africa as an investment destination is right on our doorstep and we should not ignore it. While the growth prospects in Africa are evident, the main problem is a lack of liquidity in the short term and the relative immaturity of the market. But again, these issues do provide greater opportunities when markets are naturally inefficient.

Hedge funds: These are a critical form of unconstrained investing, as they allow the investment manager to allocate risk wherever they deem it beneficial. Hedge funds are important in that they offer the ability to generate growth despite prevailing market conditions. Ultimately, they are designed to protect against negative market movements. As such they will naturally underperform equities somewhat when markets are strong, but don’t participate as much in the downside when markets fall.

What is a liquidity premium?
The one element common to all alternative investments is what we call ‘the liquidity premium’ inherent in them.

A liquidity premium is the premium that investors will demand when a security or asset cannot be easily converted into cash, or converted at the fair market value. When the liquidity premium is high, the asset is said to be illiquid. The more risk-averse investor will naturally require a higher expected return as compensation for this liquidity risk. More illiquid investments, such as hedge funds, offer higher yields than liquid ones.

The concept of high liquidity refers to the ability of investors to access their invested capital over a relatively short period of time. A good example of high liquidity versus low liquidity investments would be the contrast of a 14-day cash account (high liquidity) versus buying fixed property (low liquidity) investments.

The discussions in this article question the need for high liquidity investments when the investment is long term, such as a retirement fund, and which therefore does not require short-term capital redemption facilities.

What is an implicit and explicit liquidity premium in alternative investments?
When investing in assets such as hedge funds, Africa or private equity, the investor is typically required to relinquish shorter term redemption abilities. For example, a hedge fund may only be able to return investor capital after a calendar month from the notice of disinvestment. The investor therefore has implicitly paid away liquidity in return for the investment gain that is expected. Part of this investment gain should compensate the investor for the liquidity lost on the investment. This is all ‘implicit’.

In most structured products, the cost to the investor is an ‘explicit’ loss of liquidity, for example, a 5-year structure. In return the investor is rewarded with various possibilities including leverage upside returns, protection from downside risk or maybe a combination of both.

The argument therefore is a fairly simple one. If you’re investing for the long term, a short-term give-up of 4 years is not significant in the overall context of a long-term investment. So why be averse to alternative strategies where liquidity is not provided daily?

Alternatives in action
There are many types of strategies and structures out there available to us. A lot of structured products will require you to “pay away” 5 years’ worth of liquidity, but what you do get in return is some form of capital guarantee or some form of leverage.

Alternatively, what you could do is get cheap access to beta, in the form of futures and derivatives, swaps and forwards. So using these types of structures, you could enter into portable alpha products, 5 year structures with some sort of leverage and guarantee. These options do become quite liberating once there is general acceptance of these strategies.

And this is precisely what we refer to as ‘The tools of modern finance’.