Zilla Efrat
After years of toe dipping, many superannuation funds have been taking the plunge into the murky waters of alternative investments. Allocations have been edging up, with some funds now placing over 40% of their assets in these investments.
Westscheme, for example, has 43% of its total portfolio invested in what its asset consultant Access Economics describes as a "target return portfolio". Close to 40% of this is held in direct property with around 30% in infrastructure and the remaining 30% in subordinated debt, private equity, hedge funds, collateralised debt obligations and timberland investments.
Following three years of poor equity markets, alternative investment activity has been picking up, particularly overseas, as investors search for new ways to add value, or alpha, to their portfolios.
QIC head of alternative investment strategy Jim Christensen says: "Overseas pension funds have had nastier experiences with equities than super funds in Australia over the past few years... and this has given them an urgency to move into these products.
"They got a shock and recognised that returns from traditional assets are unlikely to be exciting going forward and this has led to a whole new way of thinking. The world has changed."
Garry Weaven, executive chair of Industry Fund Services, adds: "The relentless marketing of hedge funds is starting to have an impact. A number of funds started adopting the fund-of-fund approach five years ago and it was a tussle with their asset consultants who didn't favour hedge funds... It proves that ultimately marketing can triumph."
Reality yet to stack up
But while there is a lot of kicking of tyres, Mercer Investment Consulting head of research in Australia John Stroud believes that the actual flows into alternative investments are less than the interest expressed.
Similarly, Towers Perrin head of research Denis Sands says: "The market is split. Some funds are not doing anything or only marginal bits, but some are heavily committed."
He adds that in the alternative investment space, superannuation funds tend to start small and then build up. "It takes time to invest because there is no history. You have to be comfortable with these investments and it takes time to set them up and to get to know the managers."
Counterpoint principal John Parrish concurs, noting that once funds dip their toes in the market, they are likely to increase their exposure, unless they really get burnt.
QIC and Mercer Trust are among those who have already got their toes wet and are now reviewing their exposures with a view to expanding them.
Christensen says QIC, which has been investing in real estate for 10 years and offers an active currency overlay product, is considering private equity and diversifying its tactical asset allocation product in its drive to find alpha.
Mercer Trusts already has 2% of its portfolio in global macro hedge funds and is now examining timber, hybrid securities, hedge funds, infrastructure and commodities, but not private equity because of its time frame and illiquidity.
Russell Clarke, chief investment officer (CIO) of Mercer Trusts, says, "All these investments have different characteristics and we must consider their characteristics against that of our own funds."
Large funds increase exposure
Large superannuation funds, like Telstra Super, are also beefing up their exposure. After researching hedge funds for the past three years, Telstra Super CIO Steve Merlicek says his fund started investing in them earlier this year. It also recently moved into international private equity.
Merlicek says the exposure to alternative investments of Telstra Super's defined benefit fund could be built up to 14% over time, of which up to 7.5% could be in hedge funds.
Other Telstra options have some investments in private equity, infrastructure, opportunistic property and long-short funds, aimed at return enhancement.
"Our Australian private equity program grew 47% in the financial year to end June 2004. On the hedge funds side, we are looking for volatility reduction and absolute returns," says Merlicek.
An Access Economics survey of 25 industry funds, released earlier this year, found that allocations to alternative investments have increased markedly over the past few years.
Larger funds were the bigger alternative investors. While the average industry fund had 17.3% in what Access Economics calls the "target return portfolio" at end-June 2003, larger funds tended to have greater allocations pushing the weighted average exposure up to 19.7%.
However, Access Economics consultant Paul Cheever notes that industry funds would be well ahead of other funds when it comes to alternative investments.
Principle Advisory Services managing director Les Fallick says: "A 10% allocation to alternative investments a couple of years ago was considered to be ahead of the market. Now there are funds going for 30%."
Market goes global
He says larger funds are increasingly growing their global alternative investments, compared to five years ago, when the majority of their investments were domestic.
Fallick notes: "When a fund passes the $1 billion mark, it makes much more sense to make an allocation to alternative investments. Below $1 billion alternative investments are not a particularly workable proposition.
"With alternative investments, you need at least one gatekeeper or adviser and you may need one for infrastructure and another for hedge funds. Below $1 billion, the expenses may be a deterrent."
By all accounts, the search for higher returns, given the lacklustre forecasts for equities and fixed interest going forward, is a key driver towards alternative investments.
But according to Sovereign Investment Research principal Ray King alternative investments are also viewed as a means of reducing the total level of risk in a portfolio and of producing a risk dividend that can be spent elsewhere.
He says: "Those funds that are doing it properly are approaching it with a clear idea of what their objectives are. Some are taking an absolute return focus. Others have a very strong relative return focus. They are also approaching it with different time frames in mind and these demand different styles of investment."
Making the water murky, however, is the lack of research available and limited track records. Managers' skills vary widely, as do their results.
Cheever says: "Alternative investments have the potential to be disappointing for some funds if they don't change the way that they look at acquiring them. They can't apply conventional processes and conventional wisdom to alternative investments."
Sands adds that while infrastructure and private equity do have some track record, the challenge is to find ways of measuring the performance of hedge funds.
"Some of the processes may have been used elsewhere before, but you generally have to make judgments without track records."
Evaluating the risk
Stroud says: "With the FSR Act and the safety in super legislation, trustees have an increasing burden of fiduciary duty. They have to be careful about what they do with their money... and it's very difficult for them to deal with the new kids on the block. While they may be very good managers, the question remains, is the risk you run with them worthwhile taking?"
A worry too is the high casualty rate of hedge funds. Stroud notes that on average 8-10% of these funds disappear each year.
One emerging option for those hesitant about dealing with small hedge funds is the multi-strategy offerings emerging from institutions which have bundled up their best ideas in one portfolio.
Christensen describes these as the institutional response to hedge funds. He says while QIC has not done any hiring yet, it has been tracking almost a dozen of these institutions and is in discussions with some of them.
Clarke expects these institutional offerings to take off because they have much more transparency compared to typical hedge funds.
"They have one layer of fees rather than two and because investors often know the underlying strategy being used, the comfort level is higher... They have experience and pension funds like dealing with institutions," he says.
Sands, however, cautions that while institutions have the compliance frameworks that appeal to superannuation funds, investors need to ensure that the institution has skills across all sectors that it is investing in.
Popularity diminishes opportunity
Another concern is that as more and more investors move into alternative investments, there will be less opportunity available.
Clarke notes: "A lot of alternative investments are attractive but have limited capacity and high fees. If we all come to the same conclusions, there will not be enough to go around and this will affect returns."
Towers Perrin consultant Bill Humphreys agrees. "Implementation is becoming harder," he says. "Those wanting global exposure are finding that fund-of-funds or private funds are increasingly being capped."
Sands adds: "It's hard to find long-short hedge fund capacity in Australia. If you don't get in early, you can miss out on capacity."
He says it is also getting harder to find good property investments while Weaven says the challenge in infrastructure is finding adequate deal flow.
So where is superannuation money going in the alternative investment space?
Cheever says most of it is going into infrastructure and direct property because of the attractiveness of the assets being offered and because these assets are larger investments.
"Super funds can allocate more to these areas because they are able to analyse what they are buying, compared to private equity where they are buying the manager's skills," he says.
"But while the money is flowing into infrastructure and direct property, the popularity contest is being won by private equity, which has been enjoying returns as high as 50% lately."
Buy-out sector finds favour
On the private equity side, Victor Bivell, editor of the Australian Venture Capital Journal, says: "The buy-out sector has been quite popular lately with significant money flowing into this sector from super funds.s
"But the early stage and technology sectors are still out of favour and fund raisings are still difficult."
However, early stage venture capital is still slow and the only bright spark is life sciences, says Bivell.
He cautions: "Many of the investments made in the buy-out sector were made in the downside... When sectors are booming it may not be such a good time to invest. When people buy on the upside, results may not appear or they may be a long time coming."
MLC investment analyst, Michelle Heinrich, adds that a problem with private equity is that valuations are few and far between. The only measure of true value, she says, is on the sale of the business or an IPO.
This creates a number of issues for superannuation funds to consider, especially if they offer daily unit pricing and given the possibility of increased member mobility in a choice of funds environment.
In the future, Weaven says assets with some built in inflation proofing and social infrastructure (such as water recycling, wind energy and healthcare facilities) will take off.
Humphreys believes that while private equity investments have typically been in IT, communications, retail or manufacturing concerns up until now, they could shift into power, energy, gas and oil.
'Road to the future', on page 36 of Superfunds October issue, discusses infrastructure investing in greater detail.