Despite the numerous quantitative easing programmes and bailouts of recent years, the quest for self-sustaining global economic growth has proved elusive. Furthermore, the effectiveness of future monetary stimulus is increasingly being doubted, and global markets have been prone to bouts of volatility, while Asia has also been impacted by recurring China-related uncertainties.
In this environment, many investors are seeking to reduce exposure to the volatility of traditional markets and enhance returns from less correlated assets. Alternatives are on the rise.
For more than 17 years LGT Capital Partners has been allocating a substantial part of the LGT endowment fund, Europe’s largest of its kind, to alternative assets. The purpose is to diversify into attractive risk premia across global markets by combining alternative and traditional asset classes, and achieve sustainable long-term returns with moderate volatility.
The following three examples illustrate how alternatives can offer diversification and different sources of returns – and can be of particular interest to Asian investors.
Decorrelation through insurance-linked strategies
Relatively new in Asia, insurance-linked strategies (ILS) are becoming mainstream in the US and Europe and represent a key element of the LGT endowment. ILS are structured in a similar way to bonds, except that their risk/return drivers are almost completely unrelated to the financial markets. ILS investors earn a premium on their catastrophe bonds (or collateralised reinsurance contracts) as well as the money market return from the collateral assets. Policyholders will claim on the bond (or contract) if certain specified loss levels are triggered from a natural catastrophe (e.g. a large earthquake, hurricane or windstorms/floods). If this happens, the ILS investment will lose value.
However, most portfolios would have benefited from the inclusion of ILS, especially during the financial crisis in 2008. Figure 1 (immediately below, click charts to enlarge) shows how cat bond ILS achieved consistent returns with low correlation versus a range of other assets.
Due to the lack of natural catastrophes, risk premia in the sector have dropped over recent years, but we think collateralised reinsurance contracts are still attractive compared with the premia found today in many other areas. At the same time, it is important to ensure that an ILS portfolio is well diversified across regions and disaster types, and to fully understand the risks involved.
Enhancing returns with private equity
LGT made its first private equity (PE) allocation in 1998 and remains convinced of the attractions this asset class can offer long-term investors who are prepared to accept a degree of illiquidity – namely, higher returns, lower volatility and a more robust overall portfolio. As figure 2 (below right, click to enlarge) shows, LGT’s PE investments have delivered an excess return over listed equity markets over the entire allocation period.
PE managers typically acquire a controlling stake in a company and pursue growth strategies. They launch new products or services and enter new markets – and combine this with a strong focus on cost control, cash flow and aligning their interests with a company’s management.
Managers themselves are also aligned with their own investors as they usually hold significant shares of their own funds, and stand to gain a performance fee on successful investments.
By contrast, public companies’ managers are typically more preoccupied with administrative issues such as compliance, risk management, organisational design and succession planning, while their shareholders usually own only a small percentage of the business and have little ability to influence management to ensure that their actions are always in shareholders’ best interests.
In PE, once the value creation goals are achieved, managers will seek to sell the company, either through a trade sale, a sale to another PE fund or an initial public offering. As PE has a long-term horizon, managers can wait until they achieve an attractive price for the business and rarely need to sell in bad market conditions. As a result, PE allocations can significantly lower the overall volatility of a portfolio. As figure 3 (above, left) shows, PE returns have helped to shelter investors from the more severe downturns experienced by listed equity investors.
It is however important to note that, although PE has generally outperformed public equities, there is a significant return dispersion between various managers, which highlights the importance of gaining access to the best-performing ones (i.e. manager selection).
Finally, occasional bear markets offer counter-cyclical opportunities through secondary transactions, or acquisitions of existing PE funds from investors who need to sell them. Prolonged or extraordinary market downturns can force leveraged investors to sell high-quality assets at steep discounts, resulting in very attractive opportunities for investors.
In today’s environment, we believe PE provides a compelling proposition to enhance returns and reduce volatility.
Diversifying through trend-following strategies/CTAs
Trend-following strategies, or CTAs, went through a dry spell recently, but the long-term track record remains solid and has consistently provided protection in periods of market turmoil, as shown in figure 4 (below right).
In a portfolio context, CTAs help to avoid large losses and are thus paramount to achieving an attractive compound rate of return. Also, these strategies can generate returns during both long-term bull and bear markets, and are positively correlated to equity markets in good times and negatively in bad times. Overall, the historical correlation since 2001 has been near zero, thereby serving as an efficient source of portfolio diversification.
It is often said that these strategies are complicated to understand and lack transparency. But large, experienced investors can have full transparency if CTAs are accessed through the correct channels, such as a managed account platform which is monitored by an experienced team, as we have done for the LGT endowment fund.
In the aftermath of the global financial crisis, investors face an unprecedented economic environment that requires alternative thinking to enhance the diminishing and very low yields on traditional investments. At the same time, as investors seek to reduce overall levels of volatility, alternative investments are becoming a more widely accepted and effective proposition.
Specifically, asset classes such as ILS, private equity and trend-following strategies/CTAs can assist in making a portfolio more robust, enabling it to perform well in rising markets, while providing significant downside protection in volatile times.
Finally, we believe that the trend toward alternatives will continue to gain momentum in Asia, which remains particularly vulnerable to shifts in macro policies and international risk aversion.
Partner at LGT Capital Partners
Tel: +852 2913 7156