While referred to as “alternative investments,” hedge funds, private equity, commodities, structured products and other real assets account for a significant proportion of global investment and trade activity. The combined value of private equity and hedge fund assets under management alone is in excess of US$ 4.5 trillion, with derivatives (just one part of the structured products umbrella) being a magnitude greater than 100 times larger (The Bank for International Settlements stated that the total outstanding notional amount of derivatives was in excess of US$708 trillion as at June 2011).
The global financial crisis has severely affected the attractiveness of equity, bond, cash and real-estate instruments (the typical main-stay of portfolio management) meaning that alternative classes are coming to the fore as instruments for diversification and risk management together with being in many cases, the primary investment vehicle for many strategies.
To learn more about the alternative investment market I spoke to Dr. Bob Swarup who is a world-renowned expert and commentator on alternatives and financial markets as well as being a visiting fellow at London School of Economics.
Bob is a respected expert and commentator on alternative investments, financial markets, macroeconomics, asset–liability management, regulation, risk management, insurance and pensions. He formerly was a partner at Pension Corporation, a leading UK-based pension buyout firm with c. £5bn of assets, where he ran their investments in alternative assets, was the Chief Risk Officer and oversaw their macroeconomic and policy research unit. In addition, Bob was a visiting fellow at the London School of Economics, setting up the Pensions Tomorrow research initiative; a member of the Advisory Board of Adveq, a leading European PE fund of funds with $5bn AUM; and an Observer Member of the Board of CatCo, a $1bn reinsurance hedge fund.
Bob is a CAIA (Chartered Alternative Investment Analyst) charter-holder and a member of the CAIA Examinations Council. He is also on the Editorial Board of AllAboutAlpha.com, and on the Development Advisory Council of the Institute of Economic Affairs (IEA), the UK’s oldest and one of its most influential think tanks. Bob holds a PhD in cosmology from Imperial College London and an MA (Hons) in Natural Sciences from the University of Cambridge. He has written extensively on diverse topics and most recently put together a book of essays on the challenges for asset-liability management under Basel III and Solvency II published by Bloomsbury in May 2012. He is currently writing a book on financial crises throughout history and the common human factors underlying them, to be published by Bloomsbury Press in 2013.
Q: Can you give us an overview of the ‘alternative‘ asset class?
[Dr. Bob Swarup] To my mind, an asset class is one of the most ill-defined things in the world. Most asset classes get defined by some regulatory prescription or perhaps, people’s perception that something has become an asset class by virtue of them having pursued some strategy for a long time. The notion of ‘alternative‘ as an asset class sits badly with me because for me, saying hedge-funds – as an example – are an asset class is akin to comparing mutual-funds to being an asset class. The sheer diversity within these groups makes it difficult to define them as a class in their own right, given the complete lack of commonalities across the board (fees excluded, of course).
Alternatives really refer to people who play around sometimes with traditional instruments like equities and bonds utilising different strategies. Sometimes they bring in newer forms of money and instruments, e.g. CDS and other derivatives, but fundamentally all they aim for is to trade in such a way that they feel they are either doing it with more skill (which is easier said than done) or in a more risk-managed manner (hence the reason hedge funds were originally called such… the hedge was supposed to be the important aspect).
The two most well known members of the ‘alternatives’ universe are hedge funds and private equity, though there are others such as insurance-linked securities and the distinctions are sometimes blurred. One attempts to try and capture shorter-term opportunities as well as hedge out risk to get higher returns, while the other plays in traditional areas such as equity or debt but over longer time-horizons and with a view to harvesting an illiquidity premium.
None of this is new. The Romans traded forward contracts in commodities 2000 years ago; a Dutch fugitive, Isaac le Maire, conducted the first-ever bear attack on a stock in 1610, leading also to the first ever regulatory ban on short-selling that same year; and Munehisa Homma, a Japanese merchant, used trend following strategies 250 years to earn as much as $10bn in a year trading rice futures. while a Japanese trader made $10bn. Private equity is another great example. The first ever publicly traded stocks only emerged in the 17th century. Before that, the only form of equity investment was private equity. One could argue, therefore, that it is public stocks that are the alternative asset class, not private equity. it’s all a matter of perspective.
Looking at the role of these asset classes… People tend to like certainty which has given rise to beliefs in strategic asset allocation and so on. Strategic asset allocation only works if markets are in a state of stable equilibrium over the long-term, which we are all re-learning, is more transient than lasting. If somebody told me the US stock market returned 12% per annum over the last 50 years, I would simply ask them what the returns were over the last 150 years, 250 years, 10 years and so on. I could make up any return I want just by picking the appropriate time period. This is the power of confirmatory bias at work. That same bias and ability to choose my horizon allows me to argue, as an example, for any proportion of equity in my portfolio from 0-100%.
The reality is we live in a very dynamic world that’s full of risks and all we should really care about are risk drivers – both financial and non-financial. Alternatives – however you choose to define them – may provide us with ways of hedging out or managing future risks better. People in this sense often regard risk as being a proxy for uncertainty, which is strictly not true. Sometimes, such as what’s happened over the past 2-4 years, there has been a decoupling of uncertainty and risk. People are now more paralysed by the sheer uncertainty of the market because they cannot quantify it.
Q: Where do alternatives fit into the investment market?
[Dr. Bob Swarup] The most basic tasks in any investment portfolio are to understand your risks and only take those risks for which you are rewarded; to cut off your left-tail risk and change your distribution to being positively skewed; and to have the ability to react dynamically to a shifting market.
Alternatives aid in the creation of a more efficient portfolio. They certainly add some diversification as they play on risks in different ways but they bring their own dynamics to the table. Do they have zero correlation, which is often cited for hedge funds? It’s highly unlikely. The correlations themselves are not stable, they will change regularly and have their own cycles.
Q: How have alternative classes been affected by the European and Global financial crises?
[Dr. Bob Swarup] The past few years have been humbling for most people in the industry. It’s taught people that skill is much harder than anyone realized. If you look at the last 25 years before ’07 you had one of the most amazing bull markets that people had ever come across, driven by huge growth largely fueled by debt being built up in the public and private sector.
When you have this huge tailwind behind you of easy money in many forms, it’s not hard to make money! In the 80’s and 90’s it almost didn’t really matter what asset class you were in, you made money. Post ’07, we were in a different world. Debt was still around, but it’s not so easy to get hold of. The global economy is de-leveraging and that affects everybody. It impacts consumers, sovereigns, financial markets, everyone…. Most of what we thought of as ‘alpha‘ was in fact a different form of ‘beta‘.
People have realized some truth in the Keynesian motif that markets can remain irrational for as long as they remain solvent. I suspect they are also re-familiarizing themselves with Galbraith’s assertion that the only point of economic forecasting was to make astrology look respectable.
Q: Do you think risk managers really understand these asset classes?
[Dr. Bob Swarup] Let me put it to you this way, the world is a very big place, but our brain is only about 3 pounds. One of the big failings of risk management over the past few years is that as they mapped out risks in more complexity and detail, they lost sight of the big picture.
If we use the example of regulators, they went into bank after bank with almost exactly the same VaR model and nobody stood up and said, “hey, don’t all these models look kind of similar? Isn’t that worrying?“. Models are nothing more than a quantification of human bias. When you put in your time horizons for volatility, choose your smoothing methodology, and so on… you are putting in your own biases.
Risk management has really come to the fore, people are now talking about it a lot more. The danger is that people sometimes replace common sense with pseudo-risk management. I cannot tell you how many funds I’ve come across who will show me that under all the scenarios they’ve mapped out, the most they can possibly lose is -9.83% or something equally and absurdly precise. The reality is you should start this process the other way round. You start by saying, “guess what guys! I’ve just lost 25%! how did that happen?” and then you start working backwards. The best tool we have is the grey matter between our ears, not the big computer in the basement.
Q: What are the areas of opportunity presented by these asset classes?
[Dr. Bob Swarup] We’re looking forward to 10-20 years of miserable growth, but that does not mean there are no opportunities. There is always opportunity out there. In many ways, people should be excited as in today’s market, they can uncover some real value and try to make some real money.
Just as one example of this, as banks deleverage, they create several opportunities. The way regulation is evolving, banks are quite quickly disposing of things like non-performing loans and so on. Once LTRO3 comes to a close, and the ability to borrow unlimited amounts of money goes away, some of the more liquid stuff may come off their balance sheets too. Similarly, if you look at the way banks are repositioning themselves, they are slowly shrinking towards their core and shedding business areas which existed on their peripheries. That creates opportunities for acquisitions, new business and more.
To give you an idea of scale, European banks have a combined balance sheet of $40-45 trillion against a GDP in Europe of around $12 trillion. I don’t know what the right ratio is for bank balance sheets to GDP but I’m guessing 350% is the wrong number. In the US the figure was at 250% and people thought this was excessive. European banks have to shrink by $10-20 trillion.
The future is about dynamic markets where risk moves around very rapidly and correlations change very rapidly too. That creates opportunities for those people who are nimble enough to trade around that. People who are looking at trading strategies, quant strategies and macro strategies will do very well, though the environment will also separate the wheat from the chaff.
Another opportunity – in a world where there isn’t much meaningful growth, people will pay any price for return and security – hence why money is rushing into sovereign debt and into other markets like London real estate and so on. People who can spot these opportunities and see where the money is going? They will do very well.
Taking this one step further, you see that an enormous amount of money is entering the system. I’m not sure where I sit on the debate on whether this creates inflation or deflation, I think a bit of both. I’m a fan of a concept called ‘biflation‘ where you can have both. Local balance sheets are deleveraging creating a deflationary effect, while imports and real assets like food and energy are rising in value and acting as sources of inflation. The result is a price scissors that creates social tensions as you can clearly see around the world. Anything that is deemed to hold its value will always do well. Despite recent weakness, gold is a good example. Oil is another good example where despite the lacklustre performance of the world economy, it has still performed remarkably well.
Q: What are the areas of innovation which could emerge within these asset classes?
[Dr. Bob Swarup] People will always spend a lot of time innovating. It is a truism about money that whenever people run out of one form, they will create another. The same is true for regulation. Whenever a regulated market is created in something (for example CDS), people create another OTC market and move the money elsewhere. The SIVs and SPVs that spawned the 2007 crisis are a perfect example of the obscuring impact that poor regulation has.
I think deleveraging also means that you’re not going to see as many exotic forms of derivatives as before. Writing complex derivatives puts pressure on balance sheets, and nobody wants that in this environment. It also exposes some of the flaws in the market. The biggest writers of bank CDS’ are the banks themselves! If you’re actually being sensible, would you buy them? The same time a bank goes bust is the time another bank may not be able to pay out on the CDS!
New markets will always develop. I think you will see increasing development in real assets. Farmland is a fascinating example and is an old forgotten asset class now being rediscovered by the investment community. Suddenly over the list 5-7 years, it’s become a huge area where farmland funds are being set-up, private equity funds are entering the space and buying farmland in Brazil and the US and more. This activity is resulting in new markets being created.
People will always move to where the opportunity is and go into situations with the same forms of temporal myopia as they always done. This is the aspect of our nature that helps us take risks, drives speculations and more. It means we don’t remember blowing up long enough for it to get lodged into our memory.
What does this mean for Investors & Risk Managers?
Our economies and financial markets have greater speed, complexity and interconnectedness than any other time in human history. In many ways this advancement itself has been the engine for the growth of alternatives as innovations have created instruments and markets which simply could not have existed before. Many of these innovations are still in their infancy, misunderstood or misapplied (this latter case being particularly apparent when considering markets such as derivatives) but there is no doubt that these instruments not only provide solid returns for investors, but provide diverse methods for risk protection.
Referring to these instruments as alternatives perhaps belies the their importance and deep integration to the global economic framework. It’s rare to find any investor who doesn’t use an alternative instrument in some form within their portfolio or strategy.
Maybe the time has come to drop the word alternative…..