Three-in-a-row for alternative investments?

If 2010 was not quite as strong a year as 2009, it has not dented enthusiasm for alternative asset classes and investment strategies this year, although there are differences of emphasis between investment managers and very few seem willing to put hard numbers on their projections in terms of return forecasts (as evidenced in yesterday’s AAA post).

Many allocators seem to think that markets are normalising – this is good news for hedge funds. One adviser thinks that patterns of market correlation may matter more than the overall direction of markets: “More normal correlations between and within markets” bode well for hedge fund strategies, according to Rothschild Private Bank in this January 2011 report which also takes the popular view that rising inflation is good for gold and other commodities, in particular grains like soybeans and corn.

However, Rothschild is more cautious on property as an inflation hedge, fearing it may still struggle in highly indebted countries. Their worry is that banks have a backlog of foreclosed properties that will feed supply, as well as that the new Basel banking rules could accelerate such disposals.

Conversely, Credit Suisse likes property, particularly in its native Switzerland and in emerging markets.  But the firm advises underweighting UK property in this January 2011 report highlighting its 2011 investment ideas.

Deutsche Private Wealth Management also begs to differ with Rothschild on real estate, pointing out in its recent “Outlook 2011” report that commercial property offers better yields than sovereign bonds; still, that firm doesn’t foresee an upside resulting from higher inflation.

Altogether, DB’s Global Investment Committee recommends investors allocate 34% to alternatives, with more than the 25% it counsels for equities. This weighting would be substantially more than most UK pension funds and retail investors have in the space, although in the US and Switzerland – countries that embraced alternatives much earlier – allocating as much as one third does not look unusual for a big endowment or pension fund.  (Chart below created using data from the DB report.)

Within the alternatives segment, the report recommends 5% in a mix of real estate and infrastructure and another 5% in private equity, adding up to 10% in illiquids. The same percentage is modeled for currencies and commodities, but hedge funds (at 14%) are the largest slice of the alternatives pie.

Whereas Rothschild see normalising correlations as the driver for hedge fund returns, the Deutsche report views “growing capital market and growth divergences” as the source of opportunities that hedge funds will exploit.

Low equity valuations and cheap debt are the two reasons given for betting that 2011 will be a nice vintage for private equity investors – and Deutsche and Credit Suisse advise focusing on opportunities in emerging markets. This is perhaps contrary to a recent Edhec research explored here on AAA “Giants at the Gate” not so tough after all showing returns have historically been far lower for emerging markets. Credit Suisse also recommends taking a look at the growing secondary private equity market that was recently discussed on here on AAA as well: Facebook 50 Billion Valuation, Volcker, Shine Spotlight on Secondary Private Equity Markets. CS seems to accept the Edhec view that small is beautiful for private equity, and tips its hat to small and mid-sized LBOs.

Private equity is the only alternative that will come close to returns from emerging market equities, according to this December 2010 paper from Pinebridge Investments, which is the only one mentioned here that actually provides explicit return forecasts. The firm’s private equity projection is around the 15% mark over the next 5 years. That would be more than double Pinebridge’s forecast of 6% for funds of hedge funds and unlevered real estate, and also well ahead of their 8% return expectation for commodities.

In summary, it is hard to find 2011 surveys and projections that are negative on alternatives, with the exception of one or two worried about real estate – which is not always much of a diversifier for homeowners anyhow.

How reliable these predictions are is open to debate. Did anyone warn that 2008 would be the worst year on record for hedge funds?   This Russell Survey from 2007 found North American investors expected returns of 9.2% in 2008, which turned out more than 30% too high! Reaching further back to 1999, Ken Fisher, and academic Meir Statman teamed up to write this paper claiming that the sentiment of Wall Street strategists was a reliable, statistically significant, contrary indicator. It might be worth reapplying that exercise to the soothsayers of alternatives to see if they are any better at forecasting than the evergreen optimists of the equity markets.

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