Research

Eurekahedge European Investor Perspectives – Series 1 of 2

Pension Fund Allocations. Green Bonds. Insurance Linked Securities. Alternatives Asset Allocation. Real Estate & Infrastructure. Structured Credit. Hedge Funds

The way forward for pension funds

Altinvestor Europe 2017 took off with a powerful opening presentation from a highly experienced pension executive presenting on how pension funds could secure long term success through collaboration with peers and asset managers and taking a more active and innovative approach to pension fund investment management.

The speaker stressed that pension funds should not fear doing things differently and rethinking their investment strategies provided that they worked on strengthening governance which is key in making timely and informed decisions as well as key to planning for the future. Strong governance is also critical in going after the ‘next big idea’ with a genuine active management focus that can help in profiting from complexity premiums and identifying value in long term opportunities in illiquid assets and also in diverse geographic markets.

The overall message was that an increasing number of deals can now be done with effective collaboration between asset owners and also with asset managers. Pension funds should move into private markets to create alternative opportunities and often partner with asset managers on deals including taking equity stakes in the asset managers in some instances to ensure aligned interests in investment management. Pension funds and other asset owners should also share ideas, strengths and networks with each other to cut costs and drive efficiencies as well as execute and create new opportunities which wouldn’t otherwise be possible.

The speaker’s insights were backed by his pension fund’s proven investment case studies in diverse sectors across emerging markets which have delivered higher than expected returns.

Green bonds

One of Sweden’s largest pension funds presented its case in having a dedicated green bond portfolio and their decision behind breaking out the green bond holdings from its global fixed income portfolio. The speaker started with providing a background on their pension fund and its assets with an objective to maximise returns with low risks and complying with ESG without compromising on its returns.

The fund has been increasingly moving towards managing more assets in-house with a big focus on global emerging markets, China, Asia, risk premia strategies and also green bonds. ESG continues to be a big part of the investment mission consisting of an in-house committee working on areas such as fossil fuels, energy and climate change.

The pension fund sees green bonds as important investments to broaden the integration of sustainability within its fixed income mandate and to increase climate change awareness among issuers and borrowers. In terms of returns, the green portfolio returns have been higher than government bonds and less than corporate bonds; however, the fund still prefers green bonds over other fixed income instruments of similar value given the sustainability factors. Performance (in terms of green good done) is measured on an aggregate level as different opportunities have varying degrees for realisation of green savings. Green bonds currently represent 1.7% of the fund’s AUM and 5.2% of the fixed income portfolio given the shortage of green bond supply and the fund has been benchmarking Bloomberg Barclays MSCI Global Green Bond Index since 2016.

Word of caution on Green washing – it was acknowledged that this is a serious issue as some companies with dubious track records in environmental protection and/or sustainable investments try to raise money through the issuance of ‘green bonds’ whilst paying only lip service to the principles behind green bond investing. Whilst companies doing so risk their own reputation and their future access to the green bond space, any investment in this space merits a thorough due diligence of the issuer to ensure the investment is truly ‘green’ in nature.

Insurance-linked strategies (ILS)

This was a sponsored roundtable discussion conducted by the CIO of a leading asset manager providing an update on the 2017 catastrophe events and shared his view on how the market will develop and what this will mean for ILS investors.

The discussion started off with a roundup of the key catastrophe events that had occurred in 2017 along with their estimated losses as presented in the table below. The confluence of these tragedies and their occurrence over a short span of time was indeed quite unprecedented and led to the ILS sector posting its steepest losses in more than a decade as captured by the Eurekahedge ILS Advisers Index which tracks the performance of hedge funds investing in the ILS space.

Table 1: Estimated losses by catastrophes

Estimated Losses / US$ billion*
Hurricane Harvey
42
Hurricane Irma
56
Hurricane Maria
54
Earthquake Mexico (8.1 Magnitude)
3
Earthquake Mexico (7.1 Magnitude)
3
California Wildfires
10
*Estimated losses as of Oct 2017

Source: Eurekahedge

Figure 1: Performance of insurance-linked securities investing hedge funds
Performance of insurance-linked securities investing hedge funds

Source: Eurekahedge

Despite the losses posted by ILS strategies in recent months, investor appetite appeared unnerved for this uncorrelated asset class as the discussion shifted to the opportunity at hand - ‘retrocession’. Retrocession, which is reinsurance of reinsurance is an opportunity that presents itself post an ‘event’ with the prospect of locking in high premiums. Assuming estimated losses from post-event appraisals do not surprise on the upside, retrocession focused strategies can offer investors with a sufficient risk appetite high double digit gains ceteris paribus. However, since premiums subsequently decline post an event, the retrocession offering is for a shorter time horizon (three years maximum) and is positioned as a high risk-high return strategy.

The roundtable ended with a lively discussion around the theme of climate change and its possible impact on the risk profile of ILS strategies. While climate change’s contribution to natural catastrophes was deemed lacking as a statistical reality, it was argued that this talk of climate change added in an element of ‘fear’ based premia that was contributing to rising premiums for ILS based strategies. The audience also contested if insurance companies can tap directly into capital markets without a need for reinsurers as middle-men, however the CIO believed that the role of reinsurance companies is not under threat and will continue with capital markets only playing limited part in providing a buffer in the case of extreme events.

Alternative asset allocation panel

A Swiss pension fund, a Swiss insurance company representing pension and insurance assets and a UK pension fund provided their respective backgrounds on their alternative asset allocations and what asset classes they thought were necessary to meet their funds’ objectives and target returns.

Key perspectives from the Swiss pension fund – They currently allocate 6% of their portfolio to alternatives, split roughly evenly across private equity (PE), hedge funds and insurance linked securities (ILS) whilst the rest of the portfolio is biased towards traditional sources of risk premia in equities, bonds and real estate. Currently, they expect PE to outperform public markets by over 3% annualised and hence are looking to increase their allocations in the PE space. On the other hand they felt that hedge fund alpha and alternative beta is priced quite expensively and hence they intend to maintain their current level of allocations to this space. Overall this Swiss pension fund indicated and emphasised the importance of diversifying the portfolio across multiple geographies, differentiated sources of risk premia and different fund sizes.

Key perspectives from the Swiss insurance asset managers – While they did not share a precise breakdown of their over US$20 billion portfolio, this asset manager maintains sizeable exposure to alternatives and intends to scale it up as they reduce the size of their traditional bond-equity book. Much of their investments into alternatives is channelled using a ‘satellite approach’ via the engagement of external managers, though they do some direct and co-investments as well. With regards to their hedge fund allocations, the insurance company has favoured allocations to CTAs (commodity trading advisors and managed futures strategies) though given the disappointing spate of returns from this strategy it was suggested that their patience was running thin with this strategy.

Figure 2: Performance of CTA/managed futures hedge funds vs. average global hedge fund
Performance of CTA/managed futures hedge funds vs. average global hedge fund

Source: Eurekahedge

Nonetheless, the prospect of uncorrelated returns and crisis alpha added to the appeal of CTAs in their portfolio and they expect the strategy to pay off in the near future. This expectation is line with global investor allocations towards CTA/managed futures hedge fund strategies as evidenced in Table 2. Despite struggling returns for CTAs, investors have poured in almost US$54.4 billion in the last three years alone into this strategy.

Table 2: Net investor flows

Net Investor Flows / US$ billion
Year
CTA/Managed Futures Hedge Funds
All Other Hedge Fund Strategies (Combined)
Total Net Flows into Hedge Funds Globally
2006
8.8
136.2
145.0
2007
16.8
158.7
175.5
2008
(11.8)
(207.3)
(219.1)
2009
0.1
(123.0)
(122.9)
2010
(7.6)
73.8
66.2
2011
21.0
26.1
47.2
2012
(9.2)
5.4
(3.8)
2013
3.4
134.1
137.5
2014
(16.1)
50.9
34.8
2015
29.0
51.8
80.7
2016
11.0
(66.1)
(55.1)
2017
14.46
99.0
113.48

Source: Eurekahedge Global Hedge Fund Capital Flows

With regards to PE related investments, the amount of dry powder in the industry remains a concern for them and they are seeking opportunities with good entry points. Overall they indicated that the costs and fees that come with alternatives were one of their biggest challenges when pushing for increased allocations towards alternatives.

Global unlisted real estate and infrastructure panel

This panel examined viable strategies and potential risks in investing in global real estate and infrastructure. The panellists were a Danish pension fund along with a Swiss insurance company as well as an independent advisor for a group of Swiss pension funds and family offices all of whom discussed what determined the use of active internal versus external management.

The Danish pension fund with approximately EUR14 billion in total assets and with a team of six people only manages an alternative and illiquid credit portfolio comprising 25% of total assets. It started off with a fund of funds approach in infrastructure but now invests through four large active infrastructure managers who do private equity-like infrastructure investments and have collectively delivered 30% returns last year for the pension fund’s infrastructure portfolio. The infrastructure investments are diversified across these four managers and the panellist stressed the fact that they maintain a trusted relationship with these managers and view them as partners rather than just managers. The panellist stressed the fact that it was very difficult to consider active internal management for a small team. Even if they expanded their team, it would have been difficult to maintain the team and for the returns they were looking for, it would have been difficult to execute and manage a diversified infrastructure portfolio effectively which is important for the pension fund as it had come through the 2008 financial crisis without selling any of their illiquid assets thanks to the investment risk diversification, the current investment strategy and framework.

The Swiss counterparts also both used external managers; however the insurance company used a mix of both internal and external expertise as it had a much larger team and is moving towards more direct investments in the future. The insurers have been shifting its money from fixed income to infrastructure and real estate to focus on more reliable cash flows. It has been investing in utilities in the US, roads in Germany, renewable energy all across Europe and is also looking at opportunities in Southern Europe right now. Most of the European investments are managed internally while external managers are used for pursuing opportunities in North America. The other panellist also mentioned that they are investing in distressed real estate opportunities in Spain and also looking at opportunities in Shipping.

All the three panellists seemed to be echoing the words of the first opening speaker in terms of working more closely with external asset managers in the illiquid and unlisted space.

Structured credit – a longing for nostalgia?

In light of the prolonged low rate environment, asset backed securities, also known as structured credit, were examined and why the asset class still looks attractive post the sub-prime crisis. One of the managers with US$10 billion assets in management (AUM) in structured credit assets made the case for investing in the asset class with a global approach, citing some risky areas in the ABS market mainly in US retail properties (due to increase in e-shopping) and CLOs of US shale oil producers post-oil price decline (solvency issues). The manager also presented returns for various ABS instruments by tranche ratings across geographic exposure for the 2007-2008 sub-prime crisis period which showed all European ABS exposure yielded positive to slightly flat returns whilst the US ABS sector posted significant losses – pointing to need for sufficient diversification across geographies.

Structured credit outlook – Regulatory clampdown on structured credit post the 2008 financial crisis and government intervention in the loans market has led to better quality control leading to a shrinking in the ABS market assets under management from its 2007 peak (estimated US$7 trillion assets) to almost 50% below its historical high (estimated US$2.4 trillion). Overall fundamentals remain positive following recovery of the housing market and improved balance sheets and the asset class can be used by those looking to diversify away from traditional fixed income to harvest liquidity and complexity premiums without taking excessive risks. Further it was pointed out that rising rates could pose an indirect challenge to returns as whilst structured credit is a floating rate instrument, a faster than expected rate hike would impede the underlying’s ability to pay off (service) their loans at higher rates and hence could potentially reduce the quality of structured credit products and create some downside risk.

Investor perceptions around hedge funds

This was a panel discussion featuring an insurance company, a multi-family office and a large European pension fund all of whom maintain sizeable allocations to hedge funds. The discussion ranged from the challenges facing hedge funds to investor perspectives on opportunities in the hedge fund space as well comments around hedge fund fees and the rise of ‘artificial intelligence’ applications to hedge fund strategies.

What is causing the negative perception around hedge funds?

Panellists agreed that the environment is a bit challenging for hedge fund and shared their unique perspectives on the reasons for the gloom that often surrounds the hedge fund industry. The issue of ‘alignment of interest’ between investors and hedge fund managers was highlighted as a key factor holding back the industry. It was felt that the relationship between hedge fund managers and investors is often cut short due to lack of transparency that can impede an allocator from conducting thorough due diligence on a fund. However, the panellists agreed that things were improving on these two fronts, i.e. interest alignment and transparency, and the real culprit in recent times was lacklustre performance on part of hedge funds, especially in relation to underlying markets. Some panellists did however point out that the ‘artificial conditions’ in the market were in part to blame for the struggling returns being posted by some of the brightest brains in the hedge fund industry.

Figure 3: Hedge funds vs. SP500 index since 2009 – the main cause of the gloom
Hedge funds vs. SP500 index since 2009 – the main cause of the gloom

Source: Eurekahedge

What to expect around strategic allocations into hedge funds?

A common theme here centred on how equity long-biased hedge fund strategies appeared crowded, especially those focused on North American markets. All panellists showed concerns around this strong directional move and indicated a preference for relative value and other hedged strategies which they expect should outperform their long-bias peers as interest rates normalise. Interest was also cited in the insurance linked securities space, in particular opportunities in the retrocession space as well as in distressed debt hedge fund strategies.

Relative value hedge fund strategies offer better downside protection

Figure 4: Equity long-bias vs. relative value hedge fund strategies
Equity long-bias vs. relative value hedge fund strategies

Source: Eurekahedge

On hedge fund fees

Panellists agreed that fees can vary across different hedge fund managers and the kind of alpha-generating strategies they offer, and that they don’t mind paying the higher fees provided the manager offers something unique and consistently delivers on it. On further probing from the audience, the panellists indicated that a 1% management fee and a 15% performance fee was a rough guide which they utilised when negotiating on hedge fund fees. However, they expect to pay lower management fees when allocating to larger hedge funds whilst can be supportive and flexible when allocating to emerging managers setting off with a small asset base.

Table 3: Average hedge fund fees through the years

Average Fees Based on Launch Year
Year
Performance Fees (%)
Management Fees (%)
2007
17.97
1.63
2008
17.17
1.52
2009
17.04
1.54
2010
16.82
1.56
2011
16.76
1.51
2012
16.20
1.46
2013
14.81
1.34
2014
15.13
1.35
2015
14.15
1.28
2016
15.22
1.31
2017
15.27
1.22

Source: Eurekahedge

On the rise of artificial intelligence (AI) and big data

Panellists agreed that this was a field which they were keenly watching but indicated numerous challenges which are likely to remain in the interim. Perhaps the most important point which was raised was that artificial intelligence (AI) hedge fund strategies can be quite complex to understand hence the due diligence process can be time consuming and costly. Further, while the use of big data in systematic strategies could potentially provide an ‘edge’ to hedge fund managers, it was more important to focus on the ‘exclusivity’ of this data because if it is publicly available then returns for AI/Big Data strategies would eventually revert to the norm.

Table 4: Artificial Intelligence hedge funds are beating their hedge fund peers

Year
Eurekahedge AI Hedge Fund Index
Eurekahedge Hedge Fund Index
2011
14.10%
(1.72%)
2012
(1.80%)
7.37%
2013
10.44%
9.29%
2014
7.83%
5.04%
2015
26.97%
2.12%
2016
7.91%
4.58%
2017
9.26%
8.37%

Source: Eurekahedge

 

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