Eurekahedge Asian Investor Perspectives – Hong Kong 2019

Altinvestor APAC 2019 is Eurekahedge’s fourth Asian asset owner event and the sixth of its kind across Europe and APAC, delivering exclusive insights from family offices as well as institutional asset owners on exploring alternative assets and optimising portfolio returns. The event is aimed at facilitating a private environment for candid discussions between investors and to serve as a melting pot of ideas connecting Asia’s leading institutional investors under one roof. The first day of the event was geared towards large asset owners such as pension funds, while the second day focused on single and multi-family offices.

Asian asset owners making space for alternatives

The first day of the event started with an opening presentation from one of the world’s largest institutional investment advisor, highlighting the increasing allocations toward alternative investment vehicles from Asian asset owners. According to the firm’s recent survey, properties and infrastructure accounted for a significant majority of Asian asset owners’ allocations into alternatives, leaving roughly 20% for private equity and 10% for other alternatives. There has been growing recognition by asset owners who under-allocate to alternatives, yet resistance is still present when it comes to increasing allocation.

In general, asset owners in the region see capital preservation, market-uncorrelated returns, return enhancement, as well as ESG framework as the main draws of alternative investment. Hedge funds in particular, are seen as a way to generate absolute return, gain exposure to niche markets, or meet new specific economic themes. In recent years, infrastructure investments in Cambodia and Vietnam have attracted significant interest among Asian investors.

Figure 1 exhibits the performance of the Eurekahedge ESG Fund Index, a custom index tracking funds within the Eurekahedge database which employ ESG frameworks over recent years. The index has generated an annualised return of 3.62% since the end of 2007, narrowly trailing behind the MSCI ACWI ESG Leaders which has gained 3.79% per annum over the same period.

Figure 1: The Eurekahedge ESG Fund Index performance since 2007
The Eurekahedge ESG Fund Index performance since 2007

A major Danish pension fund also provided some insights on how they implement ESG framework on their portfolio. Active ownership is a key part of ESG investing, and options available to asset owners include engaging portfolio companies to reduce exposure to climate risk, divesting from high-carbon companies, as well as screening out companies with issues such as labour rights, or exposure towards tobacco and firearms. Impact investments in green energy, climate funds, and sustainable solutions could also contribute towards emission reduction.

Institutional asset allocation – private equity

Interest level in private equity (PE) investments among institutional asset owners have remained high over recent years. A panel discussion took place on the first day of the event where representatives from an insurance company, an advisory firm, and a family office shared their insights on the key challenges in the PE space.

One of the major concerns shared by participants of the panel discussion was the record level of dry powder in the PE market, which could be seen as an indication of general partners taking a more careful approach before deploying capital. An overcrowded market has also contributed in making it more difficult for general partners to deploy capital in the private market at attractive valuations. On the other hand, high volumes of dry powder are disadvantageous to PE fund limited partners, as management fees are often charged based on committed capital, rather than invested capital. This has led investors to closely scrutinise the capital commitment terms given by PE general partners.

Despite all of the aforementioned challenges, the outlook of the PE space has remained positive, with forecasts putting PE market growth ahead of other alternative investment vehicles, including hedge funds and real estate. Alpha and illiquidity premium are expected to persist in PE – even if the latter has been shrinking over the past few years, indicating that there is still a strong case for institutional investors to allocate into the sector.

Infrastructure and alternative investments to improve yield

One of the largest insurance companies in Japan presented their case on the firm’s portfolio allocation, which was designed to avoid asset-liability mismatch due to low interest rates. The representative of the firm, which oversees in excess of US$300 billion, noted that the share of domestic bonds in insurance companies’ portfolios has grown over the past decades, in contrast to how corporate lending has shrunk. Duration matching approach is typically utilised to manage asset-liability spread, and insurance firms use Japanese Government Bond (JGB) swaps to meet duration targets or free up capital for deployment on other assets.

Japanese yen-denominated fixed income assets, such as JGB, yen-hedged global bonds, Japanese corporate loans still form the bulk of the insurance company’s portfolio – roughly 75%, while foreign unhedged bonds, Japanese and global equities, as well as alternative investment vehicles make up the rest. At the moment, alternatives still represent a small fraction of the firm’s portfolio, with roughly US$3.6 billion allocated into relative value, macro, equity and CTA hedge funds, and US$3.0 billion allocated into private equity funds. Infrastructure was introduced into the PE portfolio to reduce correlations within the overall PE bucket.

An endowment approach for Asian families

On the second day of the event which focused on family offices, a representative from a Hong Kong-based multi-family office shared their view on adopting the Yale endowment model in their investment approach. The endowment model pioneered by David Swensen places an emphasis on diversification and allocation toward illiquid alternatives – which in turn resulted in lower cash and traditional fixed income allocations. Over the last decade, Yale endowment’s return has mostly been contributed by venture capital (VC) and PE strategies.

Contrary to the conventional investment approach commonly adopted by family offices, which comprises asset allocation, security selection and trading, the Yale model places higher importance on manager selection, with a focus on few quality managers. Asset managers adopting the Yale endowment approach typically run high conviction concentrated portfolios with bold long-term approaches, necessitating access to high quality VC and PE managers, which proved to be a hurdle for Asian family offices adopting the model.

Evolution of the ILS market

The insurance-linked-securities (ILS) market has seen robust growth in the recent years, with an estimated US$362 billion of assets in traditional reinsurance, and just under US$100 billion in alternative ILS capital by the end of 2018. Historically, the industry has seen growth phases following major catastrophe events, which typically lead to growth and evolution of the Cat bond market – from pure property risk into Cat bonds covering wind events, pandemics, and most recently terrorism.

Figure 2 compares the performance of the Eurekahedge ILS Advisors Index against the Eurekahedge Hedge Fund Index and the Merrill Lynch Global Government Bond Index II. ILS hedge funds have generated annualised returns of 4.44% since the end of 2005. The two most recent Atlantic hurricane seasons have posed as headwinds against the performance of the Eurekahedge ILS Advisors Index, which declined 5.60% in 2017 and 3.92% in 2018.

Figure 2: Eurekahedge ILS Advisers Index performance since 2005
Eurekahedge ILS Advisers Index performance since 2005

From the supply-side, ILS market growth could be attributed to the increase in competition, vertical consolidations between insurers and reinsurers, product innovation and increasing pressure on costs. On the other hand, the demand-side has continued to see widening scope of investor types, as asset owners seek market-uncorrelated returns to enhance their portfolios – even in the face of shrinking Cat bond yield spread. Despite the growth the ILS industry has seen over the years, the market is still extremely skewed toward wind events in the US, resulting in significant tail risk for ILS investors, which is one of the primary challenges facing the industry going forward.

Figure 3 below shows the ILS hedge fund industry size and asset flows over the last few years. The ILS hedge fund industry has grown from an estimated US$29.0 billion of AUM back in 2010 to US$94.0 billion by the end of March 2019. Despite the performance-based losses suffered by ILS fund managers in 2017 and 2018, the industry saw robust investor allocations which supported the industry growth. Preliminary figures showed that investor redemptions stood at US$2.5 billion over Q1 2019.

Figure 3: Annual asset flows and AUM of the ILS hedge fund industry
Annual asset flows and AUM of the ILS hedge fund industry

Integrating hedge funds in today’s portfolio

Wrapping up the first day of the event was a roundtable discussion regarding the recent trends on hedge fund allocation among Asia’s institutional investors. Similar to their peers from the Americas and Europe, Asian hedge fund investors seek absolute returns and low correlation to public equities.

It was noted that institutional investors have been increasingly interested in China’s asset-backed securities (ABS) strategies, which could be viewed as a source of diversification from similar ABS strategies from the US market. Other hedge fund strategies which have attracted attention include quantitative and smart beta hedge funds, although investor allocations have been largely funnelled to larger funds in the space. More complex strategies also attracted some interest from asset owners, but high fees and lack of transparency remained as major deterrents.

Some participants of the discussion have also noted an increase in US investor allocations toward China A-shares despite the escalation of trade tension between the two countries last year. On the other hand, concerns have been raised regarding capital control and the ability to take capital outside of the country.

Figure 4: North American and Asian hedge fund performance since 1999
North American and Asian hedge fund performance since 1999

Figure 4 above compares the performance of North American and Asian hedge fund managers since the end of 1999. North American hedge funds have generated an annualised return of 9.15% over the period shown in the figure, outperforming their Asian peers who have returned 7.54% per annum since the turn of the century.

How do we approach tech investments?

Another highlight from the second day was a discussion among family offices on tech investments in Asia. Chinese tech investments have attracted considerable level of interest among asset owners, owing to their unconstrained growth, in contrast to how western tech companies are tied up by regulatory and privacy concerns. Payment technology, blockchain, artificial intelligence (AI), speech recognition and 5G technology were some of the sectors which attracted foreign investors.

In Figure 5 the performance of the Eurekahedge Tech Hedge Fund Composite, a custom index comprising 480 tech-focused funds is displayed. The custom index has generated an annualised return of 6.97% since the end of 2010, outperforming the Eurekahedge Hedge Fund Index which gained 4.31% per annum over the same period.

Figure 5: Eurekahedge Tech Hedge Fund Composite performance since 2010
Eurekahedge Tech Hedge Fund Composite performance since 2010

Nevertheless, tech investments in Asia carry significant challenges, from valuation risks to difficulties in due diligence. The staggering number of venture capital opportunities in the tech sector has also proved to be a challenge for investors, forcing them to choose between adopting a scatter-gun approach and investing in only a tiny fraction of these companies. The former approach entails investing in a large number of companies, taking losses on those who couldn’t deliver, doubling-down on those who delivered, and repeating the process until the best companies are identified. In the latter’s case, it is not uncommon for an asset manager to receive materials on hundreds of companies and end up actually investing in less than 1% of them.

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