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Alternative Investments: No Longer “Alternative”

Cyril Demaria

3 March 2008

Russell Research and JPMorgan Asset Management have recently published surveys showing that alternative investments are a must have for any sensible asset allocation strategy. Alternative investments regroup hedge funds, private equity, real estate and “others” which include an emerging category for JPMorgan: infrastructure. Whilst the JPMorgan report focuses on Europe, Russell Research has produced a worldwide survey. Evolution of Allocations JPMorgan notes that investments into alternative assets have risen modestly since 2003, with alternatives representing 13 per cent of the average portfolio. Of the institutions surveyed, 25 per cent are invested in the three main alternative asset classes – real estate, private equity and hedge funds. “Historically, high net worth individuals have supported the emergence of hedge funds. They paved the way for traditional institutions by pioneering this asset class”, says Pascal Duval, managing director at Russell. “Foundations and endowments were the only institutions to target absolute returns, in the same way as HNWs. But traditional investors have moved on. This explains why alternatives have welcomed such an influx. This has changed the scale of the game.” Diversification is the key motivation: investments are spread among a number of fund managers and favour diversified investment vehicles (multi-strategy and funds of funds). According to JPMorgan, since 2003 the incidence of investment in real estate and private equity has remained stable, whereas the percentage of institutions investing in hedge funds has almost doubled to 42 per cent. In the last case, the incidence of investment does not appear to depend on the size of the institution, with small and large institutions having a similar likelihood of investing. For real estate or private equity, smaller investors are less likely to invest. This is confirmed by Watson Wyatt: the mandates of its large clients have increased last year by 60 per cent for hedge funds search. Searches also strongly progressed in real estate and private equity. Real Estate: The Most Established Asset Class JPMorgan states that the main reason for investing is diversification (61 per cent), with a 10 per cent average allocation. Thirty per cent of current investors intend to increase their exposure over 2.9 years. Investment focus is on core/core-plus real estate strategies. Thirty-nine per cent of investors plan on restructuring their investments towards indirect real estate investments. Almost two-thirds of respondents plan to increase exposure to international real estate, whilst annualised returns are expected to decline from 12.2 per cent to 8.1 per cent per annum. Hedge Funds: The Fastest Growing Asset Class As for hedge funds, JPMorgan notes that the average allocation is 5 per cent (42 per cent of respondents invested), but 63 per cent of current investors intend to increase their exposure over the next 2.2 years. Diversification (53 per cent) is also the main reason for using alternatives. Investment focus is on local/European-domiciled multi-strategy funds of funds. Hedge funds are perceived as the most risky alternative asset class. However, for the first time, the average exposure to hedge funds exceeds the average exposure to private equity among European institutional investors. Annualised returns are expected to decline from 8.9 per cent to 8.0 per cent p.a., resulting in the highest anticipated Sharpe Ratio (1.06) of the three key alternative asset classes. Private Equity: The Highest Expected Return Private equity exposure has risen marginally, as surveyed by JPMorgan. However, in the Nordic region, allocation has risen quite strongly from 3 per cent to 8.6 per cent. The average allocation is 4 per cent. Fifty-one per cent of investors have less than 40 per cent of their commitment invested but 50 per cent of current investors intend to increase their exposure to private equity over 3.4 years. Investment focus is on local/European-domiciled funds of funds and the main reasons for investing are higher returns (55 per cent) and diversification (40 per cent). Investors do, though, express concerns regarding practical risks of private equity. Annualised returns are expected to remain stable at 12 per cent per annum. Infrastructure: The New Asset Class €15 billion ($22.7 billion) has already been invested in infrastructure by JPMorgan’s respondents, with a further €14.5 billion planned by 2011. An average strategic allocation of 4 per cent is anticipated in the next three years in Europe and expected return for the asset class is 10.0 per cent. Future Allocations Russell states that allocations to private equity are expected to increase worldwide through 2009. The lion’s share will be for secondaries and venture capital over the next three years. As for hedge funds, allocations are expected to increase in all regions, mainly from strategic allocations. Funds of funds are the most popular and increasingly investors turn to consultants to help them with selection. Real estate is forecast to retain its strong position in portfolios, with a consensus towards higher allocations and more interest in non-domestic markets in the future. According to JPMorgan, in Europe 63 per cent of investors intend to increase their allocation to hedge funds, 50 per cent to private equity investors and 30 per cent to real estate. Respondents of the JPMorgan survey (280 European institutions representing €1.3 trillion) strongly favour local or European vehicles. They intend to invest additional €103.6 billion into alternative assets in the next two to four years, as follows: €27.2 billion in real estate; €17.1 billion in hedge funds; €16.3 billion in private equity; €14.5 billion in infrastructure; €28.4 billion in “other” alternatives (e.g. commodities and currency). For JPMorgan’s respondents, over the next five years real estate should benefit from an increased array of investment opportunities and a broader exposure to international markets; hedge fund allocation will increase by 50 per cent, notably through funds of funds; and private equity allocation will rise by 50 per cent, with particular interest in the higher end of the risk spectrum (for example, opportunities in Asia-Pacific and global emerging markets). What are the Lessons for HNWs? These surveys were built from institutional answers, but this will necessarily have an impact on wealth management. “HNWs are already investing 10 per cent to 20 per cent in alternative assets. In the UK pensions moved from 0 per cent three years ago towards 5 per cent in the coming two years,” says Mr Duval. “Declining yields are driving this trend”. The pervasive influence of hedge funds and private equity on securities combined with the greater use of hedging by fund managers mean that even the most risk averse investors are affected by alternatives. “However, institutions are very inquisitive and many single managers do not want to deal with them. We expect funds of funds to remain the solution for institutions”, said Mr Duval. JPMorgan Asset Management, The European Alternative Asset Survey 2007, Nov. 2007, 40 pages Russell Research, The 2007-2008 Russell Investments Survey on Alternative Investing, Jan. 2008, 102 pages