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Institutional investors seek alternatives to plain-vanilla bonds and equities

Alternative investments are becoming more common in Canada and thw outlook is promising, according to Scot Blythe of advisor.ca. However, much needs to be done for the sector to develop to its full potential.

Confronted with flat stock markets and declining bond yields, many institutional investors have begun to look elsewhere to bolster returns. Hedge funds and placements in private companies are two alternative investments that have experienced rapid growth in the past five years. 

Alternative investments have long been the preserve of high net worth individuals, but they are now becoming mainstream. Already in the United States, CalPERS, the $152 billion US pension plan for California public employees, has committed to hedge fund and private equity investments, as have a number of other public pension plans and university pension and endowment funds. Some universities have up to 25% of their capital placed in alternative investments, mostly in private equity.

In Canada, the city of Montreal's pension plan, Canada Life, the Insurance Corporation of British Columbia and the Ontario Municipal Employees Retirement System have all either considered or invested in hedge funds, while the University of Toronto is looking at investing up to 10% of its endowment fund and 5% of its pension fund in private equity.

The interest in alternative investments is sufficiently pervasive, in fact, Benefits Canada is currently running a poll on its Web site that asks the question: "Are Canadian pension fund managers irrationally exuberant about alternative investment strategies?"

"This is a really challenging area," adds Kelly Rodgers, an investment management consultant in Toronto. For Canada, "it's a very new area. There's not a lot of good data on it."

Both Ahmad and Rodgers made their comments at a summit for non-profit, endowment and foundation investing organized by the Strategy Institute in Toronto this week.

Apart from the promise of higher returns, one reason alternative investments have grown more popular is a receding memory of disaster. Hedge funds fell into disfavour after the Russian currency crisis of 1998 toppled one of the most speculative of funds, Long-Term Capital Management. Similarly, private equity investments had to outlive the excesses of the 1980s leveraged-buyout boom, even though buyouts are only one slice of a private equity sector that runs from start-up financing through funding for expansion to buying out the owners.

In the U.S., both sectors are carving out a significant share of capital markets, with some $500 billion invested in hedge funds. Private equity funds are attracting in-flows of $16 billion a year, up from less than $2 billion five years ago.

In Canada, too, the alternative investment sector is maturing, though it is still poorly understood, says Bob Gorman, chief investment officer at TD Private Client Group.

"Are alternative investments for you? Probably yes," he said at the same summit on endowment and foundation investing. "Five years ago I couldn't have said that."

What makes a difference now is the spread of a fund-of-funds structure for hedge funds and private equity investments. They can offer a "simplified turnkey solution" for institutional investors at reasonable cost, Gorman says.

The fund-of-funds approach is particularly useful in diversifying risk in hedge funds. The classic hedge fund strategy was to buy some stocks long, and others short, so that the fund would benefit whether the market was up or down. But this traditional "market-neutral" approach has been supplemented by a variety of strategies, including buying distressed securities, looking for companies that are potential merger targets, and arbitraging — trading on minute price variations among different securities issued by the same company. U.S. research firm HedgeFund.net enumerates 33 different hedging strategies.

Some hedge fund strategies strive for outsize gains by taking on much higher risks than straight equity investing — much like trading in options and futures. But many are actually quite conservative, offering a higher return than bonds, but with less risk than stocks.

Gorman suggests that a balanced investment manager could use a hedge fund to replace some bond holdings, and generate a higher return for a slightly elevated risk, or, contrariwise, reduce the risk profile of the portfolio by replacing some equities with a hedge fund.

Still, "you have to be very, very careful about what you're buying," Gorman says.

Most funds haven't been around very long. Finding a hedge fund manager with a track record of low volatility and high returns — usually on the order of 12% to 15% annualized — can be difficult, in part because hedge funds don't advertise. Instead, investors usually require the services of a consultant to link them to one or more of the 5,000 funds in the U.S.

A consultant is also valuable because there are no real statistical benchmarks for hedge funds — existing efforts compare funds that have quite different strategies, and tend to be biased thanks to survivorship bias, Gorman notes. The successful funds skew performance because the returns on defunct funds are stripped out of the benchmark. Another problem is that there is a significant difference in performance — in industry parlance, there is a high dispersion of returns — between the top 25% of hedge fund managers and the average fund manager. That makes it imperative to hook up with the best managers.

Private equity investments, by contrast, are a bit more visible and easier to understand, says Gorman. Like hedge funds, a private equity investment can be expected to deliver higher returns than equities, but more than hedge funds, they require a long-term buy-and-hold strategy.

"There's no doubt about it. This is a highly risky class," Gorman notes. A major reason is that the historical benchmarks that fund managers use to analyze public companies don't apply to private companies. In the absence of a trail of data, judgment, instead of comparative analysis of a company's fundamentals, plays a crucial role and necessitates hiring a professional investment manager.

For investments in the start-up of a company, an institutional investor might expect, over the long term, a return of 40%. For investments to help a company expand, the long-term return drops to 30%. Finally, an investment that allows the owners to sell out might return 20% over the long term. That compares with a 14% return on the Standard & Poor's 500.

But private equity investments also see a high dispersion of returns, most strikingly in the venture capital phase. In the U.S., the top 25% of managers returned an annual 66.4%, while the median return 23.8%.

Diversification is key to controlling risk. There are three vehicles for making private equity placements. The most problematic is to invest directly in a company, since that brings with it potential tax and employee obligations should the firm run into trouble. Another method is to invest in a limited partnership, or a series of limited partnerships. That entails a trade-off between access to the company and professional investment management.

Finally, there are private equity funds of funds. Although the most expensive option, a fund of funds offers the most diversified approach, though some endowments do participate in private equity investments through a series of limited partnerships.

As for diversification among asset classes, in the U.S., private equity is somewhat correlated to equities — it follows the direction of large- and small-caps about half the time. It is negatively correlated, but only slightly, to fixed-income investments, moving in the opposite direction roughly 20% of the time.

While a case can be made — using modern portfolio theory — for greater exposure, Gorman recommends modest investments in alternative assets, up to 10% of the equity portfolio, and 5% of the total portfolio.

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