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Israeli institutions find it’s time to move assets15/11/2006. Source: Israel Venture Capital Journal (IVCJ).
 Israeli institutions are gearing up to move assets into alternative investments. In this IVCJ article, Yitz Raab of KCS Capital discusses issues that institutions will face as they diversify their portfolios among non-traditional assets.
Alternative investments have been an integral part of the portfolios of North American and Western European institutional investors for decades. Israeli institutions, previously restricted to local traditional investments, have begun to invest in alternatives in recent years. In fact, allocations to alternative investments by Israeli institutions are expected to reach European levels within a few years.
The global standard
Alternative investments can refer to any investment outside of traditional equity and fixed income investing, but has generally come to mean private equity (including venture capital), hedge funds and real estate. As recently as 20 years ago, alternative investments were uncommon among institutional investors, but today they account for up to 20 percent of the average institutional investor's portfolio.
Modern investment theory emphasizes the importance of diversification among multiple asset classes. During the bull market in US equities during the 1980s and 1990s, institutions relied increasingly on beta-oriented investments to earn their returns, leading to a significant focus on index and index-like investment strategies. After severe disappointments following the bear market of 2000-2002, many institutions shifted their focus from achieving market-like returns to targeting their internal actuarial return requirements – making absolute-return alpha approach strategies much more appealing. As a result, investors have been engaged in an ongoing struggle to find new alpha-oriented investment opportunities with strong risk-adjusted returns. Alternative investments serve this need by providing diversification with potential for high returns and low correlation to the rest of the portfolio.
Another catalyst for alternative investments has been excess liquidity in global financial markets, which has forced investors to seek new investments outside of traditional equities and fixed income. Institutional investment in private equity and hedge funds has reached record rates, and will continue to rise in the coming years.
Israel’s capital market revolution
For many years, a combination of regulatory and market factors prevented most Israeli institutions from investing in anything other than local traditional investments. However, recent changes in the market and regulatory environment, such as those based on recommendations from the government-appointed Marani and Bachar committees, have paved the way for investment in alternatives by Israeli institutions. Key changes have included:
• increased discretion in asset allocation by investment managers, and cancellation of the special issue government bonds which institutions were required to hold
• tax equalization on foreign investments, removing the unfair advantage local investments have held over international investments
• pension privatization and reform which has increased competition for new pension money, and has led to a more professional approach to institutional investing
• forced divestiture by the banks from provident fund and mutual funds, effectively detaching the manufacture of financial products from distribution channels and bringing a new era of "survival of the fittest" for institutional investors
These changes and others have given Israeli institutions the ability as well as the motivation to look for new ways to invest. Israeli institutions have begun to diversify their holdings and have increased investments overseas. Some institutions have grown from absolutely no overseas assets just a few years ago to over 10 percent today. This trend is expected to continue as local investors are finding fewer opportunities in shekel-based investments such as the Tel Aviv Stock Exchange (as returns enjoyed in recent years have begun to diminish). The trend may eventually lead to institutions allocating a majority of their assets to overseas investments.
The increased geographic diversification by institutions is an important development, but has been confined almost exclusively to traditional equity and fixed income investments. The majority of international investments to date have been index-based making them high in market beta as well as their correlation to global markets. Local institutions that find themselves constantly redefining their investment and allocation strategy to keep pace with the changing market are faced with an unmet need for highreturn high-alpha investments with lower correlation to the portfolio.
Moving to alternative investments
Many Israeli institutions have already begun their entrance into alternatives. Most of the larger institutions have begun to invest, albeit in local funds. In previous years, these investments had
been in local venture capital funds, but more recently local Israeli private equity funds and hedge funds have become common, too. Some institutions have also made direct investment in infrastructure and BOT projects, buildings and real estate, various forms of credit and lending, and in local companies, all of which fall under the alternative investment heading. Much of this investing had been done opportunistically, without a clear policy or allocation. This, however, is changing. Responsible institutional investors now view allocations to alternatives as an important strategic portion of their portfolio, and a necessity for survival in this new competitive market environment.
Many Israeli institutions are evaluating alternative investments for the first time and are grappling with issues such as allocations per asset class, and how to effectively use funds of funds and external advisers. The larger institutions are attempting to learn quickly and thoroughly, and have appointed dedicated alternative investment professionals. Some have invited speakers from overseas to lecture, while others have sent investment managers to attend courses and seminars abroad. Institutions are beginning to define allocations, and have given their managers a mandate to invest in alternatives. Clearly, these institutions face no small challenge.
The good news is that Israelis are fast learners, and, as was the case in areas such as technology and defense, may catch up quickly and even become innovators in the industry. As institutions begin this journey, there are several issues that they will confront along the way:
Understanding Alternatives – Investing in alternatives requires a deep understanding of their merits as well as their drawbacks. Alternative investments are generally less liquid and have less transparency than traditional investments. Although alternatives do serve as an excellent diversification tool, lowering overall portfolio risk, some individual investments can be relatively volatile making expertise in managing risk particularly important. One specific dilemma associated with private equity and venture capital investing is managing the J-Curve effect, which can have a short term negative effect on performance, by vintage diversification.
Allocating Resources – Institutions will need to get serious about their alternative investment programs. The complexity involved in making alternative investments does not allow for an opportunistic approach. Local investors should allocate resources, in the form of time, money and professional staff. Many of the large insurance companies already have a dedicated staff in place, in some cases by specific asset class. In order to cover ground quickly, institutions should also take advantage of outside experts, including local investors who have previous experience in the field.
Building Allocations – Clearly defined allocations to alternative investments as a percentage of the overall portfolio are critical for establishing an effective program. Some local institutions have already defined total allocations to alternative investments, but have not outlined their allocations to individual asset classes. Each alternative asset class has its own correlations, benchmarks, risks and rewards and must be evaluated individually based on the overall investment strategy of an investor. In each case, an institution’s liquidity requirements will play a major role as investments such as private equity and real estate may offer limited liquidity, while hedge funds and some commodities are more liquid.
While some leading institutions such as the Yale University Endowment allocate the majority of their portfolio – about 60 percent – to alternatives, most institutions in Europe and North America assign 10-20 percent of their assets to alternatives. Allocations by institutions to private equity have grown to seven percent in recent years, and allocations to hedge funds – a more recent phenomenon among institutions – have already reached a similar level. Israeli institutions must consider these international standards when creating their own investment programs.
Diversifying Geographically – Israel’s economy is experiencing excellent growth, and the local opportunity for alternative investments is significant, even for investors from overseas. However, as with any asset class, only a small portion of the opportunity can be found on the local markets. Israeli investors must look to US and European markets for opportunities in private equity, hedge funds and other investments.
Regional opportunities, such as investment in emerging markets, are becoming an important part of the alternative investment universe as well, and Israeli investors may have an advantage over their Western counterparts in some Asian and Eastern European markets.
Making the Investment – Executing the plan properly is the most important and, very often, the most challenging part. Local investors will face difficulty in finding the best investment opportunities, in accessing the top investment funds, and in carrying out thorough due diligence and setting investment terms. For example, Israeli institutions with alternative investment allocations have been looking for smart ways to enter the global private equity and hedge fund markets, but have quickly become aware of the difficulty in identifying and gaining allocations to the leading funds. Mid to small-sized institutions, such as those found in Israel, seldom have their own direct investment program and generally execute these investments through a fund of funds or adviser. In fact, a majority of institutions execute their private equity programs in this way, with a full 91 percent of institutions that invest in hedge funds doing so through an external program.
After an initial learning period, we can expect to see Israeli institutions with investment strategies similar to those of their international counterparts. Allocations to alternative investments will match, or even exceed, those of European institutions within a few years. Over time, I believe that local investors will come to develop an international reputation for expertise and innovation.
Yitz Raab is CFO of KCS Capital, an international asset management firm, focused on alternative investments.
This article appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com
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