2016-06-02

<p>Liquid Alternatives provide a lot of flexibility as well as diversification for investors. Watch as four investors discuss the various types of liquid alternatives and how investors can incorporate them in their portfolios. </p>
<ul>
<li><p>Sinead Colton - Head of Investment Strategy at Mellon Capital</p></li>
<li><p>Ryan Levitt - Partner at Pomona Capital</p></li>
<li><p>Larry Kissko - Client Portfolio Manager at Man AHL</p></li>
<li><p>John Ehli - Portfolio Manager, Direct Real Estate at Deutsche Asset Management</p></li>
</ul>

Video Image:



Duration:

0000 - 01:02

Recorded Date:

Tuesday, May 10, 2016

Transcript:

Gillian: Sinead I'm going to start with you. Liquid Alternatives we have many representations on this panel of different types of liquid alts, but I'd like to start out more broad than that. How do you define liquid alternatives?
Sinead: [0:00:12] Well, the first thing about liquid alternatives is that they should be a more liquid representation of what we've been able to see through various hedge fund and alternative strategies over the last several decades. But really when you get into the liquid alts category, what's really important to realize is that the category is very, very broad. So it can range from a very dynamic multi asset strategy through to managed futures, through to a single, or a multi manager, multi strategy approach. And within that there's a very broad spectrum in terms of the outcomes that these strategies are aiming to achieve. That's probably the first and most important difference relative to, for example traditional assets. Across the board these strategies are outcome oriented, so they're not aiming to generate returns relative to a benchmark. So they will have a particular target return that they're aiming to deliver within a particular risk range, and generally aiming to deliver less downside to protection, or putting it more positively, more downside risk management. But it's important to distinguish between them because at the lower risk end of this spectrum you have absolute return strategies that are maybe aiming to deliver cash plus 3, to cash plus 4, and doing so within a pretty low risk allocation, maybe an expected risk range of 5 to 7%. At the upper end of the spectrum you have strategies that are aiming to deliver more asset class like returns, potentially an equity like return, and doing so typically with less risk, maybe 7-10%. But some of the strategies are aiming to deliver more like an equity like risk. So there's a very broad spectrum, and the most important thing for any investor whose looking at this space is to be very clear on what type of approach a particular manager is taking and how that fits with their overall risk tolerance.
Gillian: [0:02:13] So you define them less by some strategic orientation that you can unify all of them and more by the fact that they define their outcomes differently from traditional alternatives?
Sinead: [0:02:24] In part, and again it depends on the particular area, but once you move into the liquid spectrum, and you're moving away from that, if you like, illiquidity premium, then particularly if you look at say the multi alternative category then yes, they tend to be more outcome focused in terms of the return that they're aiming to generate.
Gillian: [0:03:17] Okay. And Ryan, broad strokes, how do you define the liquid alternative space?
Ryan: [0:03:22] I think it's been covered a bit. But generally speaking, I think traditional investment options would generally consist of equity markets, fixed income markets. I think of alternatives as derivates of those strategies, hedge fund strategies, real assets, energy, timber private equity within that buy buyout venture capital growth equity, and then alternative credit strategies. And then I take the liquid portion of that one step further which is your traditional funds are locked up partnerships ranging from quarterly lockups to 19 year plus lockups with traditional private equity. And your ‘liquid component’ is taking that a bit closer to what investors are generally used to which is daily NAV traded funds. I think it's important to note that just because something is called a liquid alternative does not necessarily mean it's liquid. I think it's generally intended to mean that it's more liquid than traditional alternatives. So that may be a better way to name the asset class would be more liquid alternatives.
Gillian: [0:04:26] That’s a really important point and I’d love to discuss with each of you the liquidity profiles of your products more in depth, Larry, the question to you, what are liquid alternatives?
Larry: [0:04:34] I think my fellow panelists have covered it nicely. But I think it’s a little bit like if your neighbor on a cold fall day invites you over for a chili dinner and to watch the game. And so you know when you go it’s going to be warm probably, and you know it’s going to be in a bowl but you don’t know much else. And that’s a little bit like the liquid alternatives where it’s very broad but lacks a little precision. So your chili could be white bean or it could be red bean. It could be chicken or beef; it could be flavored jalapeno or cumin. And so I think that that’s part of the challenge is just offering a little bit more precision, possibly some benchmarking to help define it. But it think very broadly it’s something with typically daily liquidity, although Ryan has a slightly definition, I’m curious to learn more, daily liquidity, maybe some increased transparency and something that fits around this 40 Act structure.
Gillian: [0:05:32] Okay, it’s interesting, I liked your chili metaphor, I’ll have to remember that one. Sinead, you touched on this a little bit but much of the liquid alts category as you mentioned is dominated by multi asset strategies which seem similar to traditional balanced strategies. But can you explain just how they differ?
Sinead: [0:05:48] Sure. Well, I think the fact that they may invest in equities and bonds, similar to a 60/40 or a traditional balanced is pretty much where the similarity ends. The multi asset strategies, as the name would suggest can invest across a very broad range of liquid asset classes using a broad variety of instruments as well, whether it’s futures, individual securities, using options, it’s really very, very broad. And then if you start thinking about the characteristics of these strategies there are really a few main ways in which they differ to the traditional balanced type approach. So the first one’s in terms of asset allocation flexibility, so multi asset liquid alt strategies have a lot of flexibility in how they can allocate. They can be net short a particular asset class; they could be for example, a 100% in equities, a 100% in bonds. They could be a 100% in cash if they’re being very, very risk averse. And you should also expect to see some pretty dynamic asset allocations, so really taking advantage of that flexibility. Now, what that also means is that they are aiming to deliver an outcome. So it’s not about relative returns where a traditional balanced manager may focus on the, if you like, active risk and the active returns over and above the benchmark. Here the manager is responsible for absolutely everything that’s in the portfolio and the outcome that it then delivers. And within those approaches you can see a lot of differentiation in terms of how that may be implemented.
For example, some managers may be single manager strategy if they manage everything directly. Some managers may be using external managers, whether it’s a full multi manager, multi strat approach or they may utilize external managers for particular areas of expertise. And that of course can have an impact in terms of the underlying fees that you see in the strategy. And then finally these strategies often will use leverage. They can almost certainly short, whether at the individual security level or the overall asset class level and utilize a degree of options. So you can see very dynamic beta exposures within the strategy. But the bottom line is the focus on the outcome rather than the benchmark relative outcome. And maybe a good way to encapsulate it is that for a traditional approach if a manager isn’t taking any active positions their neutral position is the benchmark, so that 60/40 position. For the multi asset manager they are responsible for everything that’s in the portfolio. So that is a conscious decision.
Gillian: [0:08:35] It’s really interesting. And I’d like to speak with each of you a little later on about how you’re defining this outcome of performance for each of your individual strategies. But, John, we’ve been speaking broadly. Now I really want to drill down on what each of you are focused on because the topics vary quite widely. So can you tell us a little bit about your focus on real estate and what your investment process looks like?
John: [0:08:55]. I’m a core real estate manager, and really what the core space is, it’s a strategy that’s derived primarily from producing income from real estate assets. Over the past 5 years or so a lot of the total return has been driven by appreciation. If you look at core real estate over a long period of time, say 25 years, it’s typically produced about a 9% total return with usually about two-thirds or even more of that coming from income. And over this past series we’ve seen returns in the mid to high teens with much of it coming from appreciation . Over the past 5 years I would symbolize as a growth appreciation phase; really starting to move into much more of an operational income driven phase where I think we’re going to begin to see much more normative returns in the single digit range.
Gillian: [0:09:50] Now, when I think of real estate, liquidity maybe isn’t the first thing that comes to mind. So can you give us a sense of allocating to this market?
John: [0:09:57] Most of these strategies are very, very low levered. So the leverage typically for the benchmark, the ODCE Index that we measure ourselves by, is anywhere from 20-30% which is somewhat atypical for this space. Most people think of real estate being more higher octane, levered in that 50, 60, 70th percentile. But for most of the core space it’s very low levered. So there’s a tremendous amount of equity behind most of these transactions. The other thing is, is these properties are generally invested in better quality properties in markets that are gateway markets like Boston, San Francisco, New York, that typically have fairly open capital markets. So albeit real estate is not a 100% liquid, there’s certainly much more of a market today and available today than there ever was. In terms of the depth of investments there is really broad investments from the whole world. We see a lot of capital from both Asia and Europe, there’s a lot of domestic capital. And as we talk about some of these alternative investments, we’re also seeing that really kind of start to land on the radar of defined contribution, which real estate has historically had very, very little space, really had very, very little allocation to the defined contribution space. So there’s more capital forming that provides that liquidity to existing investors and we’re also seeing that many investors are looking at this as a cornerstone of their portfolio for investments that are much longer in duration, 10, 15, 20 years plus.
Gillian: [0:11:38] Interesting. And, Ryan, what about you, talk us through your investment process and what you’re investing in.
Ryan: [0:11:44] Yeah. So Pomona’s investment process is a bit different. I think you have to think about private equity as an asset class. Pomona’s been investing in private equity in various forms since the early 90s. And our approach to private equity was how could you capture the upside of private equity? Well, eliminating or limiting some of the inherent risk. So if you think about private equity on the positive side of equation you have long term outperformance over public markets over any time period you look at, 5, 10, 15, 20, 25 year period, typically by hundreds of basis points. So if you think about the last 10 year period, private equities delivered about 13%, traditional equities about 7%, fixed income, 5 or below, so clear outperformance. You do have to contend with though, blind pool capital risk. So when an investor allocates to the asset class traditionally, you’re not sure what the manager is going to buy. So you commit capital for a 5 year period which they can draw to make new investments. They can return your capital to you over the next really 8-10 years. So, private equity realistically speaking is a 12-15 year ultimate commitment to not only the asset class but that particular manager. Pomona’s approach over 22 years has been to buy secondary positions in private equity funds.
So the original investor makes a commitment in year zero and they take the blind pool capital risk, they have to exit that position for any number of reasons, largely internal to them. And we go and buy that position in year 5 or year 6, capital’s largely fully funded, we can underwrite actual companies that are in the portfolio, figure out what we think they are worth and what we think they’ll be worth in the future, buy that position typically at a discount. So it’s a value approach to private equity. And we’ve managed 8 successive institutional funds in this space and then May of last year we launched a registered retail fund, a closed end 40 Act interval fund. And that’s where I get to, it is a more liquid alternative, but it’s not a liquid alt as it’s traditionally defined. So it’s not a hedge fund strategy. That is a daily NAV product. Traditional private equity, 10 year locked up limited partnerships, secondaries a shorter duration form of that with a lot of near term liquidity compared to the original asset class view. The closed end 40 Act interval fund uses that natural liquidity off the secondary portfolio to offer redemptions 5% per quarter, 20% per year to investors. So that’s why I draw a distinct line between our product, the Pomona Investment Fund and traditionally defined liquid alts. I think the daily NAV products have their benefit. I don’t think private equity fits into a daily NAV product construction.
Gillian: [0:14:32] You touched on this briefly but what are some of the reasons that some of the investors might be getting out of their positions? And do you have to mitigate any risks associated with that?
Ryan: [0:14:41] Yeah. So investors sell positions in private equity funds for any number of reasons. If you go back to 2008, 9, 10, it was more a liquidity driven selling, 2011, 12 was more regulatory driven selling, local rule, pressure on financial institutions to reduce capital ratios, so on and so forth. Today it’s much more active portfolio management. If you think about a traditional municipal pension fund with two people managing billions of dollars of private equity, there’s the portfolio management from an administration standpoint challenge. And I pretty much guarantee that Pomona with a team of 25 investment professionals knows more about that portfolio than the seller does. So I’d say the dominant reason for selling today is active portfolio management, which might be administrative burden, it might be a CIO change where the successor CIO wants to sell some of their predecessor’s portfolio and redeploy into their own choices. So there is risk inherent in that. But I think there’s risk inherent in all kinds of investing. We mitigate that through careful bottoms up company level selection as well as diversification. So our secondary funds over time will accumulate dozens, if not hundreds of fund interests with underlying companies numbering again in the hundreds, most likely in the thousands. So our loss ratio is municipal bond like, far from traditional equity like loss ratios in the asset class.
Gillian: [0:16:10] It’s very interesting. And I’d like to go into more of your view on the market for secondaries in a moment. Larry, managed futures, this is a carve out of the hedge fund strategy that predated the liquid alternative strategy, is that correct?
Larry: [0:16:23] So it’s not a Pari-passu strategy but it relies on the core models and concepts of our hedge fund strategies at AHL which AHL has been in existence since 1987. So we have a long track record of doing this and then in 2014, August of 2014 we launched a daily dealing 40 Act Fund. And it really, so on the managed futures side we’re trading in over 80 markets across four big asset classes: equities, fixed income, commodities and foreign exchange and looking for really two to three month trends within those asset classes. And in our program it’s all algorithmic, it’s all computer driven and it’s agnostic about being long or short any of these asset classes. So what makes our program tick is market movement, market moving to new highs and lows and that really helps us.
Gillian: [0:17:22] It’s very interesting. And the difference between the hedge fund product and liquid alternatives product, is it that you are focusing on the more liquid assets that the hedge fund is trading and maybe dropping some of those less liquid ones?
Larry: [0:17:31] That’s right. That’s right. So, on the hedge fund side we will trade a handful, actually hundreds of over the counter markets in our trend following program that doesn’t … those markets won’t quite fit into a daily dealing construct. So we limit it to the most liquid markets that will trend.
Gillian: [0:17:48] Very interesting. And Sinead how does Melling Capital manage the investment process for liquid alternatives?
Sinead: [0:17:54] Well, our liquid alternative strategy is a multi asset managed volatility approach. So really aims to deliver a total return that is equity like but with about a half to two-thirds of the risk of equities over a typical market cycle. And part of that is aiming to limit downside risk. So really what we are aiming to do, and again similar to some of the other panelists, we’ve been managing strategies within the more traditional hedge fund sphere for close to three decades. And so what we’ve done is taken that approach and really translated it into the 40 Act sphere. So our approach is fundamental valuation based but we combine that with a macro awareness quite simply because there are periods of time that … where fundamentals can be overwhelmed by the macro. Now, our approach is systematic, so we’re model driven. But it’s very much not a black box. So typically what you see in the broader market environment you can relate back to what’s happening in the portfolio. And we’re also aware that no matter how well you specify any model there are certain things that models can never see, I mean geopolitical risk is a perfect example. So there’s an element of discretionary risk management built into our process as well. And really what we do is look for the most attractive opportunities across liquid asset classes. And so that’s typically across the equity markets, bond markets, currency markets, and real assets. And we take long and short positions.
So typically we will have a net exposure to equities and bonds, but within that we will be very specific about the country exposure that we want to take. Now, I think one important distinction particularly within the liquid alts space, and this is something I would encourage every investor who’s looking at this space to do is really understand how you expect each strategy to perform in different market environments. So given that we’re a total return strategy we’re probably at the higher end of the risk and expected return spectrum of the liquid alts space and truly liquid as opposed to real estate or private equity. But what that means is that if you see an equity market downturn we will participate in some of that because what we’re aiming to do is really curtail the significant left tails. Whereas if you look at say an absolute return strategy, they’re running at very low risk, their return expectation will be lower but in an environment such as we had in the first quarter that’s when they should really help in terms of the downside or having a very, very small downside risk management. So again even though strategies might sound the same at the high level, what they’re aiming to achieve and what you should expect from them can be very different.
Gillian: [0:20:47] Do you find that you have to be very careful about how you communicate this to a now broader base of investors that are able to access these vehicles?
Sinead: [0:20:53] Yes. And we’re really clear about it. So in every conversation that we have we will talk about what you should expect in different market environments and in particular what you should expect during a market downturn. And I think that’s the most critical element for any investor because the multi alternative with a liquid alts universe is very, very broad, how different strategies will behave, whether it’s managed futures, absolute return, total return in different environments is importantly different. And that also potentially leads to help investors make a decision about where they may allocate capital from in order to invest in this particular area.
Gillian: [0:22:31] Let’s move on to a macro view in each of your strategies, just generally what you’re seeing in the market. So, Ryan, I’m going to start with you. Tell us a bit about the market for private equity secondaries, what are you seeing, what does the deal flow look like?
Ryan: [0:22:44] Sure. So private equity generally speaking matches about $4 trillion of assets, roughly 3 trillion was raised in the last 5 years alone. So the asset class, well, today it’s more limited to institutional investors, it’s quite massive. And we think that ‘retail investors’ who have a sub 1% allocation to the asset class are missing out an opportunity. It’s not for lack of interest; it’s more for lack of suitable investment options hence why we created the Pomona Investment Fund.
Gillian: [0:23:41] I’m going to move on to a macro view for each of your particular focus in investment classes. Ryan, starting with you, can you give us a little sense of what the private equity secondaries market looks like right now?
Ryan: [0:23:53] Sure, happy to. If you think about the generic private equity market it’s about $4 trillion in assets that are managed. Investors, as we mentioned before want access to the asset class largely because of the return potential and largely because of the volatility mitigation. So if you look back, historically private equity has tended to shallow the lows during market declines while capturing much of the upside, over medium to longer term periods of time that has led to significant outperformance versus public equity markets. So over the last 20 years investors’ allocations to private equity have risen in a pretty linear fashion. So the asset class today, $4 trillion in assets, those assets turned over at a given rate per year somewhere in the single digit range. As you mentioned earlier, investors sell assets or limited partnership interests for any number of reasons. But the secondary market today is about $40 billion a year in annual closed volume; obviously gross flow is above that. So Pomona over the last couple of years has seen north of $150 billion of deal flow. So we have plenty of assets to choose from. We typically close on about 1-3% of our doable deal flow. So we don’t lie awake at night and worry when the next deal comes in, it’s more about how do we want to spend our time. And our challenge is to buy the best assets that we can find at the most attractive prices which generally is a discount to carrying value since at the end of the day they’re still illiquid assets.
We think the secondary market is a fantastic place for investors to be. We’ve spoken a lot about volatility on this panel. Secondary funds typically exhibit minimal volatility. It’s certainly not a zero correlation to public equity markets. But again if you can buy more mature assets, if you can diligence companies rather than buying full capital risk, if you can mitigate the inherent J curve in private equity and you can buy those assets at a discount we think it’s largely a win, win for investors.
Gillian: [0:25:56] Interesting. And your outlook for deal flow going through into next year, do you expect to see an uptake, do you expect to see it kind of unsteady?
Ryan: [0:26:03] So deal flow has grown over the last roughly 10 years at a 20% [inaudible] over that time period. It’s ebbed and flowed in some years but again generally as attracts private equity allocations, secondary deal flow has largely been up into the right. So we do expect to see another robust year of secondary deal flow, whether that’s 35 billion or 45 billion or 50 billion this year remains to be seen.
Gillian: [0:26:28] Interesting. And, Sinead, what are some of the macroeconomic factors that you’re focused on right now as you evaluate your portfolio?
Sinead: [0:26:35] Well, clearly it’s been a very interesting start to the year. You know, I would express our view as being cautiously constructive. So there are particular markets within equities that we think represent some more attractive opportunities. But we’re seeing a lot of variation within earnings; I mean how we’ve seen earnings expectations move down over the last number of quarters. And that’s something that really influences how we look at markets. So selectively we think there are some interesting opportunities in Europe, also within Asia. And within bond markets, so bond markets are actually where it gets really interesting. And we tend to look at global government bond markets primarily, that’s where we take most of our risk. With yield levels at such low points, often there is a view that, you know, well, really how much more movement are we likely to see? But actually if you look at the 10 year, pretty much across most markets you’ve seen a lot of volatility, say for example with the German bund yield moving between 5 basis points in April last year up to a 100 basis points in the space of a couple of weeks. And that’s really the type of movement that we are aiming to exploit. So we look at bond markets globally and we are … we’re looking at opportunities across the sphere. So although bond yields can be very low, right now that actually makes our approach much more tactical. I mean so that presents a lot of opportunities.
And it’s unusual to think about it but treasuries even with a 1.7/1.8% yield on the 10 year; they’re effectively the high yielder within the global government bond space. Looking at currencies, again we’re seeing some of the macro conditions evolving quite rapidly. We think that there are … there’s further room for European currencies to fall, in particular the euro and the British pound, we’re very focused on the Brexit risk at present. There are some more interesting opportunities in Asia. We have seen the Reserve Bank of Australia cutting interest rates very recently. But still we’re actually seeing the pace of slowing and that economy declining. And so that relatively speaking can make some of those currency opportunities more interesting. And then in the real asset space, really the way we look at real assets is thinking about helping to hedge against inflation risk. Now, right now we’re not seeing anything significant in the way of inflation risk, so it’s a pretty low allocation in the portfolio, but we’re tending more towards TIPS than we are towards commodities at present.
Gillian: [0:29:21] Very interesting. And Larry, we actually have a viewer question for you on the broader focus of the managed futures market and the assets that are flowing into it, so.
Rick Spurgin: [0:29:35] I’m Rick Spurgin; I’m a finance professor at Clark University in Massachusetts. And one of my research interests is managed futures. And I’ve noticed in the last few years that managed futures has really exploded in the liquid alts in terms of assets [inaudible] fund. I wonder what you think is the explanation for this and whether you’re recommending investors to allocate to that?
Larry: [0:30:00] Yeah. So that’s a very good question and we are seeing increased interest and there have been an increase in, I guess, product proliferation as well. We maybe fall into that category, launching in 2014. But I think that what investors are seeing and what Richard is pointing out perhaps is that when you look at managed futures it really is an uncorrelated asset class. And so generally what you find across the space is that it’s slightly negatively correlated to equities. And it adds this element of what some academics will call crisis alpha where managed futures funds have an ability to perform quite well when equities are in a down trend. So I think, you know, one case study for that might be the beginning of this year where if you look at January, you know, the world started off there on a very sort of wobbly state where China came in and its stock markets really tumbled again, the rest of the world followed suit. And there are also these growth concerns. And you saw the S&P drawdown by about 5% in January. And if you look at one of my favorite benchmarks for the mutual fund CTA space is a Soc Gen CTA Mutual Fund Index. That index was up 2.6% over that same timeframe in January. And it was also positive in February when the S&P was flat. So I think that this idea of diversification, negative correlation really helps to round out a portfolio and reduces the vol within a portfolio. So I think that investors are coming to see that and especially as these products come onboard and become available there’s more on the dashboard to look at. And we’re seeing growth in our program as well.
Gillian: [0:31:53] Now I know in managed futures you’re not taking directional views but looking backwards since the start of the year at some of the trends that may have performed well for you that your model has identified. Can you kind of give us a little bit of a back story at some of the things that you picked up on and that have now since played out in the markets?
Larry: [0:32:08] Yeah, sure. So it’s a really good point within our strategy, it’s we’re looking to participate in trends as they develop over these 2 or 3 months. And it’s less of having a house view and forecasting. But in terms of what we’ve seen in the first quarter and into April and May it’s been quite interesting because the world as I just mentioned, came in with this really risk off view in January. And so our portfolio was and really the industry as a whole was maybe slightly risk constructive coming into the year but was able to participate in these downward trends in equities, staying long, fixed income was another trend. We have seen things like the Dollar Index, DXY if you look at currencies, that is currently sitting at a 16 month low. So we have seen a lot of interesting things out there. So the space positive for the first part of the year, S&P negative. And then the mid part of February we saw this reversal and this risk on which is detrimental to a strategy like ours. But it’s very interesting because … so we’re losing money as our models try to reverse and catch on to the new trends and positioning across the space, the managed futures space is now more pro risk. So really long everything and short the dollar against the rest of the world currencies, is how the industry looks like it’s currently sitting now in terms of positioning. But it’s … it brings up some points, it almost goes back to Richard’s question, where here we’re sitting on a time when the S&P is just 3% shy of it’s all time high.
And if you look at the Schiller PE, it’s about 25, which is at … it matches the highs of the PE right before the financial crisis in 07/08. So you’re at this time where the world seemed … it still seems a bit toppy to me and bond yields are negative in some areas of the world, in Japan and in Europe for sure. And so I think that that makes managed futures … it puts it into perspective where it’s a way to profit when the rest of the world may look a little toppy.
Gillian: [0:34:29] It’s really interesting. And, John, last but not least, can you give us your outlook on the real estate market this year?
John: [0:34:35] I think the real estate market has been really, really strong as I mentioned earlier. It’s continued to see a lot of capital inflow, particularly because of low rates that other people have alluded to, really across the globe. And there’s a migration to it because of that income component, which is it’s hard to find today. What we see really on the real estate side and somewhat if you will, of the kryptonite to that market is new supply. And outside of the residential apartment sector, largely the markets are not oversupplied. The other interesting component about it is while inflation, on a very macro level remains low, the cost to replace real estate, the real asset is becoming increasingly more expensive and it’s driven by a lot of the labor costs, a lot of the regulatory costs. So the replacement cost in many of the assets that we have in our portfolio trade or are being held well below what it costs to replace them. So it means there’s still room for appreciation in many instances. The occupancy levels across most of the spaces are at very, very strong levels, which give the landlord extremely strong pricing power which is very, very favorable. And the amount of loan to value ratio is relatively low. So the properties are much better capitalized across the board than they were going into the global financial crisis in 2007 and 2008. So it still looks to be a relatively strong place to be given where the equity markets are, where interest rates are on bonds, real estate is a real asset, looks like a strong place for the near term.
Gillian: [0:36:19] So we definitely look better than we did in 2008 going into 2009?
John: [0:36:22] Yes, absolutely.
Gillian: [0:37:17] Larry, we actually have a viewer question for you today, a little bit about the assets flowing into the managed futures space right now.
Rick Spurgin: [0:37:28] I’m Rick Spurgin; I’m a finance professor at Clark University in Massachusetts. And one of my research interests is managed futures. And I’ve noticed in the last few years that managed futures has really exploded in the liquid alts in terms of assets [inaudible] fund. I wonder what you think is the explanation for this and whether you’re recommending investors to allocate to that?
Larry: [0:37:53] So that’s a great question. And we certainly see that out in both the institutional space and kind of the wealth community. I think what Rich is alluding to and what we’re seeing is that investors are starting to become more and more aware of the diversifying properties of managed futures. And you look at things like generally the space has a slightly negative correlation to equities and its slight positive correlation to bonds, but very close to zero. And also it’s able to provide this idea that academics will call crisis alpha, so the ability of managed futures firms to profit in times of equity downdrafts. And so I think maybe a case study that fits perfectly with sort of what Richard wants to cover is the first part of the year when we saw in January the S&P 500 got off to a rocky start with sort of fears in China and it was down about 5% in January. And if you look at what I think is a very nice benchmark for the mutual fund CTA space is the Soc Gen CTA Mutual Fund Index. That index was positive at 2.6% in January when the S&P again was down about 5. And then as you roll into February the index continued to profit, it was up about 1.6% while the S&P was flattish. So this idea of it’s really non-correlation may be a small native correlation to equities is it’s quite beneficial to a portfolio, that’s really most institutional and personal portfolios are typically heavily laden with equities. So this diversification I think is something investors are growing more and more aware of and is driving them towards managed futures.
Gillian: [0:39:44] Interesting. And I’m going to move now to kind of bring us all back together to talk about the value proposition of liquid alternatives to investors. So, Sinead I’m going to start with you, we actually have a viewer question about this.
Bill Kelly: [0:40:00] Hi! My name is Bill Kelly; I’m the CEO of the CAIA Association. My question is around liquid alternatives and the value proposition [inaudible]. I think it’s an alternative source of beta in an equity market that’s [inaudible] fairly valued in an interest rate environment near zero. Having these sources to uncorrelated risk in a portfolio are understanding. But I do worry about the term liquid in liquid alts and whether or not that truly is a benefit or merely a feature. And I think we’re getting a very sophisticated solution to retail investors, understanding that these are not strategies that should necessarily be traded on any given Monday morning. I think it’s a very important part of the education piece. And I’m curious to see what your thoughts are on this.
Sinead: [0:40:40] Well, I think there are a couple of facets to that question, one is about liquidity itself. And then the second is about how the strategies are being used. So when it comes to liquidity, again you know you need to be very clear on the strategy that each individual manager is pursuing. For example, many of the strategies that sit more within a broader multi asset or macro or managed futures category, what they’re trading is typically futures, individual securities. And I always like to use as a rule of thumb or a good litmus test is don’t focus on what a manager is saying about liquidity today. Given their portfolio ask them what their liquidity would have been given the instruments they’re holding today in October 2008. And the reality was in October 08, as I’m sure everyone remembers, if you tried to trade much outside developed market equities and developed market bonds and the relative futures, it was pretty difficult. So you know we’ve had a couple of high profile mutual funds that have suspended redemptions within the last six months. So that also gives rise to the importance of understanding the full portfolio because if there are elements that are less liquid and managers choose to meet redemptions by selling the liquid part of the strategy then those investors that remain therefore end up with a larger holding in those less liquid securities. And that’s a big issue.
[0:42:15] You know, for the strategies broadly, that 2008 reference should be a pretty good hallmark. And if managers are using instruments that weren’t around in 08, that’s probably another good question to ask them about. And then the second element really comes back to how investors are using the strategies and their holding periods. So again within the universe there’s a very broad range of what strategies are trying to achieve. And it comes back to setting expectations. So if you invest in an absolute return strategy that’s maybe aiming to deliver cash plus 4, if equity markets are up 20%, you should not be disappointed that that strategy when cash is zero is delivering a 4% return. Equally if equity markets are down 20% that’s the part of your portfolio that you should really be expecting to hold up very well, potentially even to be positive. For a managed futures type strategy, again if you’re seeing very strong trends in markets either up or down, that’s when you should expect that strategy to perform well. If markets are moving sideways, no clear trends you shouldn’t be expecting that strategy to outperform, you shouldn’t be disappointed or surprised if that’s got more lackluster returns. It’s all about what the strategies are designed to do. Again, total return, you should expect to see more participation in equity market upside, a little bit more participation in the first leg of the downturn but when, if markets are down, you know, 30/40%, they’re really cutting off the significant left tails.
So coming back to the point about, you know, these strategies are liquids and maybe it’s tempting to think about trading them every day. It’s not, because they’re not going to achieve a strategy on a day-to-day basis really for most of them, you’re looking at full market cycles. So you know, on average we’re looking at maybe a five year hold period. And that’s why the education around this space is so important, so that when an investor selects a strategy, they’re allocating from the appropriate part of their portfolio and they really understand the role so that in an environment where maybe the returns aren’t so great, they understand if that’s consistent with the strategy.
Gillian: [0:44:34] I think those are really important points. And, Ryan, on the liquidity point I know that you’re looking at a different liquidity profile. You expressed the liquid nature of your strategy in comparison to preexisting private equity strategies.
Ryan: [0:44:45] That’s correct.
Gillian: [0:44:47] Talk us through how your strategy fits into an investor’s portfolio.
Ryan: [0:44:51] Sure. So I think the value proposition of private equity is relatively straightforward. If you can get returns in excess of public markets by accessing largely a series of private companies with best in class managers, with best in class boards that can take a five year view, so there’s been in recent news, calls for public companies to suspend quarterly earnings guidance, that managing to quarterly earnings is not beneficial to shareholders in the long term. I happen to agree with that. I think a large component of private equities value creation compared to public equities has been their view – long term view over a 3-5 year period. So the board and management can make investments in a sales force, in research and development, in international expansion, whatever it may be with a view that it might be detrimental in the next quarter to, but very positive two or three years out. So I think that is a large driver of private equities outperformance versus public companies. If you can capture that upside and that relative outperformance while accepting relatively limited liquidity compared to a daily NAV mutual fund, I think that’s a tradeoff that’s worthwhile for most investors. Clearly it’s not a short term strategy. So I agree with the five year full market cycle outlook.
Our guidance to investors in our vehicle is that you should be thinking about an investment in this asset class with at least a five year horizon knowing that if you need to in a relatively orderly market, you could get all of your capital back in a quarter or two, but also knowing that you should not be making investment in private equity, even in more liquid types of private equity with an eye towards withdrawing at a year from now. We think most investors should have an illiquid portion of their portfolio and we think private equity is uniquely suited to that. But I agree investors should not be accessing this asset class thinking that in the worst crisis of 2008, they can push a button on their computer and get all of their cash back into their bank account. It’s just, it’s not a sound outlook. So it’s a relatively illiquid asset class with some liquidity features built in. The tradeoff there is that you should get long term outperformance.
Gillian: [0:47:11] Great. And John, how does private real estate as an alternative investment fit into an investor’s portfolio?
John: [0:47:16] I work on a fund that’s been around since 1998 and by and large there’s generally good liquidity around this space. But I think on a broader context how much of your portfolio needs to be liquid. And I think if you’re looking at alternatives you do have to section off a piece of it and say, “I may not be able to get to that at all phases of the cycle. But it’s an important component for me to have for the non-correlation aspects of it.” And certainly when we look at private real estate, our counterpart is public real estate, right, which is liquid, which you can push that button at any time. And they work a little bit differently, the correlations are different. There’s much greater dampened volatility in the private real estate side than there is in the public side. And again getting back to this fund from 1998, it has an uninterrupted dividend history over its life. So although people may not have been able to get to the principal, they were still achieving some level of cash flow from this. And for pension funds that’s an important component and one of the reasons that they’re in this space to begin with.
Gillian: [0:49:01] Great. And Larry, what about you, how does your managed futures strategy fit into an investor’s portfolio?
Larry: [0:49:06] Yeah. So I think it does fit into this diversifying sleeve that we’re maybe all talking about here, although it certainly is really maybe on the polar opposite side of the liquidity spectrum where our fund itself wasn’t around in 2008, but the managed futures space as a whole did quite well in 2008. And because we’re trading the most liquid vehicles and looking for price movement when there is stress, that that can be a time when we can do quite well. So I think that that really … what that leads us to or should I think, lead investors to is really a pairing or a marrying of different strategies, because you definitely need liquidity in crisis times and you need some of this non-correlation that a strategy like ours can provide. But an investor’s portfolio also needs less liquid real estate and private equity type ideas in their portfolio. So I think that you can’t just … it’s not like a large cap equity fund, where you can just buy one and be happy with it. I think you do need, you need a portfolio of liquid alternative funds.
Gillian: [0:50:18] I have one last viewer question for all of you and this is on the topic of how you manage risk within your portfolios.
Olga Yangol: [0:50:28] Hello! My name is Olga Yangol; I’m an Emerging Markets Debt Portfolio Manager at the HSBC Global Asset Management. And the question that I have is related to how you might manage your strategies. We at HSBC have dedicated EM debt strategies that are managed against an index and those that are benchmark agnostic. And in the benchmark agnostic strategy the focus is on managing risk and on managing volatility downside risk and our stress testing and back testing is a big part of it. Now the question to you is how you might look at risk, what type of tools and techniques and strategies that you use to control for managing volatility in your portfolio.
Gillian: [0:51:12] John, starting with you, what are the tools you use?
John: [0:51:13] Tto begin with we’re very low levered. So today we’re about 22% levered across our portfolio. We’ve never broken a covenant; we’ve never had to give a building back to a lender, any of those type of things. We always have cash flow coming in. And subsequently we had a good test period to see how our risk process worked, that was 2008-2010. And to give you some sense around that, our portfolio going in to a global financial crisis, was about 92% occupied and the [inaudible] of that market was about 87%. So we lost 5% in occupancy, our income was down roughly only about 10%. So through really what was one of the worst cycles we’d ever seen for the real estate market, it performed very, very well. And again we still were able to provide a dividend to investors over that timeframe, subsequently have found all that value back. So it’s a strategy that seems to be able to weather some of those kind of impacts and some of those storms very well.
Gillian: [0:52:34] Great. And Sinead, how do you manage risk?
Sinead: [0:52:37] Well, I think first of all we focus on managing total portfolio risk. So again with an outcome oriented strategy that sits within the liquid alts space, one of the key differentiators is that we are responsible for everything that sits in the portfolio. So there are a number of methods that we employ to effectively manage risk. The first if you like, and this is really inherent within our portfolio construction is that we diversify and we do use leverage when we think it’s appropriate. So for example, when we have a large exposure to equities, because we’re taking most of our bond risk through government bonds, we will take greater than 100% net exposure, essentially because if we’re at 80% in equities and we’re only holding 20% in government bonds, that’s not going to do a huge amount to diversify us, but the leverage is dynamic. So we will typically see that net leverage in the portfolio when we have a very high equity allocation, we think they look attractive.
Now, outside of that we have what we call four pillars of downside risk management within the strategy. The first is explicit volatility management. So we run our strategy with an expected risk level of 7-10% which is really based on our long term expectations. We also have a shorter term risk forecast if you like, that’s much more responsive to changing market conditions. And when we see that the shorter term risk forecast is telling us that the risk of our portfolio is moving above the upper end of that 7-10 threshold then we start scaling risk back in the portfolio, focusing on reducing risk in those parts of the portfolio that are causing the overall risk to rise. The reason we do it is because if you’re seeing rising volatility typically you’re seeing falling markets, markets tend to go up by the stairs but come down in the elevator.Then the second is a macro indicator, something we’ve developed in-house which is really designed to give us a heads up when the global economic is moving into a significant downturn. It relies on economic data, so it is slower. So what you’ll typically see in the first instance is risk reduction through volatility management and then potentially more through the use of the macro indicator.
[0:54:46] The third pillar is options, essentially which we use for tail risk hedging, aiming to buy that protection in the most cost effective way possible, whether that means looking across different markets, different maturity profiles or potentially selling some upside to help finance the cost of that protection when it’s more expensive. And really the way that we’re using the options is in conjunction with the fourth pillar which is the stress testing of the portfolio. Now, this is the discretionary element that I mentioned which essentially because we have a model based process we want to be able to take account of those things that are coming down the track that the model just can’t see. And what we care about in those scenarios is the drawdown. And if the drawdown is greater than we’re comfortable with then we will take action to reduce risk in the portfolio either by buying more option protection, decreasing our equity exposure or potentially increasing our defensive asset exposure. And what we think is really important is that two of the pillars are more structural and two of the pillars are more, if you like, proactive and forward looking. In an ideal world it’s always the forward looking pillars that you employ. But we think that’s a little bit optimistic. So we want to have those structured pillars to help us derisk in a disciplined way as an event is unfolding.
Gillian: [0:56:05] Great. So you’re looking at risk in terms of being proactive and also building it in?
Sinead: [0:56:10] Exactly, yes.
Gillian: [0:56:11] Brilliant. And Ryan, what about you, how are you managing risk in your portfolio?
Ryan: [0:56:15] So we think about risk in a couple of different ways and how we manage it. If you think about generic private equity risk, we mitigate a lot of the inherent risks in private equity, i.e. manager selection by doing secondaries. So I use the real estate analogy, if you have an investor that wants to put capital into a commercial real estate opportunity or investment option, let’s say it’s a multifamily. They can, you know, the primary way to access that compared to an investment in a newly formed private equity fund would be to go buy an empty lot of land, hire an architect, hire a general contractor, permit the house, build the house, finish all your permitting, hopefully get your Certificate of Occupancy, and then go hire a realtor to find your tenants. Maybe you’re two years in before you get your first rent check, hopefully the house was built on time, no construction delays or cost of overruns. Hopefully your realtor found tenants, hopefully your tenants treat the property well and hopefully they pay their rent bills. Our view on that is we don’t want to take that construction risk, we don’t want to take the permitting risk, we don’t want to take the realtor finding your tenants risk. We want to go find an existing multifamily structure, we want to kick the tires, we want to do a thorough inspection, we want to look at the last two years of rent rolls and figure out did tenants pay on time? Did they destroy the property? What condition is it in?
We want to buy that property on December 31st and collect our first rent check on January 1st. So that’s our way of mitigating private equity risk from a manager selection standpoint, much earlier liquidity, much lower asset level risk. From there where we mitigate risk within the secondary world, we do a lot of company level analysis, so most of the partners at Pomona come from direct equity backgrounds. So we view secondary as just buying a series of companies within a holding company, and that holding company might be Bain Capital fund 10. So if we can underwrite those underlying companies, run an enormous amount of sensitivities on various outcomes, buy that portfolio at a discount, derisk through near term cash flows to pay back invested capital. Then we can do that across hundreds of funds, if not thousands of funds, with thousands of underlying companies you’ve created essentially, not a bulletproof but a pretty close to bulletproof portfolio of private equity assets. And I mentioned earlier that our loss ratio is low single digits. We think you can generate an equity like return with this approach with a loss ratio that is effectively better than senior debt.
Gillian: [0:58:53] Great. And, Larry?
Larry: [0:58:54] Yeah. So within our strategy, again it’s all algorithmic, it’s all model based. And so the large part of our risk management efforts are embedded within the models. And so we begin by constraints around market size that we can get in any one instrument and sector constraints as well, limiting that within a suitable range. But also within the strategy itself managed futures sort of has this elegant way of derisking in that we, when a trend is going against us and it reverses, the signal strength weakens and we begin to get out of that asset class if were long. So we’re beginning to sell long positions and getting less and less long. So that’s effective in a challenging scenario. But also because we target date a constant vol within our program, so the program targets are 10% volatility, we size all of our positions inversely to their volatility. So as an example, if we’re trading in let’s say crude oil and we have a position in oil and then it has a little bit of a spiky period which generally is associated with a reversal which is detrimental to our program, let’s say the crude oil volatility itself doubles, then what our program will do is it will take half the notional position size. So as things are getting more and more volatile, we’re cutting the notional position size, so it’s embedded sort of risk management tool that … it’s certainly not perfect and we do have drawdowns, but it’s a way to really limit and control the depth of those drawdowns.
And I would add one last thing is that above all of that sits a human risk committee, right. So at the end of the day we have a team of seven people on this risk team in conjunction with the portfolio management team that can step in, generally with our programs they may step in once or twice a year. And they can only step in to reduce risk, if they see … he mentioned headline risk, you know, if there’s geopolitical risk, our models can’t read because it’s not in the data. We may step in to reduce risk, so an example of that would be when the Scottish referendum vote at the end of 2014, where if that had led to a yes vote then the whole British pound would have looked much different. And we had, not in our liquid alternative strategy, but in other hedge fund strategies, we took down some risk associated with the British pound trading.
Gillian: [1:01:32] So the humans still matter.
Larry: [1:01:34] Humans matter, at the end of the day we need to have that last layer of confidence and oversight.
Gillian: [1:01:39] Great. I’m going to close out but before I do that I want to make sure is there anything that I didn’t touch on that you particularly wanted to cover?
Larry: [1:01:48] I have a topic I want to cover just generally about liquid alts. And I think that one thing that’s very powerful about liquid alternatives, and we’ve all touched on it in several ways is that I think it really does transform risk profiles that are available to investors, typical investors that are looking to invest in mutual funds will only have access to long only strategies and maybe equity dominated strategies. And so in that case you’re sort of beholden to the beta of that strategy, equity beta, the volatility of that market and its drawdown profile. And really it’s, you know, when you’re long in asset class and that’s your only option you’re also inherently short the volatility of that asset class. So when you look at liquid alts and there’s a whole suite of liquid alts to look at, but they can give you more precise risk exposure that you want. So maybe you have a long short equity program that goes in and its beta is much reduced versus the S&P and its drawdown profile is reduced. And that can be very accretive to a portfolio or maybe you have a market mutual arb strategy that’s zero beta. And we talked about in the case of managed futures where it’s a slightly negative correlation to equities, you know, has this ability to behave well in equity crises. And we did an internal study that looked at the 10 worst quarters for the S&P since 2000. And this Managed Futures Index, the Soc Gen Mutual Fund Index was positive in 7 out of 10 … 7 out of those 10 horrible S&P quarters, so like Q4 2008, the tech wreck of 02. And so just being able to generate these different and as I mentioned, accretive profiles I think is very useful and almost kind of the raison debt of these liquid alt strategies.
Gillian: [1:03:42] Any other final takeaways, John?
John: [1:03:46] I think it’s fascinating, l to try to get exposure to some of the alternative investments that are out thereand there’s really not that many options in the DC space. And part of the reason is because of the illiquidity or the perception of illiquidity associated with this. And that’s why my comment around , what level the portfolio really needs to be liquid at any point in time, particularly when you’re looking at an investment horizon of 30/40 years plus, that can be managed at certain points in that cycle. More so as part of a target date fund where you have multiple choices or options within that to also provide some basket of liquidity along the way. I just think these type of products are something that many of would benefit from particularly as the traditional markets either don’t offer much in the way of current income return or are potentially fully priced
Gillian: [1:05:04] Sinead, final thoughts?
Sinead: [1:05:06] Well, I think this is more for this space in general. But I think it’s important that investors consider where they allocate their liquid alts allocations from. So you know, in our experience in dealing with investors, some have specific alternative allocations where you may see absolute return paired with multi strat, paired with managed futures, paired with total return to create a very diversified portfolio of alternatives. But what we’re also seeing is investors who are looking for an alternative to equities, perhaps because they feel that equity markets have had a very good run, sometimes when it’s more particularly US domestic equity heavy. And they’re looking for something that will generate more of an equity like return but with less risk, so it gives them diversification within what they still think of as their equity pool. Similarly, we’re also seeing investors who have more of a traditional 60/40 benchmark centric type allocation, carving a slice out of that portfolio and again allocating to a number of liquid alt strategies where again, it gives them more diversification because of the ability to short, to use leverage, to be more tactical, but still gives them a very similar risk profile.
And then I would say yet another cohort of investors is where they’re concerned about interest rates, I mean we’ve obviously seen The Fed being a lot more dovish over the last couple of months, but if you consider where rates are, chances are that at some point they’re going to move higher, and where they’re concerned about perhaps some of the interest rate exposure within their bond portfolio looking at maybe corporates in particular, allocating to more absolute return type strategies which again have a very similar risk profile but the ability to use more levers if you will, and to be more flexible in their asset allocation. So while we think about liquid alts as a category it’s important to understand that there are multiple ways in which they can be used, but the key is really for investors to understand the particular strategies that they’re interested in, and where that might fit in terms of the overall portfolio characteristics.
Gillian: [1:07:27] Great. And, Larry, last thoughts.
Ryan: [1:07:29] I think private equity’s been a pretty integral part of most sophisticated investors’ portfolios for decades. If you look at endowments, foundations, pension plans, family offices, they all have between high single digit or mid single digit to well into the double digit allocations to private equity. A large west coast endowment very publicly exited their hedge fund investments not too long ago. They also happened to increase their allocation to private equity. So you have an asset class that has consistently performed, that has delivered double digit returns and excess of public markets and I think that retail investors are not accessing it, again not for lack of interest but mor

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