Analysis & Trends The Case for Alternatives 2
The Case for Alternatives Alternative strategies tend to produce different performance patterns to stocks and bonds under the same market conditions. 3
The Case for Alternatives Content 5 The Case for Alternatives 5 Growing relevance of alternative sources of return 5 The alternative investments universe 7 Three broad trends have reshaped the alternatives industry in recent years 7 The rise of alternatives 7 A great variety of investment choices 8 Alternatives offer diversification 9 Understand. Act. By Ann-Katrin Petersen, Vice President, Global Economics & Strategy. Imprint Second updated edition Allianz Global Investors GmbH Bockenheimer Landstr. 42 44 60323 Frankfurt am Main Global Capital Markets & Thematic Research Hans-Jörg Naumer (hjn) Stefan Scheurer (st) Data origin if not otherwise noted: Thomson Reuters Datastream Allianz Global Investors www.twitter.com / AllianzGI_VIEW 4
The Case for Alternatives The Case for Alternatives After a 30-year bull market in bonds and a strong, multi-year recovery in equities, investors wonder what lies ahead for financial markets. The current low-interest-rate environment and the search for market-neutral solutions is increasingly prompting investors to rethink their allocation decisions with regard to alternative investment strategies. 1 Data as of August 2017. Sources: Bloomberg, AllianzGI Global Capital Markets & Thematic Research. 2 However it is important to note that, unlike hedge funds, bonds offer a fixed rate of return if held to maturity. 3 Note that less-thanperfect correlation with global equity returns may offer some diversification benefits, but correlations tend to increase during periods of financial crisis. Growing relevance of alternative sources of return What is on the cards for capital markets? Three important themes will likely remain on investors radar in the months ahead: 1. Financial repression is not only set to continue, it has even reached a new level in the past two years. Regardless of the recent correction in bond markets, investors are still facing negative nominal yields for government bonds with solid credit ratings (see chart 1). It speaks for itself when roughly 60 % of outstanding German Bunds are still in negative territory. 1 Neither real nor nominal bond yields in negative territory are able to play their traditional role for income generation. At the same time, downside risks are on the horizon as markets must start pricing in higher central bank rates in the coming years. This is why alternative strategies especially on the lowrisk, low-return end of the spectrum are becoming increasingly popular among investors seeking an alternative to bonds in low-yielding times. 2 2. Monetary policy that is still supportive globally, and a world economy growing at around potential, should support risky assets longer-term. Nevertheless, valuations of various asset classes are stretched after a multi-year bull market, stocks in some geographies might deliver fairly little upside potential. Therefore many investors are looking for more marketneutral strategies, with low net exposure, that complement their equity allocations. 3. Last but not least, investors should be prepared for increasing volatility. High valuations of various asset classes, major central banks inching towards monetary policy normalization, as well as intensified (geo-)political risks could temporarily provide some headwind for risky assets. Managing volatility and buying protection against drawdowns will therefore gain importance. Against this macroeconomic and market outlook, investors must find new ways to complement their traditional asset allocations in order to achieve their investment objectives. With clients looking for bond substitutes (i. e. income generation with managed volatility), new betas and new sources of alpha, uncorrelated returns 3 (market-neutrality), enhanced portfolio diversification, lower volatility and tail-risk protection, the relevance of alternative sources (of return) is growing. The alternative universe features diverse investment styles and strategies, though, each with its own expected risk / return profile, that can be used as tools to customize portfolios. Let s have a deeper look. The alternative investments universe Alternative investments is not an asset class in itself. Rather, the alternative investment universe has several characteristics, including: traded asset classes that fall outside the traditional definitions of publicly traded stocks and bonds such as commodities and currencies; 5
niche real assets such as timberland, fine wines, antique furniture and art, as well as intangible assets such as patents, royalty streams, and airplane leases, can be considered alternative to traditional investments, too; trading strategies that are not available to traditional long-only managers, such as shorting, hedging with derivatives, and the use of leverage; investment strategies that rely on privately negotiated deals (and are less liquid) such as private equity, private deb t, private real estate equity and debt, as well as infrastructure equity and debt, and alternative investment vehicles in which these assets / strategies are packaged such as Limited Liability Companies (LLCs), Limited Partnerships (LPs), and Cayman funds, which have fewer restrictions on how managers can execute their strategies. 4 Alternative investments can be categorized in terms of the (il)liquidity of the underlying asset or investment style on the one hand and according to the degree of liquidity of their vehicle on the other (see chart 2). Following the financial crisis, clients have increasingly requested a stronger alignment between the underlying assets liquidity and the vehicle s liquidity. 4 Certain hedge funds often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. They can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, and often charge high fees. Chart 1: Ultra-loose monetary policy makes negative interest rates the norm government bond yields still hovering in negative territory Generic government bond rates, in % 3 M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y 30Y Germany 0.65 0.68 0.71 0.58 0.43 0.26 0.16 0.02 0.13 0.30 0.44 0.62 0.90 1.19 France 0.62 0.57 0.48 0.47 0.32 0.13 0.02 0.18 0.40 0.58 0.73 1.11 1.40 1.78 Italy 0.42 0.33 0.22 0.14 0.37 0.71 1.02 1.42 1.65 1.85 2.04 2.60 2.73 3.19 Netherlands 0.65 0.64 0.56 0.43 0.31 0.08 0.09 0.26 0.41 0.56 1.25 Belgium 0.63 0.55 0.55 0.47 0.34 0.17 0.01 0.20 0.42 0.57 0.74 1.11 1.20 1.75 Austria 0.49 0.57 0.46 0.34 0.25 0.16 0.01 0.19 0.34 0.62 1.06 1.52 Finland 0.65 0.60 0.44 0.36 0.13 0.08 0.14 0.37 0.34 0.45 0.92 1.35 Switzerland 0.85 0.80 0.72 0.62 0.52 0.44 0.34 0.24 0.18 0.09 0.20 0.27 0.38 Sweden 0.75 0.65 0.63 0.27 0.05 0.30 0.69 Denmark 0.54 0.59 0.31 0.57 1.20 UK 0.25 0.24 0.22 0.24 0.30 0.49 0.61 0.73 0.85 1.08 1.45 1.63 1.74 USA 1.02 1.25 1.35 1.52 1.83 2.09 2.27 2.85 Japan 0.13 0.11 0.11 0.10 0.09 0.07 0.06 0.05 0.03 0.01 0.04 0.27 0.57 0.87 Sources: Bloomberg, AllianzGI Global Capital Markets & Thematic Research. Data as of August 16, 2017. Past performance is not a reliable indicator of future results. Eurozone member countries Chart 2: Alternatives portrayed in two dimensions of liquidity High Publicly traded Private Equity Funds REITs Liquid Alternatives Equity Long / Short Hedge Fund in UCITS or 40 Act Liquidity of vehicle Illiquid Alternatives Private Equity Private Real Estate Event Driven Hedge Funds Equity Long / Short HF in Cayman, Monthly liquidity, no notice period, mo lock-up, no gate Equity Long / Short HF in Cayman with Quarterly liquidity, 60 day notice period, look up, and gate Infrastructure Low Low Liquidity of underlying assets or style High Placement and selection of asset classes for generalized illustration purposes only. Source: AllianzGI. Past performance is not a reliable indicator of future results. Forecasts are not a reliable indicator of future results. 6
The Case for Alternatives 5 UCITS or undertakings for the collective investment in transferable securities are investment funds regulated at European Union level. They account for around 75 % of all collective investments by small investors in Europe. See EU Commission. UCITs can be distributed globally, apart from the US. 6 See McKinsey & Company (2014): The Trillion-Dollar Convergence: Capturing the Next Wave of Growth in Alternative Investments, p. 7f. 7 See PwC (2014) Asset Management 2020: A Brave New World, p. 8. Three broad trends have reshaped the alternatives industry in recent years 1. Institutionalization: A shift in the dominant investor base from risk-tolerant investors to more risk-averse institutional investors (see chart 3). This shift in the sources of capital has corresponded to a rise in low risk / low return alternatives within the industry. Simultaneously, more institutions are getting their alternatives exposure directly from asset managers rather than from fund of fund providers. 2. Retailization : The rapid growth of fully regulated alternative mutual funds in the United States and the parallel growth of Alternative UCITS 5 in Europe and Asia. This has enabled small investors to gain access to alternative strategies that were previously only available to large institutions. 3. Regulation: In Europe, offshore funds such as Cayman funds have lost market share to fully regulated UCITS due to tax transparency considerations and the Alternative Investment Fund Managers Directive (AIFMD). The rise of alternatives Alternative investments have grown rapidly in recent years, twice as fast as non-alternatives since 2005. According to McKinsey, from 2005 to 2015, alternative assets under management (AuM) grew from USD 3.2 trillion to 7.3 trillion (see chart 4). Growth has been broad-based across all alternative asset classes (defined here as hedge funds, private equity, and real assets). 6 Looking forward, PwC predicts that this mainstreaming of alternative investments will continue and that assets managed could reach USD 13 trillion by 2020. 7 A great variety of investment choices Historically, alternative investment strategies were offered solely in private, less liquid vehicles such as Cayman-domiciled funds and Limited Partnerships. More recently, liquid alternative mutual funds and UCITS funds have made these strategies more accessible to investors who prefer or require regulated investment vehicles. Within these new fund vehicles, a great variety of different investment strategies can exist, although investors should make sure that the underlying assets or style of the strategy matches well with the liquidity Chart 3: Investor landscape Risk averse institutional investors now the dominant source of hedge fund capital Hedge fund industry: sources of underlying capital, in US Dollar billion $4,000 $3,500 $3,000 $3.56T 74% Billions of Dollars $2,500 $2,000 $1,500 $1.64T 62% $1.25T 26% $1,000 $500B $500 $0 80% $125B 20% $991B 38% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E 2018E Pension funds, sovereignwealth funds, endowments and foundations High net worth and family offices Source: Citi Investor Services, based on Hedge Fund Research data and interviews. Past performance is not a reliable indicator of future results. Forecasts are not a reliable indicator of future results. 7
Chart 4: The rise of alternatives Rapid broad-based growth Global AUM* of key alternative asset classes, 2005 2015 in US Dollar trillion CAGR* 2005 2015 Total Real Assets 7.9 % 9.9 % $6.2 2.1 $7.3 2.7 $5.2 Private Equity Hedge Funds 5.1 % 10.1 % $3.2 1.0 1.1 1.7 1.6 1.9 2.1 2.0 1.8 2.9 Growth of traditional assets = 5.0 % 1.1 2005 2007 2011 2015 *) Assets under Management. Sources: McKinsey, AllianzGI Global Capital Markets & Thematic Research. Past performance is not a reliable indicator of future results. of the fund vehicle within which it is packaged. According to Hedge Fund Research (HFR), there are at least four broad hedge fund investment categories with further subclassifications: 1. Event-driven strategies are typically based on a corporate restructuring or acquisition that creates profit opportunities for long and short positions in common equity, preferred equity, or debt of a specific corporation. 2. Relative value strategies involve buying a security and selling short a related security with the goal of profiting from a perceived pricing discrepancy. By way of example, investors are able to participate in the returns of volatility as an asset class with a strategy based on harvesting the variance risk premium. 3. Macro strategies are top down investment strategies based on global economic trends and events which may involve long or short positions in equities, fixed income, currencies, or commodities. 4. Equity hedge fund strategies are bottom up -driven investment approaches that seek to profit from long or short positions in publicly traded equities and / or derivatives with equities as their underlying assets. Alternatives offer diversification Alternative strategies tend to produce different performance patterns than long-only stocks and bonds under the same market conditions. Many alternative strategies have been designed to maintain a low beta, so they move less in line with the market, providing diversification, and the potential for protection in down markets in the original sense of the word hedging. Adding (liquid) alternatives to a traditional portfolio allocation can benefit a broad range of investors in terms of improved risk-adjusted returns, enhanced diversification, and potentially lower market sensitivity. Even though alternative mutual funds and alternative UCITS are relatively new, many of the underlying hedge fund-type strategies have been tested over a much longer period of time. As a proxy for the hedge fund industry, observers often reference the HFRI Fund Weighted Composite Index (HFRI FWC Index), HFR s industry-wide index. 8 Comparing the short-term performance of aggregated hedge fund indices with equity indices such as the S&P 500 can be misleading, especially during a stock bull market, as many alternative strategies are designed to protect investments during drawdowns rather than to necessarily outperform during rallies. That is, their usefulness to investors often increases later in the cycle. Greater clarity can therefore be gained by looking at long-term figures. 8 Please note that aggregate hedge fund measures such as the HFRI FWC can be useful measures of the overall direction of travel of the hedge fund industry and they enable investors to draw broad-brush conclusions about the growth trajectory of the industry as a whole. But they are often interpreted as capturing the performance of the average hedge fund, when arguably there is no such thing. In fact, the hedge fund industry is extremely diverse. 8
The Case for Alternatives 9 Potential problems with historical returns data such as the survivorship bias need to be taken account of, though. Survivorship bias refers to the upward bias of returns if data only for current existing (surviving) firms is included. According to HFR, when a constituent fund liquidates or stops reporting, their performance remains part of the index return, reducing survivorship bias. On a risk-adjusted basis, which measures the value of the returns in terms of the degree of risk taken ( Sharpe Ratio ), hedge funds have outperformed US equities, global equities, and global corporate and government bonds over the longer term (see chart 5). Even over the last ten years, i. e. including the postfinancial crisis equity bull market, the S&P 500 and MSCI World have not performed better than the HFRI FWC on a risk-adjusted basis. Besides attractive risk-adjusted returns, the pattern of returns has been beneficial. On average, alternatives haven t performed as well as stocks in bull markets, i. e. lagging the returns of global equities in up markets, however they also haven t lost as much in bear markets (see chart 6). During the extreme market stress of the financial crisis, the maximum drawdown (largest peak-to-trough loss over a period) of the HFRI FWC amounted to 21.4 % between November 2007 and March 2009 while, by way of example, investors in the S&P 500 experienced a 57 % drawdown. 9 Similarly, when comparing annualized volatility figures it is clear that alternatives have not only been less volatile than equities, which might be expected, but also less volatile than (corporate) bonds (see chart 7). Roughly speaking, alternative strategies, as measured by the HFRI FWC, have provided less than half the volatility of stocks over the last 20 years. Investors have two choices: simply allocate broadly to alternatives via a customized advisory service. Or, add single alternative strategies, in order to achieve a specific investment objective such as lowering interest-rate sensitivity, reducing portfolio downside risk or increasing portfolio diversification. In either case, a clear understanding of one s risk / return goals and deep manager due diligence is often key. Understand. Act. With the secular bull market coming to an end, after a strong, multi-year recovery for equities, and with more volatility in the cards, the search for alternative sources of return is growing. Adding (liquid) alternatives to a traditional portfolio allocation might benefit a broad range of investors, not only in terms of improved risk-adjusted returns, but also by providing enhanced diversification, and potentially lower market sensitivity. These strategies are increasingly available in regulated vehicles with liquidity and transparency. The alternative universe features diverse asset classes and investment styles, each with its own expected risk / return profile. These can be used as tools to customize portfolios. Chart 5: Over the longer term, liquid alternative strategies have outperformed equities and bonds on a risk-adjusted basis Comparison of both annualised headline returns and risk-adjusted returns for hedge funds as a whole, equity hedge funds, equities and bonds, for various periods until July 2017 Index 5 year 10 year 20 years Annualised headline return Annualised standard deviation Sharpe Ratio Annualised headline return Annualised standard deviation Sharpe Ratio Annualised headline return Annualised standard deviation HFRI FWC 4.9 % 3.6 % 1.3 4.1 % 6.0 % 0.5 6.8 % 6.8 % 0.7 HFRI Equity Hedge 6.3 % 5.3 % 1.1 4.1 % 8.4 % 0.3 8.0 % 9.0 % 0.6 S&P500 12.2 % 10.8 % 1.1 7.3 % 17.1 % 0.4 6.6 % 16.2 % 0.3 MSCI World 9.3 % 10.2 % 0.9 4.9 % 17.6 % 0.2 5.2 % 16.5 % 0.2 JPM Global Govt. 0.0 % 5.0 % 0.1 3.8 % 6.3 % 0.4 4.8 % 6.7 % 0.4 Sharpe Ratio BofA Global Corp* 3.1 % 7.4 % 0.4 4.8 % 11.7 % 0.3 5.6 % 10.6 % 0.3 *) Dataset starting in July 1997. Please note that it is not possible to invest directly in an index. Please refer to chart 6 for a description of the indices in the table. Sources: AIMA, Datastream, AllianzGI Global Capital Markets & Thematic Research. Data as of July 1st, 2017. Past performance is not a reliable indicator of future results. 9
Chart 6: Pattern of returns Ten-year performance of hedge funds as a whole, equities and bonds (rebased, index Jan. 2005 = 100)* 200 200 160 160 120 120 80 80 40 40 2006 2008 2010 2012 2014 2016 Hedge Funds (HFRI FWC) Equities (MSCI World) Equities (S&P500) Corporate Bonds (BofA Global Corp) Government Bonds (JPM Globlas Govt. Bond Index) *) Data from January 1st 2005 to August 16th 2017 (cumulative returns). The HFRI FWC is Hedge Fund Research s industry-wide index and encompasses over 2,000 hedge funds. The HFRI Equity Hedge encompasses Equity Hedge strategies, i. e. strategies that maintain positions both long and short in primarily equity and equity derivative securities. The S&P 500 is a stock market index which includes 500 of the top companies in leading industries of the US economy. The MSCI World is a stock market index of over 1,640 constituents across 23 developed markets countries. The J.P. Morgan Global Government Bond Index measures the performance of the global government bond market; comprised of government bonds in developed countries only. The BofA Merrill Lynch Global Broad Corporate Bond Index measures the performance of the global corporate bond market (investment grade). Please note that it is not possible to invest directly in an index. Sources: Datastream, AllianzGI Global Capital Markets & Thematic Research. Past performance is not a reliable indicator of future results. Chart 7: Alternative strategies have been less volatile than equities and (corporate) bonds over the medium to longer term Annualised volatility (%) 18 % 16 % 17.1 % 16.2 % 14 % 12 % 10 % 7311.2 % 10.8 % 11.7 % 10.6 % 8 % 6 % 4 % 7.4 % 5.6 % 3.7 % 3.6 % 7.4 % 5.0 % 6.0 % 6.3 % 6.8 % 6.7 % 2 % 0 % 3 year (2014 2017) 5 year (2012 2017) 10 year (2007 2017) 20 year (1997 2017) HFRI FWC S&P 500 BofA Corporate* JPM Govt *) Dataset starting in July 1997. The HFRI FWC is Hedge Fund Research s industry-wide index and encompasses over 2,000 hedge funds. The HFRI Equity Hedge encompasses Equity Hedge strategies, i. e. strategies that maintain positions both long and short in primarily equity and equity derivative securities. The S&P 500 is a stock market index which includes 500 of the top companies in leading industries of the US economy. The MSCI World is a stock market index of over 1,640 constituents across 23 developed markets countries. The J.P. Morgan Global Government Bond Index measures the performance of the global government bond market; comprised of government bonds in developed countries only. The BofA Merrill Lynch Global Broad Corporate Bond Index measures the performance of the global corporate bond market (investment grade). Please note that it is not possible to invest directly in an index. Sources: AIMA, Datastream, AllianzGI Global Capital Markets & Thematic Research. Data as of July 1st, 2017. Past performance is not a reliable indicator of future results. 10
AllianzGI Subject Line Further Publications of Global Capital Markets & Thematic Research AI & the Second Machine Age AI Artificial Intelligence Part of everyday life, driving our future. Capital Income for the second machine age Active Management Factor Investing: A reliable source of excess returns? The Changing Nature of Equity Markets and the Need for More Active Management Active Management Active Share: The Parts Are Worth More Than The Whole Active Management in Times of Disruption Financial Repression Shrinking mountains of debt Helicopter money: The next step in financial repression? Is easy monetary policy fuelling new economic imbalances and credit bubbles? QE Monitor Strategy and Investment Equities the new safe option for portfolios? Capital Markets Monthly E S G Added value or a mere marketing tool? What does ESG mean for investments? (part 1) Added value or a mere marketing tool? What does ESG mean for investments? (part 2) ESG: A reply to the Club of Rome Alternatives The Case for Alternatives Volatility as an Asset Class Liquid alternative strategies as an answer to the low interest rate environment The Long and Short of Volatility Investing Market-neutral equity strategies Generating returns throughout the market cycle Benefiting from Merger Arbitrage What Multi-Asset Liquid Alternatives Can Deliver Capital Accumulation Riskmanagement Multi Asset Capital Income for the second machine age Capital Income: Dividends Multi-Asset: Your Assets in Perfect Balance Sustainably accumulating wealth and capital income Managing risks dynamically with an overlay Strategic Asset Allocation in Times of Financial Repression Investments in Equities and Bonds: Save on Saving. Behavioral Finance Behavioral Risk Outsmart yourself! Reining in Lack of Investor Discipline: The Ulysses Strategy Behavioral Finance Two Minds at work Behavioral Finance and the Post-Retirement Crisis The 7 habits of successful investors Steer clear of your own mind traps, or: how behavioural finance can help solve pension problems All our publications, analysis and studies can be found on the following webpage: www.allianzglobalinvestors.com 11
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