When good correlations turn bad

Previously, alternative assets such as private equity were the preserve of institutional or ultra-high net worth investors. However, as managed funds have opened up property and international shares to regular investors, so too are managed funds now using alternative investments as an increasingly important part of their portfolio mix.

While equities have historically provided the best returns for investors, they are also associated with spectacular 'blow-ups', higher volatility and greater risk.

To mitigate against equity risk, portfolio managers may diversify into other asset classes which have little, or negative, correlation to equities. The correlation between asset classes, or the extent to which they tend to rise and fall together, plays a vital role in portfolio construction and helps to maximise returns while minimising risk.

What happens when good correlations turn bad? 

Stanley Yeo, IOOF Portfolio Manager for Strategy and International Equities, said the GFC showed that in stressed environments correlations tend to move towards one.

"The benefits of diversification broke down precisely when investors needed them most," Stanley said.

"In particular we saw a breakdown in correlation where government bonds became the only asset that had negative correlations to equities," Stanley added.

"Government bonds still provide diversification but bond yields have been low and while managers still see the need for bond exposure, there has been a greater focus on asset allocation over the past five years".

This has seen a push for assets which provide a good trade-off between risk and return, but have little or no relationship with equities or bond markets.  The result is that over the last ten years alternatives have grown in acceptance and popularity as a 'new' asset class.

According to the The Towers Watson Global Alternatives Survey 20141, total investment in alternatives grew from US$3.87tn in 2012 to US$5.7tn in 2014. Of this, US$3.27tn is owned by just the top 100 alternative investment managers, spread amongst:

  • real estate managers  - 31 per cent and over $1 trillion
  • private equity fund managers - 23 per cent or $753 billion
  • hedge funds - 22 per cent  and $724 billion.

What are alternative investments?

Alternative investments are made up of 'real' or 'financial' assets. Real assets form the majority of most economies and hold an inherent value, including real estate, home loans and precious metals. For IOOF, the focus for real assets are those assets which generate a cash flow and can grow that cash flow over time.

Financial assets include cash at hand, currency, bonds and derivatives. They are usually more liquid than real assets and are often used by hedge funds to participate in the markets.

Why are they important?

Direct property, unlisted infrastructure, private lending and private equity can exhibit low correlations to the markets because their valuations are not directly based on listed stocks or readily traded bonds. While the underlying assets might be similar to those traded on an exchange, the biggest difference is the limited ownership structure. This makes the asset less liquid, but it gives the owners more control or influence over the asset.

There are a wide variety of hedge funds available to institutional investors. These range from small highly specialised sector specific managers to the large multi strategy funds that have a wide universe in which to invest. Hedge funds do not have the same investment constraints as their long only counterparts. For example, hedge funds can be long in one asset while short selling another. When done properly, this type of investing can lead to equity like returns over time with less volatility.

What are the challenges facing alternatives?

With the GFC still on investors' minds, names like Bernie Madoff are wrongly associated with hedge funds and other alternative investments. After the GFC, hedge fund trading strategies and private equity came under greater scrutiny from regulators. This has helped drive some positive changes in the alternatives space in terms of governance, reporting and liquidity. 

Investors are now more confident in using alternatives in their portfolios.

One 2014 survey in the US suggested that 89% of investors intend to maintain or increase their investments in private equity, 92% in hedge funds, 76% in real estate and 69% in infrastructure over the next 12 months.2

Click here to learn more on IOOF's use of alternatives from Hugo Agudo, IOOF Portfolio Manager, Alternatives, or learn more about why alternatives should be a part of a well-diversified portfolio here.

1. http://www.towerswatson.com/en-AU/Insights/IC-Types/Survey-Research-Results/2014/07/Global-Alternatives-Survey-2014
2. Preqin investor survey (H1 2014)

What do you think are the biggest issues facing the alternatives sector today?

The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.