Questioning conventional thinking

June 23, 2016

Funds need to dig deeper into alternatives to get results

New analysis completed by Frontier of Australia’s largest superannuation funds has raised questions about the effectiveness of some types of alternatives in diversifying portfolios and enhancing returns in challenging markets.

The analysis, presented at our Annual Conference on 21 June, comes as super funds have approximately doubled their exposure to alternative assets between 2007 and 2016.

“We’ve recently seen super funds go down the road of increased allocations to the broad category of ‘alternatives’ – and why?” said Frontier Advisors Senior Consultant Greg Barr.

“It’s quite simple: we’re looking for diversification in portfolios, a return enhancer and we’re looking for better management of downside risk. So the ‘alternatives’ exposure has become a ‘magic pudding’ which is expected to deliver growth-like returns, lower risk and low or negative correlations to equities.”

Based on aggregate industry data, funds with higher alternative asset allocations posted marginally improved crediting rates over the financial year to date as traditional markets have struggled. However, that result was reversed – higher alternative allocations actually dragged down crediting rates – when infrastructure and private equity were stripped out of the alternatives universe.

“The other assets within alternatives in terms of hedge funds, absolute return funds and the very well named ‘miscellaneous alternatives’ and ‘alternatives other’, haven’t actually delivered on that premise of low to negative correlation to equities.”

“The ‘magic pudding’ of having higher returns, lower risk and low correlation to equity markets is indeed hard to find and hard to achieve in these categories. Frontier looks at alternatives in a different way:  we divide up alternatives to make sure you’re looking at the actual characteristics of the strategy you’re investing in, for example those that are return-seeking, those that are diversifiers, and those that are opportunistic investments.”

The analysis was just one of 11 presentations at the Conference, which attracted more than 110 investment professionals in Melbourne.

Frontier CEO Damian Moloney said markets remained particularly challenging, but Frontier’s 53 strong team continued to produce strong results for clients, which collectively manage $260 billion in assets.

“Our clients are still performing well in a really challenging environment – on average our super fund clients are top quartile.”

At an earlier session, capital markets specialists Alvin Tan, Consultant, and Anthony Michael, Senior Consultant, framed Frontier’s investment view around four key questions being asked by investors: the chance of a hard landing in China, whether emerging markets or developed markets will outperform, the impact of secular stagnation over the next decade, and how the Australian economy is transitioning from the mining boom.

Tan said cash and bond markets had already priced in a secular stagnation scenario, implying much lower asset class returns – an overly negative response.

“It’s like a race to the bottom to keep rates low in this current environment, but we don’t think that means secular stagnation, we just think it means rates might stay lower for longer,” Tan said. “When we do our analysis on the global growth story, we think you can still get reasonable growth, particularly from emerging markets.”

Emerging markets growth potential is substantially higher than for developed markets, as working age population slows although global GDP growth could potentially still reach a solid 4% p.a. over the next decade, according to Frontier.

Michael said there were several concerns about China, particularly its growing debt, but over the next three years the government has enough firepower to maintain economic growth at 6.5-7% p.a.

“In the short-term, China will muddle through – it still has room to lower reserve requirements, cut interest rates, do some further investment spending, re-capitalise banks and enact fiscal initiatives,” Michael said.

Meanwhile, the Australian economy is effectively transitioning from the mining boom and growth is expected to fall into the 2-2.5% p.a. band.