Low inflation / base rate environment pouring more institutional money in alternative investment forms

ESCP Finance Society celebrates a successful 7th edition of the Banking  Trek | ESCP

By Julian Habsburg and Frederic Klaus

Last Update: 04.04.2021

Contents


I.              Where are we today and why is this impacting investments? 

The FED adapts monetary supply with the aim of maintaining price stability, maximising employment, and demonstrating stable, long term interest rates. Since the global COVID-19 pandemic struck, not only the FED but all central banks were quick to adapt monetary policy to abide by its mission and prevent a breakdown of the economy. After a long period of relatively low base rates, the American interest rate is again at 0.25% with inflation well below 2%. This low-interest environment combined with mild inflation has a significant impact on the investing behaviour of institutional investors.

One effect is the averting from fixed income strategies, as they provide dismal returns. Typically, investors allocate capital to government and corporate bonds, C.D.s and money market funds to profit from a steady flow of income with less risk than stocks. Nowadays, e.g. high yield debt tranches provide coupons with negative returns, measured by the floating LIBOR rate with a premium. Hence, to generate above market earnings, investors must look elsewhere.

A second trend, next to the low returns of the fixed income category, is the increasing correlation between the more traditional asset classes. The historic portfolio 60/40 of Equities/Fixed Income is proving to not be adapted to modern economies and the added value derived from additional “alternatives asset classes” is showing positive results. As visible in the following table, novel diversification due to incorporating the real estate sector, commodities or private equity in the portfolio leads not only to higher annualised returns but also to a better return / volatility ratio.

Theoretical effects of diversification on performance and volatility

 Portfolio IPortfolio IIPortfolio IIIPortfolio IVPortfolio VPortfolio VIPortfolio VII
Global Equities100%80%60%50%50%45%40%
Global Bond 20%20%25%20%15%10%
Global Real Estate  10%10%10%10%10%
Commodities / Natural ressources  10%10%10%10%10%
Emerging Equities   5%5%5%5%
Emerging Bonds    5%5%5%
Private Equity     10%10%
Hedge Funds      5%
 Total100%100%100%100%100%100%100%
Anualised Return6,7%6,8%7,2%7,4%7,6%8,1%8,2%
Volatility14,5%11,5%11,1%10,6%11%12%11,6%
Return / Volatility ratio0,460,590,650,690,690,670,71

II.            How are institutional investors investing in Alternatives?

a)    Private Equity & Venture Capital 

Since the industry rose to prominence in the 1980s, it operates in fairly the same paradigms. When looking at the way private equity houses raise money, the classic ten-year blind pool fund was the standard of the industry. Nowadays, the ongoing trend of customization finds more foothold in this particular asset class. Thus, while the traditional models will not vanish, investors will have other options to channel their capital into private equity opportunities. Innovation in capital formation is picking up, with the popularity of long-duration funds, private holding companies and SPACs continuing to rise.

With the increasing prevalence of family offices, endowments and national pensions, long duration funds offer an attractive way of holding particular assets for the long term. Here, near permanent ownership is sought. In private holding companies, a fund operates more in the manner of a strategic buyer. This provides sponsors with greater individuality regarding target size and holding duration. SPACs, being able to offer customized solutions, perfectly resemble the trend of tailor-made investment structures.

Lastly, next to the aforementioned structures, other approaches are also gaining traction. Here, private equity / hedge fund hybrids, continuation funds and single purpose vehicles offer promising solutions for capital allocation.

b)    Absolute Returns Strategies

The absolute returns asset class is usually defined as a segment of investments and/or mutual funds that aim to earn a positive return over time – unrelatedly of whether financial markets are going down, up, or sideways – while trying to minimise volatility. 

In the Mid-90s, this particular asset class started first in the U.S. but then expanded worldwide. Between 2005 and 2016, the expansion was particularly important and has since then slowed down in recent years. The benefits of these investments mainly come from reducing the portfolio volatility while improving portfolio risk-adjusted return, limit losses in down markets (i.e. market-neutral) and broaden the sources of returns. 

University endowments and pensions found particularly appreciate the low correlation and global improvement in terms of Sharpe Ratio. This is particularly useful in times of crisis and was one of the reasons the asset class became so popular after 2008. Nevertheless, the bullish financial cycle of the last decade has affected this investment category because of lower returns than other long-only positions, which decreased investors’ appetite for hedged positions. 

The COVID-19 crisis impact on the category has been mixed; paradoxically, even if negative results were limited, AUM went down drastically according to Morningstar data as investors partly preferred reallocating their positions towards assets which would allow them to better compensate for losses on others asset classes (with more upside potential). However, the segment remains popular as new Quant strategies are emerging (i.e. smart beta strategies) with more compressive tools. This should enable the category to retain investors over the coming years.

c)     Infrastructure & Real Estate

Infrastructure investing is compelling to managers as a long-term asset class with stable, predictable cash flow. Especially in times of crisis, their low-risk characteristics are much sought after. Thus, it comes as no surprise that institutional investors diversify their portfolios and start to include these assets more. This is mirrored by e.g. Bill Gates’ acquisition spree of farmland, now owning roughly 250,000 acres, according to disclosures in the US publication “The Land Report” this year. Next to farmland, infrastructure investment in general is poised to witness a boom. Governments worldwide are seeking to stimulate economic growth and are catching up on neglected improvements of e.g. streets and energy grids.

d)    Private Debt

The private debt assets have grown exponentially since the beginning of the 2000s, going from USD 40 bn in 2001 to over USD 1 trn in 2020. This phenomenon is mainly driven by three main factors, the first being the exit of banks of direct lending due to new Mifid regulations (among others). The second being the global search for yield in an environment where euro rates continue to be negative, and U.S. rates continue to drive lower. Finally, growth of private debt funds draws interest from institutional investors as a low or even a decorrelation tool. 

The COVID-19 crisis has worked as a proof of concept for this asset class because the global results have been so far resilient, and more importantly, the low correlation of other asset classes has been effective. Furthermore, private debt has played an essential role to businesses in need of financing recovery or expansion.

III.          What are the results?

As visualised in our prior findings, the trend of institutional investors has been to resort to alternative assets (private equity, absolute returns, infrastructure & real assets, private debt). Endowments, national pensions, fund managers, and family offices all follow this shift away from conservative strategies seeking to generate alpha by betting on riskier asset forms. This is best illustrated by the model of the U.S. university foundations. As an example, the Yale endowment, famously managed by David F. Swensen in the position of chief investment officer since 1985, and the Harvard endowment, the largest academic endowment in the world and managed by Narv Narvekar, give insights into this ongoing trend.

Exemplary, the timely evolution of Yale’s asset allocation shows a pivoting away from U.S. public equity and cash & fixed income. As discussed above, these asset classes do not provide a high enough risk-return ratio. On the other hand, venture capital, absolute returns and foreign equity enjoy a higher capital allocation. Nowadays, these riskier positions allow for above-market returns where other options cannot. In the following graph, these findings are visualised.

Evolution of Yale asset allocation

Strategic allocation of U.S. foundations (2019)

Both aforementioned endowment funds of Harvard and Yale have been ranked among the best investment funds over the last two decades. With an exceptional well managed risk return ratio and a better decorrelation compared to more “traditional” funds. Increasing proportion of leveraged buyouts, venture capital, as well as absolute return strategies helped establish this strong track record, while domestic equities and cash and fixed income has progressively been decreased. In the following graph, the asset allocation as listed in their respective annual reports of FY 2020, are displayed.

Portfolio allocation of the Harvard and Yale endowment fund

The outlook for 2021 looks promising towards alternative investments as asset managers are already sitting on more than USD 2.6 trn of so-called dry powder, money they have raised to invest in leveraged buyouts, private debt, real estate, infrastructure and natural resources, the Preqin data show. That figure is double the level that had been raised just six years previously.

Sources:

https://www.reuters.com/article/us-usa-fed-idUSKBN2B90KE

https://www.blackrock.com/us/individual/education/fixed-income

https://fred.stlouisfed.org/series/FPCPITOTLZGUSA

https://www.global-rates.com/en/interest-rates/central-banks/central-bank-america/fed-interest-rate.aspx

https://www.cfainstitute.org/-/media/documents/article/rf-brief/rf-brief-franz-university-endowments.ashx

https://www.economist.com/special-report/2020/10/08/the-eternal-zero

https://www.economist.com/finance-and-economics/2020/10/15/low-interest-rates-leave-savers-with-few-good-options

https://www.bloomberg.com/graphics/infographics/alternative-investments-beat-stocks.html

https://www.economist.com/finance-and-economics/2020/03/12/corporate-bonds-and-loans-are-at-the-centre-of-a-new-financial-scare

https://www.ft.com/content/5fc597bf-f590-42ad-a8b8-3c97ab1bcdd9

https://www.allianzgi.com/en/insights/investment-themes-and-strategy/private-lending-post-covid-19

https://www.jhinvestments.com/viewpoints/investing-basics/what-is-absolute-return-investing

https://www.ft.com/reports/ftfm-real-assets

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