Research house Lonsec has released its Alternatives Sector Review, highlighting that a changing regulatory environment and investor requirements have continued to shape the alternatives sector during the past year.

Lonsec’s review of the alternatives sector encompassed 33 products covering both hedge funds and private equity. The report found that many alternatives products have failed to perform as well as traditional long-only equity products over recent years during a relative strong equity market coupled with historically low volatility.

“The alternatives sector is one of Lonsec’s most diverse sectors,” Lonsec’s senior investment analyst Stewart Gault said. “Over the last few years, the alternatives product space has faced significant regulatory change, both domestically and internationally.”

“This regulatory scrutiny has been accompanied by increased demand from investors for greater transparency from the alternative investment sector.”

Lonsec believes this has been driven by the institutionalisation of the hedge fund investor base.

“The traditional hedge fund investor base of family offices and high net worth individuals has been supplanted over time by large institutional investors, such as pension funds and sovereign wealth funds,” Mr Gault said.

“Institutional investors typically have statutory or legal reporting requirements and so require greater transparency from their investments,” he said.

As well as greater transparency, Lonsec also found that investors were demanding less complexity, better liquidity and lower fees from the alternative investment sector.

Lonsec notes that many funds have invested in additional legal, compliance and risk resources and launched new structures to address these investor demands.

“In the Australian retail segment, sufficient anecdotal evidence exists of financial advisors preferring less complex strategies which can be more easily understood and explained to clients,” Mr Gault said. “We do believe that issuers of complex products need to make a greater effort educating investors – more detailed Product Disclosure Statements are a good, but small, step in this direction.”

While Lonsec believes there is a strong case based on diversification to include an allocation to alternative assets within a multi-asset portfolio, investors should be aware of additional risks associated with such allocations – such as reduced transparency, less or no reliance on traditional market beta to drive returns, and sometimes illiquidity.

Other key findings of the report include:

• The broad range of hedge fund strategies leads to significant variation in performance. In the 12 months to November 2014, product returns ranged from -25.1% to +24.8%.
• Unlike traditional asset classes where management fees have been under downward pressure from competition and index-linked products, this is not the case in the Alternatives sector.
• Only one product was upgraded in 2014 while three were downgraded.

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The Lonsec Multi-Asset Class Sector Review 2012, released today, found the last few years have seen a dramatic transformation in the multi-asset landscape. Once regarded as the ‘set and forget’ asset class, fund managers and investors alike are putting multi-asset funds under the spotlight.

“There is little doubt that traditional Multi-Asset Class funds disappointed during the global financial crisis. Multi-Asset Class funds proved to be anything but ‘diversified’, holding far too much equity market risk at exactly the wrong time, regardless of risk profile. Questions that went unasked during the equity bull markets of the early to mid-2000s are now being asked,” said Stewart Gault, Senior Analyst, Lonsec Research.

“The realisation that you can’t live off negative peer relative performance has hit home. While investors in the early to mid-accumulation stage of their investment cycle can typically recover from a significant drawdown over a long enough investment period, the same cannot be said for investors at or nearing retirement. Large drawdowns at this time can be devastating to retirement savings and income, forcing investors to delay retirement or re-enter the workforce.

“Investors in this stage of the investment life cycle want some capital growth to at least meet inflation plus some longer term spending goals. But more importantly, they want lower volatility and far better protection on the downside than what has been afforded under the more traditional multi-asset class model. They certainly don’t want their retirement savings dictated to by the performance of equity markets,” Mr Gault said.

The Lonsec review found investors like these are beginning to look for outcomes based, or real return solutions, rather than peer relative performance. This, combined with the recognition that there exists a sizeable gap in terms of available product for those wanting to transition smoothly to retirement, has seen the rapid development of multi-asset real return (MARR) style products over the last 12 to 18 months.

“The MARR sub-sector has grown from five to seven funds since Lonsec’s last review. While intuitively appealing to many, flows into this space have not been particularly overwhelming, with further education in how to use these funds required. Furthermore, with regards to implementing this type of strategy, current financial planning software has some limitations which will need to be overcome,” Mr Gault said.

More broadly, over the past few years Lonsec has noticed an important mind shift occurring within the multi-asset class sector. Fund managers have generally become less concerned about ‘peer risk’ (underperforming peers), and have instead become more focused on delivering outcomes that are more aligned with client expectations.

Just a fad or the future of multi-asset class investing?

With the increased interest in MARR funds in recent times, it remains to be seen if we are witnessing the future of multi-asset class investing or just another product trend that will likely lose its appeal when markets normalise. While only time will tell, Lonsec is of the view that both traditional models and MARR funds can co-exist.

“Lonsec recognises that no one investment style will outperform in all market conditions. MARR funds are likely to underperform their more traditional counterparts in strong bull equity markets, but as a trade-off, will potentially provide a much smoother ride for investors,” Mr Gault concluded.

Lonsec’s Multi-Asset Class Sector Review 2012 provides subscribers to Lonsec’s Managed Funds Research with a detailed assessment of each participating fund manager’s investment capabilities within the Multi-Asset Class Sector.

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