How DFMs are navigating fees and transparency in alt funds

Number of alt funds has risen 76% in 10 years, according to Morningstar

Fund selectors are increasing exposure to alternative asset classes as the number of strategies available continues to expand, but fees, illiquidity and transparency remain barriers to allocating more.

Portfolio Adviser spoke with three fund buyers at its recent PA Alternatives event (see video) who all said they expect to increase their allocation to alternatives over the next year. Among the areas being invested in or explored are equity long-short, absolute return and global macro.

‘Expanded set of tools’

Friends First director of multi-asset funds Patrizia Libotte (pictured) says over the past couple of years she has been increasingly focusing on managers who have what she terms “an expanded set of tools in their bag”.

“Effectively we are trying to take exposure to managers who have the ability to express long and short positions in the market either relative to asset classes or factors and have low or negative correlation to equity risk,” she explains.

Having low or negative correlation to other equity classes was also the main reason Carrington Investments head of investments Mohsin Bakhari and Premier Asset Management head of research for pooled funds Ian Rees give for using alternatives in portfolios.

Bakhari says his firm has been allocating to convertible bonds, structured products, multi-asset income products, equity long-short, absolute return and global macro – all under the alternatives banner.

He says: “Some of the asset classes I mentioned do have a degree of correlation with our traditional parts of the portfolio – equities and bonds, which is slightly irritating at times, certainly last year. So, the sole purpose for me is to act as a genuine diversifier and to not behave like the rest of the portfolio.”

Rees sees alternatives as playing the role bonds used to play as a diversifier in the portfolio. The fund group sees equities as offering the best relative value but in the interests of diversification, needs to put money to work in other asset classes that are not bonds.

“We have much less confidence now in the uncorrelated benefits of bonds, so alternatives are really trying to step into that void,” he says.

The past decade has seen an abundance of alternatives funds hit the European market. According to a recent report by Morningstar, the number of available open-ended alternative funds domiciled in Europe has risen by 76% over the 10 years until December 2018 – higher than for any other asset class.

Morningstar now has 2,663 live open-ended funds in its database, accounting for €420bn (£361bn) of clients’ money at the end of 2018 – a tenfold increase in the decade, despite seeing stark outflows in the final quarter of the year.

Fees are too high

However, it found fees remain the main factor hampering the appeal of liquid alternatives, as they directly eat into investors’ performance. The asset-weighted average ongoing charge of liquid alternative funds in Morningstar’s database is 1.08% with all share classes included.

The fund selectors PA spoke with agree that fees are front of mind when it comes to alternatives.

Bakhari says fees, particularly performance fees, are always a hot topic, and heavily influence his approach to selecting managers.

“If we can find a fund that does something similar to another fund and doesn’t have performance fees, we will opt for that one, but clearly you can’t always avoid them.”

Rees notes that alternative strategies are often trying to generate low levels of returns in volatile markets and therefore, the cost implication is crucial in understanding how they fit into portfolios.

Daily dealing is important

Fund selectors also see liquidity as one of the main sticking points when it comes to alternatives.

Bakhari says: “We focus very much on liquidity and on clients being able to take their money when they need it, so we only really deal with daily dealing funds.”

Rees says Premier groups alternatives into liquid and illiquid buckets. He says: “It is quite important if you are accessing these different asset classes you do so in an appropriate structure, so these illiquid instruments we generally access through closed-ended funds.”

This concern with liquidity could explain the heightened interest in liquid alternatives, which are daily dealing structures that invest in alternative asset classes. These strategies are catching the eye of Libotte, who is expecting to allocate more in the coming year.

“We are aware directionality of equity markets is not going to support the return environment we have been accustomed to, so we continue to add to the asset class and select managers specifically in the liquid alternatives space,” she says.

The Morningstar research also observed a pattern of large flows going into funds with no or very short track records. In fact, more than half of the trailing cumulative inflows in 2014-18 went into products launched in the same five-year period. The lack of proven strategies makes fund selection all the more challenging in this space, it said.

Libotte says: “I think it is the lack of a longer-term track record in the alternatives space which makes it difficult to ascertain whether these strategies provide that ‘crisis alpha’.”

Investors also need to get under the bonnet of alternatives because of the complexity, says Rees.

“Understanding the opportunity and the sustainability is also key because quite a few strategies we come across offer the promise of good returns but they seem very short lived, particularly if lots of other investors get drawn to it the benefits of that particular arbitrage quickly disappear.”

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