Analysis & Trends
The Case for
Alternatives
2
The Case for Alternatives
“Alternative strategies tend to produce different performance
patterns to stocks and bonds under the same market conditions.”
Spencer Rhodes
3
The Case for Alternatives
Content
5 The Case for Alternatives
5Growing relevance of alternative sources
of return
5 The alternative investments universe
7Three broad trends have reshaped
the alternatives industry in recent years
7 The rise of alternatives
7 A great variety of investment choices
8 Alternatives offer diversification
9 Understand. Act.
By Ann-Katrin Petersen, Assistant Vice President,
Global Capital Markets & Thematic Research,
and Spencer Rhodes, Alternative Investments
Global Business Manager, Allianz Global Investors.
Imprint
Allianz Global Investors GmbH
Bockenheimer Landstr. 42 – 44
60323 Frankfurt am Main
Global Capital Markets & Thematic Research
Hans-Jörg Naumer (hjn)
Ann-Katrin Petersen (akp)
Stefan Scheurer (st)
Data origin – if not otherwise noted:
Thomson Reuters Datastream
Allianz Global Investors
www.twitter.com / AllianzGI_VIEW
4
The Case for Alternatives
The Case for Alternatives
After a 30-year bull market in bonds and a strong, multi-year
recovery in equities, investors wonder what lies ahead for
financial markets. The current low-interest-rate environment
and the search for market-neutral solutions is increasingly
prompting investors to rethink their allocation decisions with
regard to alternative investment strategies.
Growing relevance of alternative
sources of return
Data as of July 2015.
Sources: Bloomberg,
AllianzGI Global Capital
Markets & Thematic
Research.
1
However it is important
to note that, unlike hedge
funds, bonds offer a fixed
rate of return if held to
maturity.
2
Note that less-thanperfect correlation with
global equity returns may
offer some diversification
benefits, but correlations
tend to increase during
periods of financial crisis.
3
What is on the cards for capital markets?
Three important themes will likely remain
on investors’ radar in the months ahead:
1. Financial repression is not only set to
continue, it has even reached a new level.
Regardless of the recent (April-June)
correction in bond markets, investors are
still facing negative nominal yields for
government bonds with solid credit ratings
(see chart 1). It speaks for itself when
roughly 50 % of outstanding German Bunds
are now in negative territory. 1 Neither real
nor nominal bond yields in negative territory
are able to play their traditional role for
income generation. At the same time,
downside risks are on the horizon as
markets must start pricing in higher US
central bank rates in the coming years. This
is why alternative strategies especially on
the low-risk, low-return end of the spectrum
are becoming increasingly popular among
investors seeking an alternative to bonds in
low-yielding times.2
2. O
ngoing expansionary monetary policy
globally, and a world economy growing at
around potential, should support risky
assets longer-term. Nevertheless,
valuations of various asset classes are
stretched – after more than three years of
bull market, stocks in some geographies
might deliver fairly little upside potential.
Therefore many investors are looking for
more market-neutral strategies, with low
net exposure, that complement their equity
allocations.
5
3. L ast but not least, investors should be
prepared for increasing volatility. High
valuations of various asset classes, an
expected first rate hike by the Fed, as well as
intensified (geo-)political risks could
temporarily provide some headwind for
risky assets. Managing volatility and buying
protection against drawdowns will therefore
gain importance.
Against this macroeconomic and market
outlook, investors must find new ways to
complement their traditional asset allocations
in order to achieve their investment objectives.
With clients looking for bond substitutes
(i. e. income generation with managed
volatility), new betas and new sources of alpha,
uncorrelated returns 3 (market-neutrality),
enhanced portfolio diversification, lower
volatility and tail-risk protection, the relevance
of alternative sources (of return) is growing.
The alternative universe features diverse
investment styles and strategies, though, each
with its own expected risk / return profile, that
can be used as tools to customize portfolios.
Let’s have a deeper look.
The alternative investments
universe
“Alternative investments” is not an asset class
in itself. Rather, the alternative investment
universe has several characteristics, including:
• traded asset classes that fall outside the
traditional definitions of publicly traded
stocks and bonds – such as commodities
and currencies;
• niche real assets such as timberland, fine
wines, antique furniture and art, as well as
intangible assets such as patents, royalty
streams, and airplane leases, can be
considered alternative to “traditional
investments”, too;
• trading strategies that are not available to
traditional long-only managers, such as
shorting, hedging with derivatives, and the
use of leverage;
• investment strategies that rely on privately
negotiated deals (and are less liquid) such as
private equity, private debt, private real
estate equity and debt, as well as
infrastructure equity and debt, and
• alternative investment vehicles in which
these assets / strategies are packaged such
as Limited Liability Companies (LLCs), Limited
Partnerships (LPs), and Cayman funds, which
have fewer restrictions on how managers can
execute their strategies. 4
Alternative investments can be categorized
in terms of the (il)liquidity of the underlying
asset or investment style on the one hand and
according to the degree of liquidity of their
vehicle on the other (see chart 2). Following the
financial crisis, clients have increasingly requested
a stronger alignment between the underlying
assets’ liquidity and the vehicle’s liquidity.
Certain hedge funds
often engage in leveraging and other speculative
investment practices that
may increase the risk of
investment loss. They can
be highly illiquid, are not
required to provide periodic pricing or valuation
information to investors,
may involve complex tax
structures and delays in
distributing important
tax information, are not
subject to the same regulatory requirements as
mutual funds, and often
charge high fees.
4
Chart 1: Ultra-loose monetary policy makes negative interest rates “the norm” –
European government bond yields still hovering in negative territory
Generic government bond rates, in %
3 M
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y
10Y
15Y
20Y
30Y
Germany
–0.32
–0.22
–0.24
–0.20
–0.09
0.06
0.14
0.29
0.41
0.57
0.68
0.91
1.15
1.36
France
–0.20
–0.21
–0.18
–0.13
0.01
0.18
0.30
0.45
0.64
0.79
0.98
1.43
1.62
1.89
Netherlands
–0.26
–0.18
–0.21
–0.14
–0.03
0.10
0.25
0.40
0.57
0.70
0.85
Belgium
–0.25
–0.20
–0.18
–0.12
0.05
0.18
0.33
0.50
0.66
0.81
0.99
1.21
1.58
Austria
–0.19
–0.17
–0.11
0.02
0.12
0.29
0.49
0.63
0.78
0.94
1.04
1.60
Finland
–0.22
–0.20
–0.11
–0.03
0.08
0.13
0.23
0.47
0.56
0.69
1.05
1.38
–0.44
–0.30
–0.23
–0.12
0.01
0.37
–0.81
–0.78
–0.81
–0.70
–0.54
Sweden
Switzerland
–0.42
–0.49
–0.38
–0.15
–0.14
0.15
Denmark
–0.93
–0.19
–0.25
0.08
0.42
0.31
1.48
0.53
1.85
0.71
0.77
0.86
1.33
Sources: Bloomberg, AllianzGI Global Capital Markets & Thematic Research. Data as of July 31, 2015.
Past performance is not a reliable indicator of future results.
Non-EMU countries
Chart 2: Alternatives portrayed in two dimensions of liquidity
High
Liquidity of vehicle
Publicly traded
Private Equity Funds
Liquid Alternatives
REITs
Equity Long / Short Hedge Fund
in UCITS or 40 Act
Equity Long / Short HF in Cayman, Monthly
liquidity, no notice period, mo lock-up, no gate
Illiquid Alternatives
Private Real Estate
Event Driven
Hedge Funds
Private Equity
Equity Long / Short HF in Cayman
with Quarterly liquidity, 60 day
notice period, look up, and gate
Infrastructure
Low
Low
Liquidity of underlying assets or style
High
Placement and selection of asset classes for generalized illustration purposes only. Source: AllianzGI. Past performance is not
a reliable indicator of future results. Forecasts are not a reliable indicator of future results.
6
The Case for Alternatives
Three broad trends have reshaped
the alternatives industry in recent
years
“UCITS” or “undertakings for the collective
investment in transferable securities” are investment funds regulated at
European Union level.
They account for around
75 % of all collective
investments by small
investors in Europe. See
EU Commission. UCITs
can be distributed globally, apart from the US.
5
See McKinsey & Company (2014): “The Trillion-Dollar Convergence:
Capturing the Next Wave
of Growth in Alternative
Investments”, p. 7f.
6
See PwC (2014) “Asset
Management 2020: A
Brave New World”, p. 8.
7
1. Institutionalization: A shift in the
dominant investor base from risk-tolerant
investors to more risk-averse institutional
investors (see chart 3). This shift in the
sources of capital has corresponded to a rise
in low risk / low return alternatives within the
industry. Simultaneously, more institutions
are getting their alternatives exposure
directly from asset managers rather than
from fund of fund providers.
2. “ Retailization”: The rapid growth of fully
regulated alternative mutual funds in the
United States and the parallel growth of
Alternative UCITS 5 in Europe and Asia. This
has enabled small investors to gain access to
alternative strategies that were previously
only available to large institutions.
3. Regulation: In Europe, offshore funds such
as Cayman funds have lost market share to
fully regulated UCITS due to tax
transparency considerations and the
Alternative Investment Fund Managers
Directive (AIFMD).
The rise of alternatives
Alternative investments have grown rapidly in
recent years, twice as fast as non-alternatives
since 2005. According to McKinsey, from 2005
to 2013, alternative assets under management
(AuM) grew from USD 3.2 trillion to 7.2 trillion
(see chart 4). Growth has been broad-based
across all alternative asset classes (defined
here as hedge funds, private equity, and real
assets). 6 Looking forward, PwC predicts that
this mainstreaming of alternative investments
will continue and that assets managed could
reach USD 13 trillion by 2020. 7
A great variety of investment choices
Historically, alternative investment strategies
were offered solely in private, less liquid
vehicles such as Cayman-domiciled funds and
Limited Partnerships. More recently, “liquid
alternative” mutual funds and UCITS funds
have made these strategies more accessible to
investors who prefer or require regulated
investment vehicles. Within these new fund
vehicles, a great variety of different investment
strategies can exist, although investors should
make sure that the underlying assets or style
of the strategy matches well with the liquidity
Chart 3: Investor landscape – Risk averse institutional investors now the dominant
source of hedge fund capital
Hedge fund industry: sources of underlying capital, in US Dollar billion
$4,000
$3,500
$3.56T
74%
Billions of Dollars
$3,000
$2,500
$2,000
$1.64T
62%
$1,500
$1,000
$500
$0
$1.25T
26%
$500B
80%
$991B
$125B 20%
38%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E 2018E
Pension funds, sovereignwealth funds,
endowments and foundations
High net worth and family offices
Source: Citi Investor Services, based on Hedge Fund Research data and interviews.
Past performance is not a reliable indicator of future results. Forecasts are not a reliable indicator of future results.
7
Chart 4: The rise of alternatives – Rapid broad-based growth
Global AUM* of key alternative asset classes, 2005 – 2013 in US Dollar trillion
CAGR* 2005 – 2013
Total
10.7 %
$6.4
Real Assets
Private Equity
$4.9
1.4
9.1 %
11.4 %
1.1
1.1
1.0
Fund of funds
Retail alternatives**
2.6
2.0
11.3 %
$3.2
Hedge Funds
$7.2
2.3
Growth of
traditional assets
= 5.4 %
2.1
1.9
1.6
2.4
2.1
2005
2008
2011
2013
5.6 %
$0.5
$0.8
$0.9
$0.9
12.6 %
$0.8
$1.1
$1.7
$2.0
*) Assets under Management. **) Retail alternatives refers to a broad array of strategies that are designed to deliver alternatives
exposure via registered retail vehicles, including mutual funds, closed-end funds and exchange-traded funds. Sources: McKinsey,
AllianzGI Global Capital Markets & Thematic Research. Past performance is not a reliable indicator of future results.
of the fund vehicle within which it is packaged.
According to Hedge Fund Research (HFR),
there are at least four broad “hedge fund”
investment categories with further subclassifications:
1. Event-driven strategies are typically based
on a corporate restructuring or acquisition
that creates profit opportunities for long and
short positions in common equity, preferred
equity, or debt of a specific corporation.
2. Relative value strategies involve buying a
security and selling short a related security
with the goal of profiting from a perceived
pricing discrepancy. By way of example,
investors are able to participate in the
returns of volatility as an asset class with a
strategy based on harvesting the variance
risk premium.
3. Macro strategies are “top down”
investment strategies based on global
economic trends and events which may
involve long or short positions in equities,
fixed income, currencies, or commodities.
4. Equity hedge fund strategies are “bottom
up”-driven investment approaches that seek
to profit from long or short positions in
publicly traded equities and / or derivatives
with equities as their underlying assets.
Alternatives offer diversification
Alternative strategies tend to produce different
performance patterns than long-only stocks
and bonds under the same market conditions.
Many alternative strategies have been
designed to maintain a low beta, so they move
less in line with the market, providing
diversification, and the potential for protection
in down markets – in the original sense of the
word “hedging”. Adding (liquid) alternatives to
a traditional portfolio allocation can benefit a
broad range of investors in terms of improved
risk-adjusted returns, enhanced diversification,
and potentially lower market sensitivity.
Even though alternative mutual funds and
alternative UCITS are relatively new, many of
the underlying hedge fund-type strategies
have been tested over a much longer period of
time. As a proxy for the hedge fund industry,
observers often reference the HFRI Fund
Weighted Composite Index (HFRI FWC Index),
HFR’s industry-wide index. 8
Please note that aggregate hedge fund measures such as the HFRI
FWC can be useful measures of the overall direction of travel of the hedge
fund industry and they
enable investors to draw
broad-brush conclusions
about the growth trajectory of the industry as a
whole. But they are often
interpreted as capturing
the performance of the
“average” hedge fund,
when arguably there is
no such thing. In fact, the
hedge fund industry is
extremely diverse.
8
Comparing the short-term performance of
aggregated hedge fund indices with equity
indices such as the S&P 500 can be misleading,
especially during a stock bull market, as many
alternative strategies are designed to protect
investments during drawdowns rather than to
necessarily outperform during rallies. That is,
their usefulness to investors often increases
later in the cycle. Greater clarity can therefore
be gained by looking at long-term figures.
8
The Case for Alternatives
Potential problems with
historical returns data
such as the survivorship
bias need to be taken
account of, though. Survivorship bias refers to
the upward bias of
returns if data only for
current existing (surviving) firms is included.
According to HFR, “…
when a constituent fund
liquidates or stops reporting, their performance
remains part of the index
return, reducing survivorship bias.”
8
On a risk-adjusted basis, which measures the
value of the returns in terms of the degree of
risk taken (“Sharpe Ratio”), hedge funds have
outperformed US equities, global equities,
and global corporate and government bonds
over the longer term (see chart 5). Even over
the last five years, i. e. including the postfinancial crisis equity bull market, the S&P 500
and MSCI World have not performed better
than the HFRI FWC on a risk-adjusted basis.
Investors have two choices: simply allocate
broadly to “alternatives” via a customized
advisory service. Or, add single alternative
strategies, in order to achieve a specific
investment objective such as lowering
interest-rate sensitivity, reducing portfolio
downside risk or increasing portfolio
diversification. In either case, a clear
understanding of one’s risk / return goals and
deep manager due diligence is often key.
Besides attractive risk-adjusted returns, the
pattern of returns has been beneficial. On
average, alternatives haven’t performed as
well as stocks in bull markets, i. e. lagging the
returns of global equities in up markets,
however they also haven’t lost as much in bear
markets (see chart 6). During the extreme
market stress of the financial crisis, the
maximum drawdown (largest peak-to-trough
loss over a period) of the HFRI FWC amounted
to 21.4 % between November 2007 and March
2009 while, by way of example, investors in the
S&P 500 experienced a 57 % drawdown. 8
Understand. Act.
Similarly, when comparing annualized
volatility figures it is clear that alternatives have
not only been less volatile than equities,
which might be expected, but also less volatile
than (corporate) bonds (see chart 7). Roughly
speaking, alternative strategies have provided
less than half the volatility of stocks over the
last 20 years.
• With the secular bull market coming to an
end, after a strong, multi-year recovery for
equities, and with more volatility in the cards,
the search for alternative sources of return is
growing.
• Adding (liquid) alternatives to a traditional
portfolio allocation might benefit a broad
range of investors, not only in terms of
improved risk-adjusted returns, but also by
providing enhanced diversification, and
potentially lower market sensitivity.
• These strategies are increasingly available in
regulated vehicles with liquidity and
transparency.
• The alternative universe features diverse
asset classes and investment styles, each
with its own expected risk / return profile.
These can be used as tools to customize
portfolios.
Chart 5: Over the longer term, liquid alternative strategies have outperformed equities and bonds on a risk-adjusted basis
Comparison of both annualised „headline“ returns and risk-adjusted returns for hedge funds as a whole,
equity hedge funds, equities and bonds, for various periods to end-2014
5 year
10 year
Annualised
headline
return
Annualised
standard
deviation
HFRI FWC
4.9 %
HFRI Equity
Hedge
5.5 %
Index
S&P500
20 years
Sharpe
Ratio
Annualised
headline
return
Annualised
standard
deviation
Sharpe
Ratio
Annualised
headline
return
Annualised
standard
deviation
Sharpe
Ratio
5.2 %
0.9
5.7 %
6.2 %
0.6
8.7 %
6.9 %
0.8
7.5 %
0.7
5.4 %
8.4 %
0.4
10.3 %
9.2 %
0.8
13.5 %
14.7 %
0.9
7.3 %
16.6 %
0.3
9.0 %
16.2 %
0.4
MSCI World
9.0 %
15.3 %
0.6
6.6 %
17.3 %
0.3
6.6 %
16.3 %
0.2
JPM Global
Govt.
1.3 %
5.6 %
0.2
4.5 %
6.6 %
0.4
5.7 %
6.7 %
0.4
BofA Global
Corp*
4.9 %
9.6 %
0.5
5.0 %
11.8 %
0.3
5.9 %
10.9 %
0.3
*) Dataset starting in 1997. Please note that it is not possible to invest directly in an index. Please refer to chart 6 for a description of the indices in the table.
Sources: AIMA, Datastream, AllianzGI Global Capital Markets & Thematic Research. Data as of May 31st, 2015. Past performance is not a reliable indicator
of future results.
9
Chart 6: Pattern of returns
Ten-year performance of hedge funds as a whole, equities and bonds (rebased, index Jan. 2005 = 100)*
180
180
160
160
140
140
120
120
100
100
80
80
60
60
40
40
2005
2006
2007
Hedge Funds (HFRI FWC)
2008
2009
Equities (MSCI World)
2010
Equities (S&P500)
2011
2012
Corporate Bonds
(BofA Global Corp)
2013
2014
Government Bonds
(JPM Globlas Govt. Bond Index)
*) Data from January 1st 2005 to December 31st 2014 (ten-year cumulative returns). The HFRI FWC is Hedge Fund Research’s industry-wide index and
encompasses over 2,000 hedge funds. The HFRI Equity Hedge encompasses Equity Hedge strategies, i. e. strategies that maintain positions both long and
short in primarily equity and equity derivative securities. The S&P 500 is a stock market index which includes 500 of the top companies in leading industries
of the US economy. The MSCI World is a stock market index of over 1,640 constituents across 23 developed markets countries. The J.P. Morgan Global Government Bond Index measures the performance of the global government bond market; comprised of government bonds in developed countries only. The
BofA Merrill Lynch Global Broad Corporate Bond Index measures the performance of the global corporate bond market (investment grade). Please note
that it is not possible to invest directly in an index. Sources: Datastream, AllianzGI Global Capital Markets & Thematic Research. Past performance is not a
reliable indicator of future results.
Chart 7: Alternative strategies have been less volatile than equities and (corporate) bonds over
the medium to longer term
Annualised volatility (%)
18 %
16.6 %
16 %
16.2 %
14.7 %
14 %
12 %
11.8 %
11.7 %
73
10 %
7.6 %
8%
6%
4%
3.9 %
10.9 %
9.6 %
5.2 %
4.1 %
6.2 %
5.6 %
6.6 %
6.9 %
6.7 %
2%
0%
3 year (2012 – 2014)
HFRI FWC
5 year (2010 – 2014)
S&P 500
BofA Corporate*
10 year (2005 – 2014)
20 year (1995 – 2014)
JPM Govt
*) Dataset starting in 1997. The HFRI FWC is Hedge Fund Research’s industry-wide index and encompasses over 2,000 hedge funds. The HFRI Equity Hedge
encompasses Equity Hedge strategies, i. e. strategies that maintain positions both long and short in primarily equity and equity derivative securities. The
S&P 500 is a stock market index which includes 500 of the top companies in leading industries of the US economy. The MSCI World is a stock market index
of over 1,640 constituents across 23 developed markets countries. The J.P. Morgan Global Government Bond Index measures the performance of the global
government bond market; comprised of government bonds in developed countries only. The BofA Merrill Lynch Global Broad Corporate Bond Index measures the performance of the global corporate bond market (investment grade). Please note that it is not possible to invest directly in an index. Sources:
AIMA, Datastream, AllianzGI Global Capital Markets & Thematic Research. Data as of May 31st, 2015. Past performance is not a reliable indicator of future
results.
10
AllianzGI Subject Line
Further Publications of Global Capital Markets & Thematic Research
Active Management
→→ “It‘s the economy, stupid!”
Capital Accumulation – Riskmanagement – Multi Asset
→→ Smart risk with multi-asset solutions
→→ The Changing Nature of Equity Markets
and the Need for More Active Management
→→ Sustainably accumulating wealth and capital income
→→ Harvesting risk premium in equity investing
→→ Active Management
Alternatives
→→ Volatility as an Asset Class
Financial Repression
→→ Shrinking mountains of debt
→→ QE Monitor
→→ Strategic Asset Allocation in Times
of Financial Repression
Behavioral Finance
→→ Behavioral Risk – Outsmart yourself!
→→ Reining in Lack of Investor Discipline:
The Ulysses Strategy
→→ Behavioral Finance – Two Minds at work
→→ Behavioral Finance and the Post-Retirement Crisis
→→ Between a flood of liquidity and a drought
on the government bond markets
→→ Liquidity – The Underestimated Risk
→→ Macroprudential policy – necessary, but not a panacea
Strategy and Investment
→→ Equities – the “new safe option“ for portfolios?
→→ Dividends instead of low interest rates
→→ “QE” – A starting signal for euro area investments?
11
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