Lonsec: The strategies best positioned for the coming markets

As vast and diverse as the alternatives strategies space is, investors need to remember that performance is not uniform either. After all, you can’t expect strategies as distinct as venture capital, infrastructure or gold amongst others, to offer the same returns at the same point in time. It’s not their purpose either.

For every point in the market cycle, there is an alternative strategy that is more likely to thrive.

In the last year, private markets have risen to the fore. But Darrell Clark, Lonsec's Deputy Head of Research & Manager for Alternatives thinks the coming environment may be more challenging for this side of alternatives.

“We’re now moving into this environment of regime change: rates are rising, volatility is coming back. Now that type of environment creates a bit more dispersion in markets and that creates a lot more opportunities for managers,” says Darrell Clark, Deputy Head of Research and Manager Alternatives for Lonsec.

He argues that volatility is more likely to suit those managers who use relative value to play the spread between different securities, assets or markets, such as long-short managers.

In this interview for Livewire's Alternatives in Focus series, Clark shares his insights on the changing alternatives space, what might perform best in the coming environment, and how to evaluate alternative strategies. He also discusses the types of fees investors might expect to pay for these strategies.

Edited transcript

Sara Allen: Hello and welcome to Livewire’s annual Alternatives in Focus series. I’m Sara Allen and today, I’m joined by Darrell Clark. Darrell is the Deputy Head of Research & Manager, Alternatives for Lonsec. Today we’re going to be discussing the state of alternatives and how Lonsec evaluates strategies in this space.

To begin with, how big is the alternatives space and how quickly is it growing?

It’s actually been growing really fast. If I think about the last two years, at Lonsec, we’ve seen our coverage of funds in the alternative universe grow by about 50% and it seems to be growing by the week.

We’re in a fortunate position where fund managers keep bringing us new funds to review and if you think about what’s driving that, it’s what we already know.

It’s been an uncertain environment. In the last couple of years, people have been looking at equities and bonds - the behaviour of these two asset classes and how they blend together in a portfolio. People are looking at alternatives as a differentiated source of risk and return that they want to bring to their portfolios.

What are some of the key trends that you’re seeing emerge across the space?

Without a doubt, I would say the biggest trend is the rise in private market offerings. 

I would start by saying if you go back two years, private markets were a much smaller part of our funds under coverage – it was probably about 15-20% of the funds we covered. 

The largest would have been something like global macro hedge funds and trend managers. That would have been about 40%. Now in the last two years, that has really switched around. 

The private market offerings are now about 40% of the funds we cover and it’s growing by the week it seems at the moment.

If you think about what’s driving that, there’s this structural change in the market where public markets are shrinking. Private opportunities have grown significantly over time. For retail investors, they’re now able to gain access to these types of opportunities through what people are calling a more 'democratised' access to private markets through a managed investment scheme that has either monthly or quarterly liquidity, normally with an alpha cap around that. 

That’s a big change compared to the past if you think that they’ve been the mainstay of institutional investors for the last 10 to 20 years and institutional investors have been able to write cheques for several million dollars to private equity firms. Now, retail or wholesale investors can gain access to the same opportunities.

That’s probably been the biggest step change we’ve seen in our coverage over the past one to two years.

Part of the appeal of alternatives is differentiated performance compared to equities and fixed interest. What are you seeing in terms of performance across the strategies that you evaluate?

It’s a fairly difficult one to answer in some respects. The one thing I’ll try and get across to views is that alternatives is a very broad church so don’t necessarily think about it in terms of an asset class but rather a range of strategies. The level of dispersion can be quite significant when you’re talking about performance.

That said, the funds in the universe have very different risk and return characteristics.

If we look back at just a shorter-term time period, like 1-year, stronger performers would have had returns of around mid-double-digits. That would be some of the private markets or private equity funds that we’ve spoken about. At the lower end, it’s been around negative double-digits, so you can see there is quite a variety there. You’d probably see something quite similar even if you were to look over a three-year period.

If we try and break it down a little bit and draw out some observations, starting on the more liquid side of the alternatives universe, something like a trend manager for example:

Go back 12 months and they had some really strong 12-month returns. Trend managers were benefiting from strong trends in markets. They do what they say they do, they’re trying to capture momentum from various markets. If you think about last year’s trends, the US dollar, fixed income, and commodities did really well.

Now, some of those liquid managers, like trends, had more muted returns this year but you can probably break that universe down into trend managers that purely capture trends versus those that have complementary strategies attached to them. Trend managers that have things like non-trend signals carry value. Some use seasonality. Some of those strategies have actually performed really strongly this year. While returns have been more muted versus last year, they’ve been OK.

And then if we turn to the more illiquid universe, private markets – which we’ve spoken about as a strong trend – they’ve been fairly resilient and performing really well. People ask about performance in private markets all the time because of unlisted asset valuations and the like, but when we speak to our managers, they tell us that, on a look-through basis of the companies they’re investing into, earnings are still fairly resilient. Valuations are still OK and the companies, while facing headwinds, are still doing OK in the market we’ve got.

Even if you were to look at the private debt universe, it’s a similar type of scenario where companies have been fairly resilient and we haven’t seen that default cycle pick up as much as some people expect. So performance from those private market offerings has been fairly good as well.

Where do you think are going to be the opportunities going forward? Which types of strategies are going to perform better in the coming months?

It’s an interesting one because I’ve been waiting for this period for quite some time. I’ve been looking at alternatives for 10-12 years and much of that post-GFC period has been tough. We’ve had central banks intervening in markets. It’s crushed the volatility and that’s been a weaker environment for hedge funds in general to perform.

We’re now moving into this environment of regime change: rates are rising, volatility is coming back. That type of environment creates a bit more dispersion in markets and that creates a lot more opportunities for managers. Whether that be long-short managers, or it could be managers who play relative value in markets where they’re playing the spread between two different securities or two different markets, that type of volatility is really important.

Likewise, if we look at the private market offerings, there’s an environment in which they can still do pretty well. Although, the time for them is a little bit more challenging. 

That doesn’t mean you shouldn’t allocate to private markets, but they could be a bit more challenged because rates are higher and it’s harder in that environment for private equity managers to generate a return. They have to lean on other levers - the traditional value creation levers that they have.

These strategies are quite complicated to build and run so they come at a cost. What should investors be expecting to pay to use these strategies?

They are a bit more complex and a bit more sophisticated so you can expect to pay more than you would for a traditional activity equity or bond manager.

Taking a step back, the way we look at fees is we score the managers on the quantum of fees. So what’s the overall level of fees? We’ll also try to take into account the fairness of that. Is this fee easily replicated by cheaper offerings for example, and are you paying a fair fee for the actual alpha that the manager can potentially generate? 

All of that said, it depends on the offering and again, it’s a broad church.

People can pay anywhere between 1% for some of the less sophisticated offerings and up to about 4% near the upper end. That would be for some of the private market offerings, but then those managers are occasionally generating returns of 15-20% as well net of fees. 

People should always expect if they’re paying a higher fee, you want them to be getting a decent return in regards to that.

How do you determine which strategies receive Lonsec’s highest ratings?

What viewers should expect is that we’re using the same Lonsec research methodology and approach that we do for traditional asset classes. You can expect that we’re looking at the business, how sustainable it is and how strong it is. We’d be looking at the quality and capability of the investment team. We obviously spend a lot of time looking at the investment process and the repeatability of that process.

There are a couple of areas I would draw out for alternatives. If you think about the areas in which some hedge funds can go wrong for example, it’s around risk management. 

We spend a lot of time looking at how funds manage their risk, what systems and infrastructure they’ve got around managing that, what kind of look-through they have to the underlying exposures within the portfolio, and levels of diversification. We also want the alternatives to do what they say on the tin.

If investors or our subscribers are going into alternatives expecting that this is going to offer a low correlation to equities, then of course, we’re going to look at correlations. We’re also going to look at the beta to equities and just try to make sure it’s delivering on expectations.

The other area we tend to focus on quite a bit, and more so for private market offerings, is governance around some of the operational aspects. 

We mentioned valuations earlier and things like that. We’ll spend a lot of time thinking about the process managers have in place to ensure fair valuations are put on things because when you’ve got an offering here that is essentially illiquid but in a semi-liquid offering, you want to ensure people can transact in and out of the fund at a fair price. What do I mean by governance around it? 

We want to ensure there’s as best as many third-party valuations involved. We want to ensure that those are audited. The more independence around that valuation process, the better.

Those are two areas I would draw out. So, risk management and the operation or governance side as well.