Your guide to alternative investments

The poor performance of the JSE this year has made the prospect of spreading investments over non-equity asset classes increasingly appealing. 

Alternative investments in hedge funds, private equity, venture capital, infrastructure and non-listed property, among others, spread the risk and in some cases these asset classes have been outperforming equities.   

But alternative investments are not easily accessible to private investors in South Africa, and the choices are few. 

There have been a number of regulatory changes to facilitate increased investment in alternative assets, although none of them come cheap.  

These include the recognition of hedge funds as collective investment schemes, and efforts to boost investment in Section 12J venture capital funds, which are tax deductible.  

In 2011, the Pension Funds Act increased the threshold for investment in alternative assets to 15% from 2.5%, opening up alternative investment opportunities for fund managers and, indirectly at least, their individual investors through retirement funds.   

But on average, institutional investors and pension funds are probably sitting with an allocation below 2%, says Pawan Singh, head of multi strategy at Sanlam Alternative Investments. 

“The number is close to 30% in the US and Europe.”  

SA’s low participation reflects the fact that equities have traditionally performed well, and that the alternative investment market is small and, relatively speaking, in its infancy.    

Singh says the lower allocation in SA can be attributed to lack of education about alternative asset classes, perceived complexity, and perception of high risk, “despite the superior risk-adjusted returns”.  

In addition, “traditionally high inflation-beating returns from listed equities and property hasn’t necessitated the inclusion of alternatives”.  

Alternative investments generally attract high fees and they are illiquid relative to equities.

Paul Boynton, CEO of Old Mutual Alternative Investments, says that in the US – and Europe, to a lesser extent – “alternatives are a space where, if you exclude real estate and hedge funds, there’s a 10% allocation to unlisted alternatives”. 

Real estate would be another 5% to 10% and hedge funds, which historically had a larger allocation, have reduced over the last few years as they have broadly not delivered from a performance point of view.    

Allocations to private equity, infrastructure and real estate assets have been led by the endowment sector in the US, whose capital is permanent capital relative to pension funds.   

In SA, the move in pension funds to defined contribution has meant that liquidity becomes more of an issue, and trustees are more reticent around illiquid assets. 

This, as well as complexity, have made trustees less willing to allocate to alternative investments.   

As a result, SA is sitting very underweight in alternative assets.   

“I do sense we are at an inflection point and that is changing, with increasing allocation by some advisers and funds, so there is good news in that,” Boynton says.    

Investment options   

RisCura’s head of investment analytics, George Tsinonis, views everything that is non-correlated to broader equity, fixed income and cash as alternative investments.

He says the only available alternative asset for the man in the street is hedge funds, through retail investment hedge funds (RIHFS), first approved by the then Financial Services Board (FSB) at the end of 2015. (The FSB is now known as the Financial Sector Regulation Authority, or FSRA.)

However, the minimum investment requirements are still higher than unit trusts, making them inaccessible to many investors.   

Private equity traditionally outperforms equity, but is not really accessible, he says, and while there have been small moves in crowd funding, private equity remains largely the domain of institutions.  

“The lack of liquidity associated with many alternative investments, high minimum-investment size and the knowledge gap in this asset class have resulted in retail investors having limited exposure to alternatives,” Singh says. 

“This is especially true for investments into unlisted strategies like private debt, property and private equity.”  

He says high-net-worth individuals and family offices have invested into alternatives and were early adopters of QIHFs (qualified investor hedge funds with a minimum investment R1m), private equity (minimum R100m) and Section 12J investments in Sars-registered venture capital companies (minimum R100 000), which offer tax rebates – provided the investment is held for a minimum of five years.  

“More recently, the launch of RIHFS has lowered the minimum investment size to R25 000 to allow greater participation by retail investors in hedge funds.” 

Listed options

While private equity is out of the reach of many, retail investors can invest through listed companies like Ethos Capital Partners or Brait.

Investing in listed private equity means investors will not have illiquidity issues inherent in the asset class as they can sell the shares in the listed entity, yet still have exposure to unlisted equity investments held by the private equity fund, he says.

Most alternative investments require a long-term view. The tenure of investments in alternatives can vary from 30-day liquidity in RIHFS; 90-day liquidity for QIHFS; two to seven years for private debt; seven to 10 years for private equity and private property; and 20 to 30 years in infrastructure, according to Sanlam Alternative Investments.

Investors need to be aware that they are locking up their funds for long periods of time, Singh says. 

“There is no publicly traded market for investments into the above strategies, bar hedge funds. In addition, investors are often restricted from selling their investments.”

Liquidity constraints are often compensated for through higher returns, or the “illiquidity premium”, he says, but illiquidity remains a major barrier to investing directly into these assets. 

Investors may also get indirect exposure through their pension plans, but as Singh mentioned previously, in SA this will probably amount to fewer than 2% of their portfolios.  

Tsinonis says Section 12J incentivises investors to invest in venture capital funds with a full tax deduction on qualifying funds, and this option is under-utilised in SA.

Performance 

To give some indication of how investors could have done better with alternatives, the most recent (fourth quarter 2017) RisCura-Savca (Southern African Venture Capital and Private Equity Association) report shows that private equity has outperformed the JSE’s All Share Total Return Index and the shareholder weighted total return index (Swix) over three and five years.

This is one of only a few measures available, and one of the biggest problems potential investors have is getting a fix on the past and current performance of alternative investments.

“The lack of a publicly available data makes it difficult to compare, for example, a composite of private market strategies with the public market counterparts,” Singh says.

The RisCura-Savca report for the 10 years to the third quarter of 2017 shows the pooled internal rate of return (IRR) for private equity was 12.9% (net of fees) compared to the Alsi total return of 9.5% and Swix total return of 10.6%. 

Singh says that the historical returns of private equity have been generally ahead of listed equities by about 5%. Hedge funds, he says, have delivered CPI plus 4% over the past 10 years, but the past three years have been difficult, especially for long/short equity managers.

According to Sanlam Alternative Investments, hedge fund composite index returns for 10 years ending December 2017 came in at 10.02%, which Singh says includes returns from funds that have gone out of business and excludes survivorship bias when reporting long-term returns. 

According to RisCura, hedge funds have had mixed returns, depending on their strategy, against the Alsi, which returned 3.8% in 2016, 1.6% in 2017 and has lost 4.4% so far this year. 

Market-neutral hedge funds returned 6.1% in 2016 and 3.5% in 2017, but the majority of hedge funds in SA are long/short and tend to reflect the share market.

But in theory, hedge fund returns are more stable than equities over time, Tsinonis says.   

“If you are investing in a market-neutral hedge fund, you are expecting a more stable return long term,” he says. “But in South Africa, 60% of them are long/short funds, meaning they are geared towards market returns so their volatility is higher. Long/short funds are not good diversifiers relative to the broader equity market,” Tsinonis says.

No similar data is available for a number of alternative investments like private debt, for example, to compare with listed debt. 

Sanlam Alternative Investments expects reporting and performance measurement to cover more asset classes going forward.

Investors who choose to put their money behind listed private equity firms may be wondering why there is no correlation between their returns and the general assumptions of performance or the data cited by the RisCura-Savca report.

Over the past year, Ethos’s share price has dropped 11%, while Brait has lost 50%.   

Boynton says listing private equity firms solves the liquidity issue, but introduces another problem – the discount that the share can trade to the underlying value, and the disconnect can be quite large. 

“At times that construction can work, and at times not.”

Private equity has constraints, he says, but the beauty of the private equity model is that investment funds are invested in specific assets and returned to the investor, and the manger gets a bonus based on how much the investor get back. 

The flaws, however, are illiquidity and other risks regarding, for example, the extent of discipline in the investment process.

“There have been different attempts to try mitigate some of the difficulties in private equity but not many have been successful,” Boynton says.  

He cites Berkshire Hathaway, for example, which was essentially a private equity shop until more recently, and which reduced agency risk by demonstrating over a long period of time that Warren Buffett would always trade in the interest of investors and that he himself would take a modest slice of the cake. 

“But to create that model is very difficult – it needs huge belief that the manager won’t dip his hand in the bucket ahead of you.”   

Private equity is, however, the right type of construct with which to invest in Africa outside SA, Boynton says, where there are not deep listed markets, and where the listed market does not reflect opportunity sets.   

Impact funds 

While the alternative investment universe covers a range of investments, industry players differ on what other alternatives should be included in portfolios. 

Gold was traditionally the go-to hedge for South Africans, but volatility has made gold and other commodities unreliable investments.   

Tsinonis does not consider commodities as a traditional asset class as there is no income derivation. 

Singh says commodities are an inflation hedge that are uncorrelated to traditional asset classes. But since 2008, “commodity prices and global inflation have come down drastically, negatively impacting returns over this period”. 

With expectations of rising inflation and commodity prices, better returns are expected from commodity strategies, he says.

Infrastructure investment is beyond the realm of most investors, but an increasing number are tapping into infrastructure and other developmental assets through impact funds, which invest for social and environmental impact as well as financial return.  

Impact funds focus on investments which align with environmental, social and governance criteria and may be invested in anything from affordable housing to low-fee schools or retirement accommodation, to investing in listed companies that a fund manager believes have good governance structures or social priorities.

Boynton says Old Mutual Alternative Investments, which has a number of infrastructure and impact investments and funds, looks at specific social difficulties and possible investments to deal with some of these problems. 

There are arguments that these types of funds generate above-average returns, but Old Mutual focuses on trying to deliver returns in line with what it would do if it did not have a specific focus.

The group started in the 1990s with infrastructure, which it believed would have knock-on effects on growth in the economy.

It has since expanded its thinking to other social challenges including low-cost housing and affordable education. 

While it debated if this was an appropriate vehicle for retail investors, at the moment it is only looking at getting institutional capital behind its impact funds.  

Portfolio spread 

Given that the investment horizons for South Africans are broader now than ever before, and that SA equities are not performing that well and are limited in scope, it is inevitable that investors will be looking at moving into alternative investments. 

Tsinonis says between 8% and 10% of portfolios should be allocated to alternative investments, but says that with hedge funds, for example, local investors are not necessarily getting the real deal. 

Elsewhere there is deeper access to hedge fund strategies, whereas in South Africa many are long/short players, he says.  

“In the US and abroad, investors allocate to those who genuinely use hedge to diversify. What’s the point of giving your money to a hedge fund if it is a proxy to the equity market?” he says.   

“Elsewhere we are seeing a broader product available, including event-driven and macro-hedge funds, which genuinely use all the tools to hedge out. We are limited in terms of choice, and access is limited.”

There are other issues too, including the challenge to price hedge funds on a daily basis. “Currently there is a drive to get them to a daily pricing system and if that materialises, retail investments will be more likely as they will be on a LISP [linked-investment service provider] trend towards daily pricing,” Tsinonis says.  

Singh says the allocation to alternative investments decision depends on risk, return, term, liquidity and tax, as strategies can range from very liquid to illiquid. 

“The low return from listed equities has definitely jump-started the conversation on the inclusion of alternatives in investor portfolios, something that the regulator has been propagating by increasing the maximum allocation to alternatives to 15% in 2011.”  

A bigger reason to invest in alternatives, he says, “is to move capital from Wall Street to Main Street” as small and medium enterprises are the real drivers of job and wealth creation in an economy, and alternatives offer the most direct way of providing capital and strategic direction to these businesses.  

“In the same way that adding global equities to local equities improves portfolio risk-adjusted returns, the inclusion of alternatives in a portfolio with local and international equites improves the risk-adjusted returns from the diversification benefit offered, as alternatives tend to have lower correlation with listed assets.”  

Tsinonis says there should always be an allocation to alternatives, and long term should be top of mind. “But it is about picking the right funds and right alternatives that do what they say on the tin.   

“In times of shock, when assets start correlating and equities and hedge funds correlate, those who stick to their process will buck the trend.”  

While hedge funds are Tsinonis’ preferred alternative asset class, especially in terms of access for individual investors, many tend to be market-orientated funds, and he would like to see them more diversified over time. 

He says commodities don’t generate income and with private equity, investors tend to be locked in for long time.   

He believes that over time, the market will force hedge funds to change as they will not be prepared to pay a high fee for returns similar to long-only funds. This will force them to relook fee structure and strategy.  

Hedge funds have not outperformed the broader market, but Tsinonis says that in reality, they should not be measured against the broader market but by their long-term profile.  

“In a more sophisticated market, you want something that is non-correlated to the normal market, and if that performance is consistent, investors are comfortable with that. The hedge fund industry in South Africa is still new, and it is morphing slowly into what developed markets look like.” 

Interestingly, despite their poor performance over the past few years, in the year to date, hedge funds are outperforming, he says.  

Singh, who is keen on impact investing, says that given the demand for market-related returns from impact investing strategies, the onus is on managers to identify strategies that meaningfully make a positive contribution to society while delivering market-related returns. 

“Going forward I expect larger flows to high-impact strategies such as energy, education, healthcare, low-cost housing.”

Boynton says his personal view is that investors need to diversify and remain in risk assets, “because over the long haul, risk assets deliver real return in excess of less risky assets”, and investors should also be globally spread. 

He has a penchant for the US, where the economy is robustly competitive, and where investments should yield better relative performance over a long period of time.   

Private equity should be a small (10%) element of a fund manager’s overall portfolio, but it should be noted that return prospects are unlikely to be what they have been. 

“Over the last 100-odd years, they have delivered 5% or more real return. Going forward, one should be expecting a lot less than that.”   

The bottom line is that alternative investments remain out of the reach of most individual investors in SA. While investors can expect to see some developments in the alternative investment space, for those looking to invest in alternative assets, or to take part in socio-economic investments like housing, education, infrastructure development or renewable energy, there just aren’t many options outside of the listed companies on the JSE.

This article originally appeared in the 21 June edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.