Investment trust expert MAX KING provides an introduction to the fast-growing alternative assets sector. (First published in 2018 and not updated but still very relevant).
According to Simon Elliott of brokers Winterflood, only 55% of the investment funds sector is accounted for by funds investing in equities. The remaining 45% – and the fastest-growing part of the sector – is accounted for by funds investing in ‘alternatives’ to equities. This growth has been fuelled by an insatiable demand for high-yielding funds. Charles Cade of brokers Numis estimates that alternatives accounted for 65% of issuance in the sector in the first half of 2018, after 76% in 2017 and 85% in 2016.
Lumping all these investment companies into a single category risks masking the diversity of where and how they look to make money. The alternatives sector comprises a number of quite different vehicles. The main sub-sectors are property, debt instruments, infrastructure, private equity and renewable energy. In addition, there are specialised companies that invest in niche areas such as aircraft leasing and music rights.
There is clearly no lack of choice – and, if this rate of expansion continues, alternatives will soon be dominating the whole investment funds sector. Some caution is advisable. History shows that issuance of new trusts is often the result of investment fashion as much as of soberly-judged opportunity, and fashions tend not to last. None of the Lloyds insurance vehicles launched in the 1990s, for example, now survive; they turned into insurance companies before being taken over. The listed hedge funds or funds-of-funds which were popular a decade ago are steadily disappearing as a result of disappointing returns. A number of the income funds launched in the last ten years have recently hit pockets of turbulence or worse.
Nor are alternatives a new phenomenon. Many of the UK’s oldest investment trusts, including FOREIGN & COLONIAL (dating back 150 years) and SCOTTISH MORTGAGE, were not founded to invest in equities but in fixed-interest securities. They switched from ‘alternatives’ to equities along the way and would probably not have survived if they hadn’t. Living up to the promises and projections in terms of investor returns made at launch has always been a challenge, especially as the world changes.
Driven by the search for income
There is little doubt what has powered growth in recent years: it is the search for income. Negligible interest rates and very low bond yields have compelled investors to look elsewhere for income to live off. Equity income has been popular, but investors have also sought assets which have a low correlation to equities (which are assumed to be volatile and risky). The one thing you can rely on is that whatever investors want at any one time, the eggheads in the City will always provide.
The core problem for investors is that when interest rates and bond yields are low, a fund that pays a yield of 5, 6 or 7% without drawing on capital has to be taking a lot more risk. Its investment return before costs will be even higher unless returns are leveraged up with debt, which is risky in itself. Unfortunately, there appears to be a behavioural flaw in the thinking of many investors; they assume that the yield, if not its upward progression, is guaranteed. This is certainly the belief of a fund’s managers and sponsors, but it doesn’t always work out that way. If things go wrong, or the rules and regulations change, the danger is that a promised payout will be cut.
Investors also forget the old adage that ‘a bird in the hand is worth two in the bush’. Turned around, it means that income now will be coming at the expense of rather more capital growth in the future. Ideally, investors would maximise total return (income plus capital gain) and be happy to draw on capital to supplement income, or to invest in funds that do that. But the Victorian belief that spending capital is a sure path to the poorhouse persists.
The reality is that income certainly matters, but so does income growth – and it is the latter which is the driver of future capital gains. With capital gains subject to taxation only on sale, and even then only outside SIPPs and ISAs, investors should logically be happy to sacrifice some income for capital growth. But that is not the way fund flows into the trust sector have been running. So before investing in an alternative asset fund paying a generous yield in a world of 2% inflation, it is important to understand where the yield is coming from and how sustainable it is.
Gauging the risk of a particular trust is not always easy. Be extra careful when there is an assurance, implicit or explicit, that a trust is somehow ‘low risk’. Don’t automatically assume that those managing or promoting a fund fully understand the risks behind their business models.
Breaking down the risk spectrum
At the top end of the risk spectrum sit listed private equity funds. Many of these funds came a cropper in the financial crisis due to leverage and excess commitments to new investment. Some were panicked into distress fundraising, some went into wind-ups and some ploughed on. Since then, they have, with one or two exceptions, prospered, benefiting from good underlying performance and narrowing discounts to asset value. In some cases, returns have been spectacular. Although the private equity cycle is now well advanced, there could well be more to go for. According to the Financial Times, the private equity industry worldwide has $2trn of uncommitted funds to invest, meaning it’s a better time to sell assets than to acquire, but managers have learned their lesson and become more cautious than in previous cycles.
The sector divides into direct investors and funds which invest in a range of unlisted private equity funds. The higher visibility of the investments of the former generally results in lower discounts to net asset value. Asset values are usually conservative and out of date so value is often better than it appears. Funds such as 3I, HG CAPITAL and (until Edward Bramson seized control) ELECTRA, which consistently sold assets at large premiums to book value, demonstrated this. They have been the ones to own, while those that sold at poor prices or failed to sell, such as CANDOVER and BETTER CAPITAL, have been poor investments despite being available on enticingly wide discounts.
Funds-of-funds suffer from an extra layer of fees, but they provide a diversity of managers and access to funds otherwise not available to most private investors. An average return of 75% over five years is impressive and suggests that the double-digit discounts at which all five of them have been recently trading may be unwarranted.
The private equity sector is shrinking with seven funds in ‘managed wind-up’ and one (Candover) already gone, compared with just one recent arrival – APAX GLOBAL ALPHA in 2015 – with the highest yield in the sector at over 6%. The trusts in managed wind-up offer a guarantee that their discounts will disappear as the date of wind-up approaches, but they cannot guarantee how well their investments will perform, not least because the remnants of their portfolios – the ‘orphan assets’ they have not so far managed to sell – are likely to be among their least successful investments.
Also investing in private equity are a few specialist funds such as RIVERSTONE ENERGY and SYNCONA. Riverstone invests in oil and gas fracking prospects and projects in North America; given how strong oil prices have been in 2018, the flat performance of its shares and the persistent double-digit discount to net asset value must count as disappointing. That could not be said of Syncona, which is transitioning from what was an innovative investment fund-of-funds to a UK-focused investor in early-stage life-science companies. Its shares have risen 50% in a year.
One of the most remarkable fund issues of 2017 was the raising of over $500m of new money by CATCO, which uses its capital for catastrophe reinsurance. This was in the wake of a disastrous sequence of hurricanes and fires which halved its share price. Presumably, investors who subscribed for the new shares blamed the weather rather than the managers. Catco has always been open about the risks in its business, but investors may have been lulled by the high yield paid in good times.
Possibly less risky but also promising high yields are the £720m BIOPHARMA CREDIT fund, which is investing in the debt, secured on royalties, of life sciences companies, and HIPGNOSIS SONGS, which recently raised £200m to buy catalogues of old songs. Whether either fund has secured the right deals to deliver the promised returns over time remains to be seen.
Infrastructure funds have come in for considerable criticism not so much for taking excess risks as for being overpaid for the supposedly low risks of privately-financed investment in the UK public sector. The high returns have largely been the result of falling bond yields which made the income streams from these projects, secured for up to 30 years, especially attractive, but the politicians who were once desperate for this investment don’t like being made fools of. Dire retribution is threatened, regardless of signed contracts.
This type of project accounts for a diminishing proportion of the infrastructure funds, who are busily diversifying into private sector and international projects while showing much less interest in dealing with the UK’s public sector. The long-term consequence will be a drying up of private capital for public investment in the UK but that is not a concern for investors. The recent bid for JOHN LAING INFRASTRUCTURE suggests that all the political scare did was create a long-term buying opportunity.
Less controversial are the infrastructure funds which focus on renewable energy. Investors have steadily overcome their initial suspicion of these new vehicles, meaning that they all now trade at premiums to asset value. The suspicion was based on the large subsidies that solar and wind power have needed to be economic, the cost of which is passed on to consumers in higher prices. But so long as the consumers haven’t noticed, or aren’t bothered by this hidden tax, then the politicians, hungry for green credentials, don’t seem to care. Anyway, the subsidies on new projects are falling as efficiency improves.
The funds investing in debt are returning to the roots of the investment trust sector. Some funds invest in fixed-rate debt, some in floating, some in long-dated income streams, some in short-dated. There are funds investing in high-yield bonds, distressed debt, unlisted loans and regulatory capital for banks. There is no emerging market debt fund, but that is probably not for want of trying. The diversity reflects the ebb and flow of sentiment towards fixed-interest securities and trends within the market rather than a campaign to cover all bases.
They all offer attractive yields but the opportunity for income growth and hence capital gains comes largely from retained earnings, which in turn depends on the skill of the managers. Yields are higher when the income is secured on specified assets rather than on the company as a whole, justified by the struggles of some funds whose security turned out to be faulty. Is the 6.9% yield on UK MORTGAGES too good to be true or a bargain? Its manager, TWENTYFOUR ASSET MANAGEMENT, is well regarded and manages two other listed income funds but the security of residential property could prove illusory in a recession.
The financial crisis and subsequent restrictions on banks led to a surge of interest in peer-to-peer lending. The result, inevitably, was the launch of six funds with £2.5bn of capital, appealing to those who prefer a collective vehicle to direct lending. Unfortunately, we will not know how good their credit control is until we have the next economic downturn. One fund has already had to make material provisions for credit losses, but it could be a mistake to be too cynical. The quality of credit control in commercial banks has always been low, particularly for smaller commercial and personal loans handled out of bank branches. These funds, helped by more modern IT, may be able to do it better.
Once upon a time, you had to be really rich to invest in hedge funds. These funds, discreetly boasting stellar returns, were famous for their exorbitant fees (a 2% annual management charge, plus 20% of all returns) and the doors were firmly closed to latecomers. Their managers billed themselves as the cleverest whizz kids on earth, enjoyed rock-star status and even greater riches. Then the exclusive clubs opened their doors to everyone, the mystique vanished and it was downhill all the way in terms of performance. Some managers were too rich to bother to come into work anymore, some lost their ‘magic’ touch, some failed to recognise that market conditions no longer favoured the strategies they had followed.
As a result the ranks of the investment trusts following hedge fund strategies grow thinner every year, but it may be too soon to write the sector off. Aftermseveral years of dull returns, BREVAN HOWARD posted a 9% return in the second quarter for its macro fund and 5% for its global fund, as some big bets on bond spreads in the eurozone paid off. Bill Ackman’s PERSHING SQUARE, whose fortunes peaked when it listed in Amsterdam in 2014, appears to have returned to earlier form after three down years. It still trades at a 23% discount to asset value.
The final segment of the alternative funds sector is property. Confusingly, many property companies are structured and taxed as ‘real estate investment trusts’ (REITs) but are not included in the investment trust sector. As a generalisation, property funds seeking to harvest the income from property ownership are in, while development companies which focus on adding value to their holdings are out – but this is not a hard-and-fast rule. SEGRO (out) has owned the Slough Trading Estate for 100 years, while F&C COMMERCIAL PROPERTY TRUST (in) has been a fairly active developer. Many conventional property companies also pay generous dividends and trade on large discounts to net asset value. They may prove a better investment than some of the property investment companies with high yields, which have less potential for added value and trade above net asset value.
Among the specialist funds, PHP (not in the sector), MEDICX (in) and ASSURA (not in) all own doctors’ surgeries on long-term leases which have been guaranteed by the NHS, making them comparable to infrastructure funds. IMPACT and TARGET HEALTHCARE do the same with care homes, but without the guarantee. EMPIRIC and GCP STUDENT LIVING own and rent out student accommodation, supported by partner universities but so does UNITE, the first operator in the area, which is a company rather than a fund. There are funds owning and leasing supermarkets, logistics warehouses and social housing; all of them promise a high and rising income, but with very different risks. The NHS will always pay for doctors’ surgeries, but care home operators can (and do) go broke. Well-located logistics warehouses may be irreplaceable, but student accommodation may not be. Housing associations should have access to cheaper finance than they can get through a listed fund.
Other property funds invest more broadly, focusing on generating an attractive and rising income from higher-yielding properties, plus an element of added value. Five funds invest in Europe of which two are focused on logistics warehouses and one on flats in Berlin, but the best exposure to Europe (62% with the rest in the UK) comes from TR PROPERTY, the only investment trust which invests in property company equities (93% of the portfolio) rather than directly into bricks and mortar (7%).
In conclusion, alternative funds are a disparate lot and investors need to tread carefully, thinking objectively about the sources of income and risk. High income does not come without risk and income growth is important for capital returns. Issuance is often a reverse indicator of future performance, so it is usually better to wait until they have proven themselves before investing. But alternative funds can also provide excellent opportunities. The shares of private equity fund-offends PANTHEON INTERNATIONAL, which sunk low in 2008, have since multiplied tenfold in value. There may be hidden jewels in what investors throw out, but all that sparkles is not gold.
MAX KING was an investment manager and strategist at Finsbury Asset Management, J O Hambro and Investec Asset Management. He is now an independent writer, with a regular column in MoneyWeek, and an adviser with a special interest in investment companies. He is a non-executive director of two trusts.