E magazine alternative investments

For professional investors

How attractive are

Alternative Investments in a low-yield environment?

INVESTMENT INSIGHTS October 2015

2 | Alternative Investments

Contents Foreword The exciting world beyond stocks and bonds

5

Commodities Beware of the economic ‘super-cycle’

6

Hedge Funds Not all streets are paved with gold

8

Infrastructure A bridge too far?

10

Private Equity In it for the long haul

12

Absolute Return Dampening cyclical shocks

14

Real Estate Location is everything

16

Interview Manager selection is key in illiquid assets

18

Alternative Investments | 3

Global assets under management USD trillion1 CAGR3 2005-2013 63.9

5.9%

57.0 50.9 46.9

48.1

37.1

42.8

46.0

37.9

42.8

45.7

45.7

50.2

56.7

5.4%

3.2

4.1

5.0

5.0

5.3

5.9

6.3

6.8

7.2

10.7%

2005

2006

2007

2008

2009

2010

2012

2013

Traditional investments

2011

Alternatives

2

Figures may not sum. because of rounding.

2

Does not include retail alternatives (i.e. exchange-traded funds, mutual funds and registered closed-end funds).

3

Compound annual growth rate.

Source: Hedge Funds Research; Preqin; McKinsey Analysis

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52.0

42.9

40.3

1

51.6

Foreword

The exciting world beyond stocks and bonds ‘There are no bonus points for complicated investments’ – Warren Buffett With high stock valuations across the board, and bond yields at unprecedentedly low levels for the current generation of investors, it should be no wonder that alternative investments are growing in popularity. According to figures published by McKinsey, assets under management in alternative investments more than doubled between 2005 and 2013 to USD 7.2 trillion.

In 2013, net inflows into alternatives made up 6% of the total, an impressive figure compared to the growth rate of non-alternatives which was between 1% and 2%, according to McKinsey. And the figures show that the growth was broad based. Direct hedge funds, real assets and retail alternatives – in the form of mutual funds and exchange-traded funds (ETFs) – all saw strong growth. Even private equity holdings, where assets had retreated from pre-crisis highs, have bounced back, McKinsey says.

Holy Grail?

Now, of course, the question is whether all of these alternatives really are the Holy Grail for investors.

McKinsey rightly notes that assets under management have grown, despite a period of not very convincing returns in hedge funds, for example. This has not dampened any of the enthusiasm.

“The vast majority of institutional investors intend to either maintain or increase their allocations to alternatives over the next three years. There is particularly keen interest from large and small pension funds (though not midsize funds) and sovereign-wealth funds,” McKinsey reports.

In this magazine, various Robeco experts look at the advantages and disadvantages of alternative investments; from commodities to infrastructure, real estate to hedge funds, and private equity to absolute return. We also look at the illiquidity premium that illiquid assets should generate and at the importance of selecting the right manager.

The search for yield is an obvious reason for the growing interest in alternatives, but it is not the only reason. Investors are also seeking to improve diversification and reduce portfolio volatility. And there’s much to be said for looking beyond traditional assets for solutions in these areas. In short, there are definitely opportunities in the world beyond stocks and bonds.

But it is also a world where other rules apply. There is often less liquidity, not always the same level of transparency, and costs can sometimes soar. Therefore, those who want to venture into the world of alternatives need to do their homework. Robeco offers in-house solutions for some of these alternative investments and has well-informed opinions on others.

Enjoy.

Lukas Daalder, CIO Investment Solutions

Alternative Investments | 5

Commodities

Beware of the economic ‘super-cycle’ A market strategist once said that “if you buy commodities, you are betting against the ingenuity of people”. When natural resources become too expensive, human ingenuity steps in to find alternatives, says CIO Investment Solutions Lukas Daalder.

“Most asset classes have a cycle: equities go up in times when the economy is booming and down in a recession, and so on,” says Daalder. “Commodities have a super-cycle.

They start off with a normal cycle, where commodities do well in the early stages of a recovery as people start to build things again, and then go down when the cycle ends. The super-cycle is a much wider, bigger and longer phenomenon that is driven by scarcity and investments.”

“The oil price, for example, goes up in the recovery cycle but at some point will become so expensive that it triggers the use of alternatives such as solar energy, which then become economically viable to tap into. And this takes time: you need to invest in new projects, and conduct R&D, etc. So it creates a super-cycle where if oil gets too expensive, people will look for cheaper alternatives.”

“It means that you are betting against the ingenuity of people. Basically, if you think that people are smart and will solve everything in the end, commodities will always find a replacement. Therefore, commodities will always ultimately decline in price. If you take a basket of ten commodities, in ten years from now, its value will probably be lower.

Ingenuity means people get smarter and find

6 | Alternative Investments

alternatives in the super-cycle outside the normal economic cycle.”

Oil remains the kingpin A major issue with commodities is that there are so many different types with different characteristics, from ‘hard’ materials such as metals and ‘soft’ agricultural products – though there is one elephant in the room. Oil. “Commodity prices are dominated by the sheer size of the oil market, so people will normally just ask what stage of the oil supercycle we have reached,” says Daalder. “Since 2014, there has of course been a dramatic decline in the oil price, which is related to the rise of US shale oil. And it doesn’t feel like we’ve hit the bottom yet, even though oil prices have recovered somewhat, because fracking is still in the development phase and has not yet peaked.”

“In addition to shale, it is clear that solar energy is becoming more competitive as the costs have been driven down immensely. Solar is set to become a serious competitor for oil, so we’re not yet at the bottom of the super-cycle.”

Risk not always matched by return Buying into commodities can therefore be a riskier investment than other asset classes, but without necessarily providing the returns needed to justify the extra risk, says Daalder.

“The risk profile of commodities is a bit like equities, but the volatility is higher, while the return profile is lower. Over the past 25 years, depending on which index you look at, commodities have yielded returns somewhat in excess of (risk-free) US Treasury bills, but at much higher volatility. Equities on the other hand have offered superior results over time.

Part of this weak return is linked to the fact that you continuously need to roll over futures contracts when investing in commodities, which is a costly exercise.”

“You may wonder why you would want to invest in commodities, in that case.

Traditionally, there are two arguments: diversification and timing. The diversification argument used to be that commodities added returns at times that equities didn’t. However, this argument has lost a lot of its shine over the past couple of years, as stocks and commodities became closely correlated during the 2009 crisis. The other argument is timing: as long as you are able to make a correct call on the super-cycle, you can beat equities. But you need to have a knack for spotting the start of this cycle.”

The market can also suffer from liquidity problems, where it may be difficult for an investor to exit if things turn sour. “Liquidity depends on each commodity. The oil market is very liquid, and it’s easy to get in and out.

However, if you move into natural gas, you can see some strange price movements at times, which is partly a result of liquidity problems, as well as transport and storage costs,” says Daalder.

At the mercy of the weather This lack of liquidity in some areas can also translate into lower transparency, he says.

“The illiquid nature of some commodities

and the fact that many are linked to the weather, where one bad summer can badly affect production and prices, makes returns unpredictable. So it may be a transparent market on the whole, but some of these commodities are pretty erratic, and go up and down dramatically in certain situations,” he says.

‘Some of these commodities are pretty erratic’

“Commodities do tend to be a good inflation hedge, but there is a question here of causation and correlation. The two major inflation shocks that we have had over the past 60 years have been due to oil prices, and were therefore the cause of the inflation.

Commodities became a hedge against the inflation they had created.”

Subsequently, commodity investing has fallen off the radar, and is no longer offered by Robeco. “The overall trend in the last five years has been for people to be less inclined to be invested. Added to that is the fact that the longer-term returns are not that interesting,” says Daalder.

Alternative Investments | 7

Hedge Funds

Not all streets are paved with gold Hedge funds are surrounded by a certain mystique. There is something secretive about the way they operate. They are regarded as products that can make a profit irrespective of market direction. But are they really appropriate for an institutional portfolio?

Robeco Portfolio Strategist and Researcher Roderick Molenaar has studied the added value of hedge funds for an institutional investor. Together with Thijs Markwat and Rolf Hermans, he looked into their performance and compared their risk and return characteristics with those of other asset classes. “Investors should be skeptical when looking at the performance of hedge funds,” he says.

Hedge funds form a broad and diverse group of products that invests in other asset classes without a lot of restrictions. They can be long only, short only, or long-short strategies, and sometimes leverage is used to increase performance. The funds can invest in a combination of equities, bonds, currencies and commodities. Often they invest in sometimes exotic derivatives on these asset classes.

There are many different strategies, but the researchers focused on global macro, equity market neutral and managed futures. Global macro takes both long and short positions in global financial markets, e.g. stock-, bondand currency markets. Equity market neutral strategies can go long and short and use stockpicking techniques, while trying to maintain a net neutral position to the aggregated stock market. Finally, managed futures use forward contracts on mostly commodities and currencies.

Historical performance is lower “I estimate historical performance to be around 6% per annum when corrected for biases,” says Molenaar. His estimate is considerably lower than the figures in the hedge fund databases, which collect performance data. Hedge fund index performance in the databases is around 9%, equity market neutral is 6%, managed futures 6% and global macro around 11%.

Companies can choose whether or not to 8 | Alternative Investments

submit performance figures for the databases.

“In general, the historical hedge fund performance is overstated. There is too much room for bias and this distorts the figures,” says Molenaar: “First, there is survivorship bias. Some funds close down, because they have taken on too much risk or as a result of redemptions. They can just exit the databases and their performance records are removed.

Survivorship bias has around a 3% effect on performance. In some rare cases, the reverse is true. Some funds exit the databases because their performance is very strong and they have reached full capacity. They no longer need new money and do not want to be in the databases as part of their marketing efforts.”

There is also the ‘backfill bias’, says Molenaar.

“Funds build up a track record, but do not necessarily report it. But once they have a good track record to report, they do so and then also include the good years from the past. This bias has an estimated positive effect of 2% on the results.

Sharpe ratios over-reported Another major issue for investors is the risk/ return profile of hedge funds. Investors should be careful when using the Sharpe ratio (measured as the return above the risk-free rate divided by volatility) to assess hedge funds, warns Molenaar. “Without adjustment, Sharpe ratios are 0.6, higher than those for equities (0.5) and bonds (0.5), but with corrections this ratio is lower. Again, biases play a role here, and in general they lead to inflated Sharpe ratios. When you adjust for biases most hedge fund Sharpe ratios are lower than those of equities and bonds.”

A major problem when assessing Sharpe ratios is the absence of a transparent price for the assets in portfolio, argues Molenaar.

“The prices that are reported are more stable than in reality. This under-reported volatility

has a positive impact on the Sharpe ratio.

Under-reporting can be caused by investments in somewhat illiquid assets as convertible bonds, for which daily pricing data isn’t always available.”

Liquidity is less Hedge funds prefer sticky money, says Molenaar. “That’s why hedge funds are less liquid than other asset classes. They are not always that easy to exit.” He explains how hedge funds operate. “In many cases there is a lock-up period (during which you cannot sell) of three to six months. And there is a notice period – which means that you have to give advance warning of your intention to sell in order for the fund to unwind existing positions. And if you want to exit earlier you sometimes have to pay a redemption fee.”

Sticky money is especially important in implementing less liquid strategies, says Molenaar. “It helps to protect the existing investors. For example, a convertible arbitrage position – buying a convertible bond and shorting the stock simultaneously – is very difficult to unwind.”

Correlation with equities and bonds The correlation with equities and bonds is an important consideration for investors who want to create a diversified portfolio. However, how hedge funds behave under different market conditions is just as important. The researchers looked at the performance of hedge funds in a range of equity markets. “In equity bull markets, most hedge funds achieve positive performance, with the exception of dedicated short strategies, which involve shorting stocks.”

“The correlation with equities depends on the type of strategy, and the performance is very diverse. In the past, managed futures did well when equity markets performed poorly.

In down markets, equity market neutral strategies did badly, while global macro

‘Hedge funds are secretive by nature’ had a break-even record.“ The correlation of hedge funds with equities is not constant; it fluctuates, says Molenaar. “On average, the correlation of the overall hedge fund market is between 60 and 80%. In terms of diversification this is not very good. But for global macro and managed futures it is less than 40%, which is more suitable for diversification. After the fall of Lehman Brothers in 2008, the correlation of global macro and equity market neutral with equities rose, while the correlation of managed futures fell. In other words, during this crisis managed futures offered better protection.”

He also looked at how hedge funds perform when interest rates fall, because this is very important for pension funds. “Like bonds, some hedge fund strategies tend to do well in times of falling interest rates,” says Molenaar.

“Global macro and managed futures perform well in these circumstances, but equity market neutral lags behind.” In general, falling interest rates have a negative effect on coverage ratios and a positive effect on bonds. “For bonds, the correlation is generally lower than for equities, and is negative during times of crisis. Again, it depends on the type of strategy.” Besides the relatively high correlations with equities and bonds it is also worthwhile mentioning that up to 80-90% of the performance of the overall hedge fund indices can be explained by the returns of commonly used risk factors such as equities, bonds, factor investing and various option strategies.

Transparency is low Hedge funds are secretive by nature, says Molenaar. “There is secrecy about what they invest in and who their clients are.” There are practical reasons for this secrecy. “If they are short a stock and this is well-known in the market, it can make it more expensive

to unwind a trade. There are exceptions and some funds actively seek media attention in order to put pressure on companies.“ This lack of transparency is an issue for pension funds, says Molenaar. ”The regulators require them to be in control. They need to know what they are investing in and to understand the investment strategy. These demands are sometimes in conflict with the world of hedge funds.”

Costs important The 2% management costs and 20% performance fee charged by hedge funds are still normal, says Molenaar. “Good hedge funds with strong track records are still in a position to demand high fees.”

But he sees some small changes. “There is pressure from pension funds to reduce costs.

Some are divesting. For example, CalPERS, often considered a leader in the industry, announced that it would withdraw USD 4 bln from hedge funds because of high fees and the complexity.” ”Some Dutch institutional investors no longer want to invest in hedge funds because of the costs, regulatory demands, or because they no longer see the diversification benefits. But other institutional investors still believe in hedge funds.“ He ends with some advice for pension funds: “When allocating to hedge funds, the key is to choose the right fund. You should be able to select a good manager, because you cannot buy a hedge fund index tracker and there are large differences in performance. If you select a bad manager, it can have a significant negative impact on performance.“

Alternative Investments | 9

Infrastructure

A bridge too far?

Anyone thinking of investing in what appears to be financially beneficial new infrastructure offering stable cash flow for decades may wish to consider the case of the Skye Bridge.

The bridge was opened in 1995 to link the Scottish island of Skye with the British mainland. It was funded through the Private Finance Initiative, which allowed private investors to invest in public infrastructure in exchange for a share of the tolls once the project was completed. Replacing an increasingly unreliable ferry service that had existed for centuries, the Skye Bridge seemed like a no-brainer.

However, locals were outraged at the cost of the tolls, leading to open civil disobedience when they drove across without paying. It took law enforcement, including the threat of jail, to enforce the tolls. Continued protests led to the bridge being nationalized and the tolls abolished in 2004.

“There are specific risks, but these depend on the type of infrastructure in which you invest,” says Steef Bergakker, who was manager of the Robeco Infrastructure Equities fund before it merged into the wider Rolinco portfolio.

Many of these assets are unique and not listed, with no daily prices available.”

Bergakker says there are four types of economic infrastructure that are investible either directly or indirectly by buying the equities or bonds of the companies that build or operate them. These are: – Transportation: e.g. roads, bridges, airports and seaports – Utilities: e.g. electricity grids, power stations and waste water plants – Energy: e.g. oil extraction, gas pipelines and wind farms – Communications: e.g. mobile masts, telephone networks and cable In addition there is social infrastructure, such as building schools, hospitals or prisons, though this sector is not normally investible. “Usually it’s restricted to economic infrastructure: you can either invest in the assets directly, or buy the shares or bonds of the companies that build or operate them, and this was the approach that we took when we had the fund,” says Bergakker.

Huge political risks “If you look for instance at concessions for toll roads, there are huge political risks – which we have seen in many countries over recent years. Despite there being a contract with the company that runs the concession, governments have a habit of retroactively adjusting the terms, and that can create a huge political or regulatory risk.”

“Another category of risk is that these assets usually last a very long time, and so there’s always a risk that they may become obsolete after 20 or 30 years, and who knows what the world will look like then.”

“We were heavily focused on companies that design, build, repair or modernize infrastructure. This typically involved a lot of engineering and construction companies, but unfortunately it’s a very volatile sector of the market. Then you have the operators, which are mostly utilities, telcos or concession companies, and that was a relatively small

Bergakker says returns will be relative to the type of infrastructure. “Investing in infrastructure is analogous to investing in real estate in a way. You can invest directly in the asset itself and collect rent as your reward, or you can invest in listed funds that invest in real estate or infrastructure assets. You can make some money in many different ways, but it comes with commensurate risks.”

“One aspect that is often underappreciated is how these assets are financed. There can be a relatively predictable stream of cash flows from funding these projects, but the overall risk profile also depends on the financial leverage that is applied. Leveraged finance risk can really go sky high for these kinds of assets, in addition to the operational risk of the asset itself.”

“So you could have a very stable asset which is generating very predictable returns, but if it is leveraged up to the hilt, it’s still a very risky proposition. Unless of course you invest in indirect infrastructure such as equities, which are usually pretty liquid, and risks can be diversified.” The location of the infrastructure, and whether it is new build or an upgrade, is also important, he says. “You have relatively defensive assets in brownfield sites where

Advantage

Disadvantage

Direct cash proceeds

Indirect Source: Robeco

10 | Alternative Investments

Similar to real estate

Pros and cons of infrastructure

Direct

“And then there is the natural disaster risk to large assets such as bridges from earthquakes or floods. Usually you can insure against these risks, but it’s difficult to price this sort of risk.

part of the portfolio. We were positioned at the more aggressive end of the spectrum.”

Predictable returns

Illiquid

Inflation protection

Lumpy; difficult to diversify

Returns uncorrelated with market returns

High capital outlay required

Liquid

Indirect cash proceeds

Easy to diversify

Returns can be volatile

Low capital outlay required

Returns correlated with market returns

‘Transparency generally is quite good’ the infrastructure just needs to be rebuilt or modernized. Once you start to build new infrastructure there is a much higher risk profile and you need to be compensated with higher returns.”

Sustainability sub-class “Making existing infrastructure greener or more sustainable is a sub-category of this asset class. And there is also the relatively new area of building wind farms or solar panels for buildings, but this is still a relatively small part of the universe.”

“Some funds have limited partnerships that are similar to REITs and are tax friendly. These funds are mostly energy-related infrastructure assets, especially pipelines, which have done very well over the past ten years or so, with good returns and relatively low risk. It depends entirely on what you are investing in, and with whom.”

He says another risk is knowing who your fellow investors are. “Transparency generally is quite good because there is only a limited number of assets, and the documentation is all there, but with whom you are investing could be murky. Unlisted infrastructure funds may have limited partners and you may not know who they are, particularly in emerging markets.”

So all in all, is it worth it? “In the run up to the financial crisis we saw a boom in infrastructure funds where people thought they had a defensive asset. But because the leverage was so high, the actual results were quite shocking. Many of these funds didn’t survive the financial crisis and some people felt a bit cheated. However, it’s still a very young asset class, with not enough history to enable us to draw any firm conclusions.”

And there can be tax or inflation-proof benefits. “Some types of infrastructure do offer some form of inflation protection, especially the concessions, as these offer a sort of indexation. But there isn’t much indexation outside the transportation infrastructure realm – it depends on pricing power and regulation,” says Bergakker.

Alternative Investments | 11

Private Equity

In it for the long haul Private equity has much in common with equities, given that both involve investing in businesses. The main difference is that private equity offers investors a premium to compensate for illiquidity.

“The low rates and high valuation of listed stocks ensure that there are currently almost no alternatives for those searching for returns in the current market,” says Erwin Quartel, Investment Director and Head of Operations at RobecoSAM Private Equity, about the huge popularity of private equity investments.

The Global Private Equity Report 2015 of consultancy firm Bain & Company indicates that at the end of last year private equity funds had some USD 1,200 billion available to acquire companies.

Private equity houses invest private assets in companies outside the stock markets.

Although the tradability is different, the capital invested is exposed to risk, just as with public stocks. One benefit of private equity is that a company does not have to focus on proving itself to the market on a quarterly basis by publishing solid financial results, so it is easier to define a longer-term strategy.

What’s more, a private equity party generally holds a majority position and thus has a controlling influence over the direction in which the company travels.

“The first thing we want to know is how an investor is going to create greater value for a company,” says Quartel: “We are not looking for managers who just want to create shareholder value by fiddling with the ratio of private equity to debt. We consider it important that a private equity firm adds operational value. For instance, improving

‘Illiquidity has its pros and cons’ 12 | Alternative Investments

efficiency (higher margins) or economies of scale by expanding on a retail concept. Private equity houses usually also specialize in a specific market or style.”

taking them public was the reason why the demand for capital from new investors fell by 6%.

Pros and cons of low liquidity Longer in portfolio One noteworthy trend is that companies are being held in private equity portfolios for increasingly long periods of time. The average holding period for such investments sold in 2014, was more than five years and eight months. According to Bain & Company, only 11% of the firms were sold on within less than three years, while more than 60% of the transactions involved companies that had been taken over more than five years previously. In 2008 the average length of an investment was less than three-and-a-half years.

The consultancy firm indicates that the relatively high takeover sums in the period prior to the financial crisis are the major cause of the increasingly long holding periods for private equity investments. These investors need more time to implement sufficient measures to justify a selling price that is higher than the original investment sum.

Furthermore, many parties opted to wait until sentiment on the financial markets was more favorable again before undertaking a stock exchange listing or putting a company up for sale.

The latter confirms why 2014 was a top year for reselling companies. In total more than 1,250 companies changed hands or went public, generating around USD 456 billion This figure is more than two thirds higher than the sum generated in the previous year and more than USD 100 billion more than was generated in 2007, the previous record year. According to Bain & Company, the high income generated by reselling companies or

“It often takes private equity parties some time to build up an investment portfolio, just as it sometimes takes a while before a holding can be sold under attractive conditions,” explains Quartel. “With partnerships, a term of ten years is common, with the option of extending this twice by one year. But in some cases a period of 15 years is necessary before such a partnership can be fully liquidated.”

There is also a positive side to the illiquid nature of private equity investments. “Over the long term, the return should be a few percentage points higher than stock-market returns,” says Quartel. “That difference is to some degree compensation for the limited liquidity.” Another factor that clarifies the premium for private equity is the value that can be added by venture capitalists. And in this area, the differences between parties can be quite large.

Historical data is limited It is difficult to make any unequivocal statements about the returns of this investment category. The availability of historical data is limited and the various studies that use this data come to different conclusions. In terms of liquidity, researchers Andrew Ang and Morten Sorensen demonstrated in their 2012 model that expected returns for an investment rebalanced once every five years can be 4% higher than a liquid investment.

The cycle of the market When tension on the financial markets increases, the sector faces different challenges.

During the 2008 credit crisis, private equity investors were confronted with three major problems. The value of all corporate portfolios had to be devalued in almost all cases, the usual exit channels were shut tight and it became very difficult to refinance loans on reasonable terms.

The sector eventually made it through the storm, partly due to the tailwind of relaxed central-bank monetary policies and sharply lower interest rates. As with stock markets, we continue to see both ups and downs, but with fluctuations in value less visible than on the stock markets owing to the lack of daily tradability.

‘In the end, the sector weathered the storm’

RobecoSAM Private Equity was set up in 2000, and focuses on investments in small and medium-sized enterprises in Europe. This segment is typified by relatively low efficiency, a local character and low leverage, so there are good opportunities for creating value from earnings growth. A second specialism is Resource Efficiency, with positions selected with an eye to the increasing demand/supply ratios of natural resources. Sectors invested in include energy, industry, water, agriculture and materials.

Alternative Investments | 13

Absolute Return

Dampening cyclical shocks Absolute return solutions can help to make your portfolio less sensitive to the economic cycle.

It’s difficult to navigate through the rapidly growing range of funds, with a larger portion of these funds bobbing along with the market than the name would suggest.

By targeting positive returns regardless of the investment climate, absolute return solutions are a popular option at a time when interest rates are extremely low and equity markets have high valuations in historical terms. Some hedge fund strategies possess absolute return properties without the structural long-only tilt, but in the form of liquid alternatives, too, absolute return solutions have been attracting greater attention in recent years.

“We start at zero,” says Klaas Smits, Fund Manager of Robeco GTAA, who explains the difference. “While for managers of a traditional fund, the composition of their benchmark index forms the starting point against which the portfolio composition and returns are compared.” Most absolute return funds aim for a return that is higher than the money market rate over a period of three years.

“The benefit of a model is that it can anticipate the psychological pitfalls on financial markets that are difficult for human investors to avoid,” explains Smits: “At Robeco, we believe that thorough research helps us identify and understand the key forces at work on financial markets. So it’s not just about finding statistical patterns, but also about discerning what the economic explanations of these forces are.”

In Europe, the assets under management of absolute return funds in Undertakings for Collective Investments in Transferable Securities (UCITS) grew from EUR 159 billion in late 2013 to more than EUR 260 billion a year later. According to the UCITS Alternative Index, there are already more than 800 different funds in this segment. This form of fund makes it possible to enter and exit on a daily basis.

Most hedge funds apply a monthly trading term. Further, a lock-up period of several months to a year is common.

This period is shorter than the complete market cycle, but a strategy can generate a positive result in both good times and bad.

That characteristic makes absolute return funds an excellent tool for reducing the volatility of a traditional investment portfolio, the returns of which are largely determined by price fluctuations on financial markets.

Limited field of activity

A wide range of strategies is used, with providers referencing these to all sorts of benchmarks. This means that the investment category has a very diverse character, so it’s difficult to make any kind of uniform statement about the returns of absolute return funds.

Discovering patterns The nature of absolute return funds to aim for a return that is to a large extent dependent on the direction of financial markets makes robust risk management absolutely essential. Key questions include who checks that risks remain within the set limits, and what happens if those limits are exceeded.

Furthermore, for highly leveraged funds that invest in derivatives and take short positions, it is crucial to monitor closely how counterparty and liquidity risks are managed.

Rising and falling markets An absolute return fund differs in a few key respects versus funds that are limited to a certain market. The biggest difference is that a position can be selected for price gains and falls on equities, fixed income and currency markets. Setting up a portfolio therefore requires different competencies than more traditional solutions, which are mostly involved in applying overweights and underweights at the level of individual securities.

14 | Alternative Investments

Robeco GTAA is a quantitative multi-asset strategy with the key objective of realizing attractive returns over the longer term. Using a model, it anticipates opportunities that arise on key markets by combining systematic decisions in the area of market timing within each investment category with relative valuations among the different categories.

The model is made up of various components that each have long track records and are being constantly perfected.

As managers, we at GTAA are of course interested in the normal distribution of returns,” says Smits: “But we primarily want to understand what can happen in the tail of the distribution. One important condition for us is that we are also able to enter and exit positions easily during periods in which liquidity dries up. The content of the portfolio is fully determined by the model. However, we do monitor risk limits to ensure that these are not exceeded. Moreover, we develop and test ideas for further improving the model.”

GTAA therefore keeps its field of activity limited to a number of extremely liquid index instruments at equity, (government) bond and currency level. Apart from the desire to adjust the portfolio in all market conditions, the selection of very liquid instruments is also driven by the format in which Robeco GTAA has been created. The fund has a UCITS form and daily liquidity is one of the conditions.

Away from market vagaries Absolute return solutions are gaining popularity due to a growing caution among investors when it comes to being too heavily exposed to the vagaries of any one specific asset class. However, many funds in the absolute return category are in practice still strongly influenced by market fluctuations.

“Many long/short equity funds and hedge

funds that anticipate mergers and acquisitions sometimes have a significant overlap with equity prices,” says Smits: “A correlation of 60 to 70% is not uncommon.”

Since the launch of Robeco GTAA in May 2010, the fund’s correlation with government bonds is 0% on a monthly basis. The correlation with equities and with an investment portfolio that comprises half equities and half bonds is around 40%. The high correlation is a result of the rise of the stock markets during this period. Smits expects the correlation in a weak market to be negative and to reach roughly 0% over the longer term.

‘The model anticipates psychological pitfalls’

Alternative Investments | 15

Real Estate

Location is everything Its stable rental income makes real estate a popular choice in periods when interest rates are low. According to Folmer Pietersma, fund manager of Robeco Property Equities, real estate prices will not automatically come under pressure if interest rates start to rise again.

16 | Alternative Investments

The real estate market usually follows a clear cycle. A strengthening economy translates into increased demand and higher prices, which often tempt people into investing in new projects. Investors should also be aware that

REITS - Equity Correlation

REITS - Bond Correlation

Avg. REIT-Equity

Jun-15

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1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 Jun-97

Investors in listed real estate are generally able to buy and sell constantly. They see the value of their investment change on a daily basis. For non-listed real estate, the benchmarks are the periodical valuations by surveyors or the sales of comparable properties. This creates much smoother price movements that lag the stock price movements of listed real estate.

Pressure at the top

REIT correlation with equities and bonds

Jun-96

As a result of the lack of daily liquidity, direct real estate prices seem to move less than those of the listed variety. The volatility of the MSCI World Real Estate Index was 19.9% in the period from the end of 1994 up to the end of June 2015. This is slightly higher than the average of 19.0% of the sectors that make up the MSCI AC World Index. The average annual return was 6.8% (index: 7.5%) and the dividend return was 3.4% (index: 2.5%).

The long-term correlation of listed real estate with equities is higher than with fixed income securities. However, its correlation with price movements in other asset classes changes constantly. “In the period after the credit crisis the prices of real estate stocks moved more in line with the market average initially,” says Pietersma. “Since the end of 2012, as a result of low interest rate levels, the emphasis has come more to rest on the income component of real estate investments. One result is that

Jun-95

Difference in volatility

One characteristic of real estate investments is that rental prices have a tendency to rise with inflation. However, in Pietersma’s view, it is far too simplistic to see this investment class merely as potential protection against rising inflation. “Price movements are affected too much by other factors such as market sentiment for this to work. And it is also evident that in the case of indirect real estate, investors price in expected changes in rental growth for the next one to two years.”

Correlation: more in line with stocks

Jun-94

On the basis of market size, this promotion of real estate to a separate subsector is more than deserved. The total value of listed real estate companies amounted to USD 3,200 billion at the end of 2014, according to real estate service provider LaSalle. According to LaSalle, USD 6,000 billion is invested in unlisted institutional funds. Both of these categories are classed as indirect real estate.

The largest part of the real estate market – around USD 40,000 billion – comprises direct investment in real estate properties.

the correlation with the bond market has increased significantly. That explains why recent price movements are more similar to those in the bond markets and less similar to equities.

In a recent study of 884 pension funds between 1990 and 2009, researchers Aleksandar Andonov, Piet Eichholtz and Nils Kok showed that high management costs offer an important explanation for why returns on direct real estate are lower than those on listed real estate stocks. This is particularly true in the case of smaller pension funds that focus on both listed and non-listed indirect real estate as a means to achieve sufficient diversity; for them the costs can be extremely high.

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Next year the discussion on whether listed real estate counts as an alternative investment or forms part of the broader equity category will come to an end. Nowadays real estate stocks in the major indices still form part of the financials sector, but from August 2016 index compilers such as MSCI and S&P Dow Jones will create a separate sub-sector for the real estate industry.

Avg. REIT-Bond

Source: Robeco Monthly correlation of FTSE EPRA/NAREIT US Index with S&P 500 Index and US Citigroup US All Mats TR Index on a rolling two-year basis / Source: Thomson Financial Datastream, FTSE, EPRA/NAREIT, S&P, MSCI World Equities, Citigroup Bond Index and UBS estimates.

there are frequent bubbles in local markets.

“However, every region has its own cycle too, so good regional diversification can help moderate the effects of local price swings,” explains Pietersma.

In addition to the cyclical movements, a number of structural changes are also taking place in the real estate market. The most important trend is the growing difference between top locations and the rest of the market. “Big brands attach great importance to having a prominent presence in the most well-visited locations to showcase their products,” says Pietersma. “Shops in less popular areas are finding it increasingly difficult because consumers are buying more and more products online instead of at the local shop.”

In the office real estate market, the gap between top locations in city centers and offices in less popular areas is also widening.

“In certain sectors such as technology and pharmaceuticals the larger companies tend to look for locations close to each other,” says Pietersma. “This makes it easier to attract talent and share knowledge.”

Prices of real estate stocks fell on only two occasions and the average return in these periods was 14.8%. “A rate increase in response to a strengthening economy doesn’t necessarily have to be negative for the real estate sector,” Pietersma goes on to explain.

“Of course, if there is another reason for rising interest rates, that’s another story. In constructing the Robeco Property Equities Fund we also take into account a rising rate scenario.”

The portfolio consists of 50 to 70 stocks that are selected using a bottom-up approach based on quantitative, fundamental and ESG research. It is also positioned to take advantage of major trends, such as the increasing popularity of prime locations.

The managers also have a preference for companies with a solid balance sheet and a solid record in terms of ESG.

Interest rate fears are unfounded A low interest rate that makes it difficult to generate income with investments makes real estate stocks a popular choice on account of their high dividend return. According to fund researcher Morningstar, inflows into the real estate asset class in 2014 amounted to 9.1%, compared to 3.6% for equities and 6.4% for bonds. However, Pietersma is not worried that potential rate hikes will put prices under pressure. To support this statement, he adds that since 1992 there have been eight periods during which the yield on 10-year government bonds rose.

‘Every region has its own cycle too’ Alternative Investments | 17

Interview

Manager selection is key in illiquid assets As institutional investors search for higher returns and better opportunities for diversification, they often opt for illiquid investments. But do these asset classes really offer the right return characteristics? Robeco’s conclusion is that effective manager selection is crucial.

Together with portfolio strategist Jaap Hoek, Robeco researchers Thijs Markwat and Roderick Molenaar have written a white paper called ‘The ins and outs of investing in illiquid assets’, based on an extensive literature study. Markwat and Molenaar explain the key findings of their research in an interview.

What factors make investments illiquid?

“There are four factors that limit the liquidity of investments,” says Molenaar. “The first is the external costs incurred through transactions.

Those are generally higher for hedge funds, real estate, private equity and infrastructure than they are for quoted stocks and bonds, for instance because legal specialists are involved in the transactions. A second factor is that market makers are needed to make the trade possible and to maintain supply. The market makers must be compensated for the risk that they may temporarily be unable to find a counterparty.

Third, illiquidity also arises when the buyers and sellers don’t have the same information.

The less well-informed party will want compensation for the risk of potentially not trading at the right price. That makes it more complex and reduces the liquidity. The fourth factor is ‘search friction’, when it’s difficult to match up supply and demand. That happens when there’s no centralized market, for instance. A small market with few parties can result in wide spreads between bid and offer prices. These various sources of illiquidity overlap too and thus reinforce each other.”

Does the lack of liquidity offer sufficient reward?

“Their long investment horizons mean that pension funds are in a good position to invest in illiquid assets,” says Molenaar. “They are less likely to experience reduced tradability 18 | Alternative Investments

as a drawback than investors with a shortterm horizon. But they can benefit from the compensation that the market demands.

They’re also less affected by the high transaction costs.”

“On theoretical grounds, you might expect there to be some kind of liquidity premium,” says Markwat. “But the results of academic research are mixed. Within some asset classes, illiquid investments offer better yields than liquid investments do. So a liquidity premium exists in such cases. But there’s little or no empirical evidence for a yield differential between liquid and illiquid asset classes. You can’t say that there’s no liquidity premium between asset classes, but it is certainly very difficult to demonstrate that it exists.”

“For many illiquid investments, there often isn’t a market value available,” says Molenaar, “so you have to work with book values that are intrinsically of a lower quality. For some people, it’s an investment belief that you should receive a premium for investing in illiquid assets.”

Are illiquid assets actually attractive enough to invest in?

“Whatever the illiquid asset class, it’s important that you pick good fund managers,” says Molenaar. “The managers and their funds must always be in the top quartile. David Swensen, Chief Investment Officer of Yale University and the architect of the endowment investment strategy, agrees. In his study called ‘Pioneering Portfolio Management’, he says that you shouldn’t invest in illiquid asset classes for the risk premium, but for the alpha you can generate. It’s not always possible to establish whether good returns are the result of a manager’s added value or perhaps because there’s a premium for illiquidity. But you do get an additional return, and that’s a

combination of factors that you can’t put your finger on.”

“Swensen argues that there are more opportunities to generate alpha because it’s more difficult to gather and process the correct information about investments in illiquid markets. That’s in contrast to public markets, where the investors have more information.”

How can the liquidity premium vary so widely?

“A study by Tilburg professors, Frank de Jong and Joost Driessen, shows that investors with a longer-term investment horizon are able to ask - and get - a higher liquidity premium,” says Markwat. “Because they can hold investments for longer and therefore have to trade less often, long-term investors have lower transaction costs. But because they won’t be satisfied with a lower gross return, the premium they receive has to be higher.”

Liquidity premiums are higher in times of crisis. Can investors benefit from this?

“Predicting a crisis is pretty much impossible,” says Markwat, “so anticipating one isn’t an option. It’s true that you can buy illiquid assets at low prices during a crisis, but the timing’s still awkward. You never know if the crisis is going to deepen. On top of that, your own situation is important. If you have a solid position, you’ll be more capable of benefiting from the discounts than if you’re affected by the crisis too.”

“There are examples of parties who got into trouble by investing too heavily in illiquid investments,” adds Molenaar. “Think of the Harvard University endowment case. The university fund got into big trouble during the crisis in 2008.”

What are the diversification opportunities?

“These investments can offer exposure to specific characteristics,” says Molenaar.

“Take inflation, for instance. By investing in infrastructure, you can acquire inflation exposure, in the Netherlands, for instance.

Or, if we’re talking real estate, investments in rental housing offer different characteristics – more defensive ones, perhaps – to quoted commercial real estate.”

“A second benefit of diversification comes from the fact that the prices of liquid and illiquid investments don’t respond at the same time to market developments. That’s because the prices of illiquid investments are based on valuations. There’s a delay in their response to developments on the stock market, for example. Because of that timing difference, the value of the portfolio as a whole is less volatile. In itself, this is just an exercise on paper applying accounting rules, but it can still be a benefit from the portfolio management point of view.”

’There’s little or no empirical evidence for a yield differential between liquid and illiquid asset classes’

What is the key message from your white paper?

“That the returns on illiquid investments are largely determined by the managers you select,” says Molenaar. “If you’re an investor who wants to invest in illiquid asset categories, you should always ensure you have the necessary skills to select the right managers.”

Alternative Investments | 19

Contact Robeco Groep N.V. Coolsingel 120 3011 AG Rotterdam The Netherlands T +31 10 224 1224

Important information This statement is intended for professional investors. Robeco Institutional Asset Management B.V. has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. This document is intended to provide general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at www.robeco.com.