In this paper, we bring together our newest thinking and research to demonstrate a series of high returning portfolios – all capable of generating returns consistent with an alpha-hunter mindset, of more than 4%p.a. over the risk-free rate in the long term, or equivalently 3%p.a. above inflation. We distinguish the portfolios according to different high level aims or constraints (based on those we most frequently encounter):
- High allocation to illiquids permissible
- Constrained allocation to illiquids (25%)
- Bias to equity investment
- Bias to contractual cashflow generating assets
These portfolios are summarised in the executive summary, with the risk breakdown in section two.
The underlying components of these portfolios are detailed in section three.
So what now/next steps
If you are an institution managing an asset only portfolio with growth as a priority, the following could be helpful questions to ask in building the most effective portfolio for your needs –
Are you making use of the asset classes discussed in this paper, or is your portfolio biased to a particular risk premium, strategy or star fund manager?
How much illiquidity can you tolerate and are you making the most of this ability to generate returns?
Are your alpha-sources diversified – do your active managers complement each other in terms of style, and are you making use of alpha across the asset class spectrum?
Do you have a preference for cashflow generating assets and strategies?
If you are unfamiliar with some of these strategies, Redington can help you understand their properties. Specifically, how they may fit into a portfolio designed with high growth in mind, as well as to select the best-of-breed asset managers to run each sleeve of the portfolio.
Investment objectives and constraints will vary among asset owners and individuals; for some, managing downside risk will be a priority, for others growth (in real or nominal terms) and others will be focused on matching or meeting liabilities. In much of our work with defined benefit pension funds, investment strategy is heavily influenced by the need to meet liabilities and manage downside risk relative to liabilities.
However, for our work with family offices, wealth funds, endowments and other institutions without those constraints the investment question is somewhat different, and frequently focuses on the most effective way to generate a high level of returns, in as diversified a way as possible.
Investors in equities have enjoyed excellent returns over recent decades (as detailed in a recent McKinsey paper) with both US and European equities enjoying real returns of almost 8%p.a. for the 30 year period ending December 2015.
As Mckinsey1 and others have argued, the picture may be somewhat different going forward.. The economic and business conditions that led to the spectacular equity market performance of the 1990s may not be repeated; valuations look high according to certain metrics; and growth/inflation backdrop is fundamentally more stagnated than it has been for decades.
Fortunately, there are a large number of other asset classes and strategies available today that can play a role in a diversified, high return strategy. These include traditional return drivers such as equity (actively or passively managed), but also an array of high returning illiquid strategies, as well as more diversified and alternative strategies in the liquid space.
Our four portfolios, designed to address the challenge of delivering high long-term (real or nominal) returns without liability constraints, are detailed below
Source: Redington ALM model. Calibrated as of 31 March 2016
|Portfolio 1: High illiquid||Portfolio 2: Constrained Illiquid||Portfolio 3: Bias to Equity||Portfolio 4: Bias to cashflow generating|
|Expected Excess return (%p.a.)1||4.9%||4.3%||4.2%||3.9%|
|95% VaR (%)2||15.4%||12.8%||14.44%||11.9%|
|Expected Real return (%p.a.)||3.9%||3.4%||3.0%||3.3%|
|Expected Total Return (%p.a.)3||7.0%||6.5%||6.1%||6.3%|
|Average fee (bps)5||140||97||88||80|
|Main risk factors||Credit / Illiquidity||Equity / Credit||Equity||Credit|
1. Excess return is measured over the risk free rate, which in this case is taken to be cash (3m LIBOR) all returns are quoted net of all fees
2. Value at risk measured over 1 year at a 95% significance level
3. Total returns calculated over a 20 year time period by applying excess return to 20 year gilt rate as of 31 March 2016
4. Sharpe ratio is a measure of risk adjusted return, defined as the excess return divided by the volatility
5. Includes performance fee components for some strategies. All expected returns quoted net of these fees
Short descriptions of each portfolio
This portfolio is the least constrained of all the portfolios and according to our capital market assumptions, generates the highest expected returns of almost 5%p.a. ahead of cash. It has the largest allocation to illiquid strategies, which at 50% of the portfolio may be higher than some investors would be comfortable allocating (if, for example the need might arise to liquidate assets in certain scenarios). Illiquidity represents a significant risk which we capture within the risk model, and gives this portfolio the highest level of risk of the 4 portfolios. However, it is worth noting that the risk level is still lower than that of an equity-only portfolio. The illiquid portion is capable of generating the highest expected returns (under our capital market assumptions) of cash + 5.5% vs cash + 4% for the liquid portion. However the illiquid sleeve also carries the highest fees, as some of these strategies will carry performance fee elements. All return assumptions quoted are net of all fees.
This takes the basic ideas from portfolio 1 and constrains the allocation to illiquids to a level more consistent with the constraints faced by many institutions with some form of liabilities. The liquid strategies include equity, diversified beta and multi-class credit. The illiquid strategies includes distressed debt.
Many institutions will contain a significant bias to equities for philosophical or historical reasons. We acknowledge that the composition of all the portfolios shown here are somewhat sensitive to the return assumptions used in the model. We recognise that some institutions will have higher expected returns from equities, justifying a higher allocation, and here we show what a portfolio with a higher tilt to equities may look like. However, we still believe that even with more optimistic assumptions for equity returns, it makes sense to have significant diversifying allocations to illiquid and credit strategies. Due to the bias to one risk factor (equities) this portfolio has the second-highest modelled level of risk, and the lowest level of risk-adjusted return (as measured by the Sharpe ratio).
The topic of income, and of contractual cashflows is becoming more and more important across the investor spectrum. Whether in generating cash to pay benefits in a mature defined benefit pension fund or to make payments in an endowment or wealth fund. This portfolio tilts to strategies that generate their returns through contractual cashflow instruments. It includes large allocations to multi-class credit and to direct lending strategies.
The underlying components of the strategies can be best understood within the categorisations of our seven-step framework as follows:
- Liquid Strategies
- Liquid Credit
- Illiquid Credit
- Illiquid Strategies
1. Liquid Strategies
Fundamental Active Equities
Equities are typically a core component of many high-return portfolios, and rightly so, as there are several well-known studies that validate equity returns going back over a century. The returns generated by an equity portfolio can arise from (i) the equity risk premium, (ii) style factors, and (iii) excess “true” alpha provided by a fundamental manager selecting stocks that outperform (i) and (ii). We describe this approach in more detail below.
In long-only fundamental active equities, the highest return potential is found in high active share, concentrated portfolios of best ideas run by fundamental portfolio managers.
The basis for these strategies can be the exploitation of a behavioural style (such as Value, Quality or Momentum) that can be analyzed systematically. A purely systematic manager will apply quantitative criteria relating to some or all of these factors to a large pool of stocks, and use that as the driving input into the portfolio.
The behavioural based styles that systematic strategies tend to exploit, however, can also be the root of investment philosophies followed by fundamental managers, some of whom are able to improve on the systematic alternative. By sourcing ideas from a pool of cheap stocks, high quality stocks or stocks starting to exhibit earnings momentum for example, the fundamental manager is starting from a position of strength, as they should have that particular style tailwind behind them over the full market cycle.
By then doing deep fundamental analysis, the portfolio manager is able to sift through the pool of stocks to select the best ideas. These are typically stocks with a.) a more predictable range of outcomes; b.) a stock undergoing change that the data doesn’t reflect; or c.) perhaps with some embedded value that is hidden from the standard balance sheet metrics. Whatever the edge the portfolio manager identifies, it leads to a greater conviction in that idea, which can then be translated into a significant weight within the portfolio.
A fundamental portfolio manager can also add value in portfolio construction, with careful trimming and adding to positions or assessing portfolio level and stock specific risks that a typical risk model can’t see. The end result is a high conviction, concentrated portfolio that typically runs at a high tracking error relative to the reference benchmark.
By blending high conviction Quality, Momentum and Value fundamental managers together however, the overall tracking error is reduced, as each style is complementary to the other, and typically outperforms at a different point in the market cycle. A scheme can then maintain an exposure to each style, potentially rebalancing periodically to lock in the gains made by one style, and reallocating to the style that was more out of favour. This creates further value on top of the stock selection alpha generated by the underlying managers.
Diversified Beta (Risk Parity and Style Premia)
What we describe as a “diversified beta” fund gains access to a range of both conventional and factor-based risk premia.
While there are multiple interpretations and implementations of this, three key characteristics are most important:
- Investing in liquid markets, such that allocations and exposures can be altered on a daily basis, if necessary
- The use of derivatives to increase exposures to the underlying sources of return to more meaningful levels than a constrained “long only” investor would have.
- The use of derivatives to take short positions to increase the return-generating opportunity beyond that which a constrained long only investor would have
This style of investing has been popularised in recent years by several well-known Risk Parity managers, particularly in the US, although the implementation described below includes more than the traditional components of a risk parity portfolios.
Diversification is one of our investment principles at Redington; often described as the last “free lunch” in finance, it is a meal that many investors are still reluctant to eat. Paradoxically, this is because they can’t afford it. One reason for this is that many implementations of a diversified portfolio reduces risk but also reduce expected return, leaving investors below their required return. Another reason is that lack of transparency and high fees means the allocation to diversifying assets is too small to make a difference – what you might call homeopathic finance.
What is needed to get the “free lunch” for investors is a diversified portfolio that offers an expected return higher than equities but with a level of transparency and low enough fee levels for meaningful allocations.
The solution to this problem is to construct a fund that gains exposure to a wide range of risk factors (“betas”) that are
- Systematic so can be implemented in a transparent and low cost way
- Low or negatively correlated with each other to provide diversification
- Historically proven to provide attractive risk-adjusted returns
- Economically rational for providing returns
- Underlying liquidity so can be easily leveraged to provide sufficient returns
- Able to perform over a range of economic scenarios
Based on these criteria we identified seven betas; equities, government bonds, inflation/commodities, equity value, equity momentum, equity defensive and multi-asset trend following. The first three betas are long-only, equity value, equity defensive and equity momentum are long/short, enabling exposure to the specific risk factor rather than being overwhelmed by outright equity market movements. Trend following is across asset classes and can be long or short at any one point in time in an individual asset class.
The diversified beta fund is an implementation of these seven betas run at a volatility of 10%, similar to the historical volatility of a 60/40 equity/bond portfolio. This gives the required characteristics of a higher expected return than equities at a lower volatility; the “free lunch” has become a lot more affordable.
2. Liquid & Semi-liquid credit
Multi-Class Credit is a strategy universe that has grown in interest and accessibility for institutional investors over the last few years. These managers are generally looking to generate total returns over the credit cycle of around LIBOR +6% or more by investing in a fairly unconstrained way across investment grade, high yield, loans and ABS sectors. Most managers tend to focus on either the US or Europe although some look at both. Typically these managers will be boutique and focus on deep bottom-up research to identify names they have conviction in less covered or less liquid areas of the credit world. They will generally not be constructing portfolios with reference to an index, which means they can invest in bonds they like on a buy-and-hold basis, riding out potential volatility or downgrades. They may also employ significant rotation among credit sectors (such as investment grade, high yield and loans) using derivatives to hedge out some risks although they will generally be long-biased.
Typically, European and US focused managers will be quite complementary in terms of style (albeit still relatively highly correlated) as the credit cycles in the two regions do not necessarily move in lockstep. In Europe, these managers may focus more on ABS and structured credit; in the US, the focus might be on specialist high yield, loans or securitized bonds (such as MBS).
3. Illiquid Credit
Banks are becoming uncompetitive in US & European SME lending due to increasingly stringent reserve requirements for underwriting loans to riskier corporate customers. This retrenchment plays neatly into the hands of specialist asset managers who can provide either the entire financing needs of the borrower, or club together with other strategic lenders. These managers can generate attractive returns for their clients in excess of L + 8% per annum, the tradeoff being that this is an illiquid strategy typically managed through a closed ended vehicle with a 6-8 year life.This strategy has become popular with institutional investors in recent years due to the high return potential, but also in part to its senior floating rate, high current income profile and an increasing ability for managers to allocate institutional investment volumes within a reasonable period.
The mid-market direct lending universe breaks down more cleanly between US and European managers, given that manager success in allocating to such markets is usually driven by a network of personal relationships between lenders, financial advisory firms and PE sponsors which may be restricted to either geography. We prefer a global approach given the more nascent European market which suffers from being more fragmented and offering lower spreads than the more efficient US market.
The key to generating attractive returns in this space is the ability to negotiate directly with the borrower to obtain attractive spreads and covenant protections that are normally absent in the private equity sponsored loan market. A wide origination network is required to provide an ample supply of flow (these loans tend to amortise within three years), along with a stringent underwriting process and the resources to carefully monitor loan performance. An ability to provide long-term, repeat support to borrowers is important, whether they need emergency operating cash or acquisition finance.
Managers use a variety of methods to earn capital gains and income (predominantly the former). They do this by acquiring positions in what they believe to be heavily discounted bonds and loans of struggling or defaulted companies, securitisations and NPLs from bank balance sheets and trade claims from bankrupt estates. Hard assets such as real estate and cargo ships have also become increasingly popular. Positions can be exited via general amortisation, re-securitisation and by trade sales to REIT, PE and other operating companies.
Bankruptcy / Liquidations / Restructurings:
- Typically involves buying the senior debt and trade claims of companies going through bankruptcy, participating actively on creditor committees to exert controlling influence over subordinated debt and equity holders to maximise value, or by litigating around contractual rights.
- Restructurings are similar to bankruptcy, but negotiated out of court and requires greater co-operation among parties as solutions can only be achieved voluntarily with consensus.
Special Situations / Rescue Finance Specialists:
- Loans provided to stressed companies seeking to avoid covenant, liquidity, leverage or maturity problems to avoid bankruptcy.
- May include features to enhance returns and/or provide downside protection (attractive coupons, original issue discounts, call protection, take-out premiums, or conversion options). All privately negotiated.
Non Performing Loans & Hard Asset Recovery:
- Acquiring private loan pools directly from stressed banks via trade sale or auction, working through non-performing debts to earn recoveries. Mixture of SME loan books and consumer ABS (credit cards, mortgages). Difficult for smaller funds to access. Delivers more stable cash flow than traditional distressed debt.
- Buying controlling stakes in hard assets such as hotels, cargo ships, aircraft and railcars with a commercial partner, revising the business plan, stabilising earnings and prepping the business for sale to a PE firm or trade buyer.
- Employ a blend of the above distressed strategies but tend to shy away from large NPL disposals and non-RE hard assets due to size constraints.
- Highly opportunistic, “go anywhere” mandate with enough capital to be on every broker’s radar but small and nimble enough to exploit esoteric situations. Bias towards complex, hard to source distressed plays and taking differentiated positions to the rest of the market.
4. Illiquid Strategies
Diversified Opportunistic Illiquids (“DoI”)
DoI managers operate at the higher-risk, and lower-liquidity end of the credit spectrum. This includes speciality finance sleeves and other forms of unrated, public and private loans with very limited secondary market liquidity. The target for these managers would be to generate substantial total returns of LIBOR + 6-8% or higher, through income and capital gains.
A key theme exploited by these manager is the retrenchment by investment banks in certain areas including lending to small and medium sized enterprises, and high-yield market making. For clients without broad exposure to illiquid credit a diversified approach (i.e., a single mandate with the ability to “go anywhere” in search of the best opportunities) represents a neat and highly efficient solution to gain wide-ranging, low governance illiquid credit exposure in one vehicle.
Portfolio composition is tilted towards bottom-up credit selection rather than top-down rotation. The majority of manager returns will be yield rather than convexity-driven and index derivatives will be most commonly used to hedge long exposures where necessary. Some examples of components of DoI portfolios are:
- Developed market high yield corporate credit (typically “off-the-run” names not present in major benchmarks) that the manager considers to be deeply undervalued or trading at stressed levels
- Structured credit backed by a wide range of underlying cash flows, predominantly from consumer loan pools and corporate bonds
- Asset-backed loans secured against real estate but also against other hard assets such as ships, aircraft and railcars
- Bi-laterally negotiated floating rate SME loans, typically senior in the capital structure
- Invoice finance with receivables backed by high quality counterparty credit profiles and carefully monitored collateral
Clients can enter on a monthly basis but are typically subject to a minimum capital lock of one year, with substantial fee discounts on offer for additional 2-3 year locks.
Opportunistic property strategies are leveraged property investments, with a major focus on increasing capital values through refurbishments, extensions, (re-)development, re-letting, vacancy reduction and change of use. Typically, the underlying assets are distressed or mismanaged in some way. For example they could have significant vacancies, the wrong tenants , poor layout, or the owner themselves could be a forced seller. It is worth noting, however, that these buildings tend to be in very strong locations, often in centres of capital cities. The idea is to acquire the assets at a discount, carry out necessary work to bring them to institutional quality, stabilise the income by putting in high quality tenants, and to sell the assets at a premium.
Opportunistic property strategies typically target in excess of 15% IRR at ca. 65% portfolio level loan-to-value ratio. For our rated managers, we actually obtained line-by-line performance figures and we decomposed these to understand the impact of the overall property market, leverage and the value added by the manager. We established that skilled managers in this asset class are able to deliver considerable alpha (as much as 2% on unlevered basis).
In order to find the best opportunities, managers typically choose to operate on the European, rather than just national scale. This also allows them to exploit macro opportunities. However, this means that managers will not have deep specialist knowledge in every micro-location. They will, therefore, often appoint local operators in some cases to execute business plans and to advise on local market dynamics. Where the manager feels that they have local expertise, they would carry out business plans themselves. In analysing opportunistic property strategies, it is important to understand how operating partners are appointed, rewarded and monitored.
It is also worth mentioning that we distinguish between value-add strategies and opportunistic funds. Both attract relatively high fees, but we see more evidence of alpha in opportunistic strategies. The main difference lies in the extent to which the newly acquired assets produce income (which is less for opportunistic vehicles) but we also note that opportunistic managers tend to apply considerably more creative and differentiated solutions around the use of operating partners (e.g. building operating companies within funds or participating in corporate deals, whereby the corporate becomes the operating partner).