Transparent alternatives wanted

(March 2008) A few years ago the thought of a hedge fund manager tipping his hand or letting investors get a glimpse inside his “black box” was laughable, the stuff of fairy tales.

This secrecy was acceptable — and still is — because alternative investments, hedge funds, were more narrowly defined and available only to accredited investors.

Nearly any product that doesn’t fit the traditional mutual fund description is called alternative. And interest in alternative investments is growing, particularly among institutional investors, private clients and even among some retail investors. Returns are also flattening, prompting managers who run institutional money to call for better risk management and transparency.

A recent study backs this up. Conducted by the Economist Intelligence Unit and PricewaterhouseCoopers, the global survey of 226 institutional investors and alternative investment providers found that quality compliance and risk management processes, along with transparency, are actually more important to them than performance.

In addition to findings that show that 41% of these investors value risk management and transparency — slightly more than the 40% who said performance was a criterion in dropping investment providers — the survey came back with four key observations: More investors understand what alternative investments are, especially on the institutional side; there is a growing focus on, and perhaps demand for, governance; the quality and scope of reporting needs attention; and investors are somewhat dissatisfied with aspects of the current regulatory regime.

Raj Kothari, partner and leader of the Canadian investment management practice at PricewaterhouseCoopers, says many institutional investors are frequently dissatisfied with the performance of their alternative products, but most still expect to allocate more to the sector in the future.

“The institutions want to put more money in, but more than half would say they’re not happy with the performance of hedge fund investments,” he says. “Though they’re not happy with the hedge fund investments, the same investors will say they’re relatively happier with private equity and real estate funds.”

In Canada, he says, demand for alternative investments is largely driven by institutional investors. In the United States, meanwhile, demand for alternative products, hedge funds in particular, has been driven by high-net-worth retail investors. At the moment, there are concerns among investors about transparency and valuations, and a cautious attitude toward traditional “exotic” hedge fund products but less concern about real estate sector funds or infrastructure funds.

Demand, though, could soon be changing in this country as well. “With low interest rates, people are looking for income products or other forms of [investment] and other asset classes so they can diversify and seek returns,” says Kothari. “Some are willing to take risks.”

Although many alternative investment providers are suffering from the effects of the global credit crunch, the report predicts the industry will enjoy rapid growth over the next three years. The survey found 41% of investors expect to increase their allocation to real estate, 40% to private equity, 35% to commodities and 33% to hedge funds. Few survey respondents said they plan to allocate fewer assets to these sectors in the future.

Kothari says this is due to the fact that global interest rates are not providing sufficient returns. “People need to find other avenues to generate income or gains, and there’s only so much scrip currently available in the marketplace. There’s a lot of money out there — with sovereign funds, new emerging economies with people who have high savings rates and a higher standard of living than they’ve been used to, and the trans-generational wealth transfer taking place … there’s a lot of cash chasing very few scrips. Money needs to find a home, and people are looking at alternative products.”

Along the way, the issue is whether investors will ask the right questions, or any questions at all. Those inclined or even able to do the due diligence required when investigating alternatives face a number of challenges.

Private equity is known for being “a very tight club.” Business practices on the hedge fund front still allow many hedge fund and alternative asset managers to manage money in relatively opaque ways, carefully guarding their trade secrets — ideas and any investment details — from investor scrutiny. Along with this, a lack of uniform accounting standards for asset valuation can easily lead to analysis problems: “With the same information, two very intelligent individuals could come to different conclusions, especially when you’re talking about fair valuation processes,” he says.

“We hope that the recent accounting standards, particularly as they pertain to valuation, will compel both providers and investors to raise their game.”

Investors need education and need to ask more questions — about sensitivity to market changes, liquidity risks, exchange rates and the impacts all of this has on the product’s overall risk profile and performance.

“People should be asking these things, absolutely,” Kothari says. “How have these been valued? How many of these products have a direct, actual, open market? How many are valued by a fair process, through observable inputs? What percentage of the securities [held] are valued by models?”

At the same time, the survey suggests the time might be coming when alternative managers also need to be more open about “operational infrastructure” — risk and control metrics, valuations techniques and back-office operations.

“Private equity managers remain pretty ambivalent about the need to demonstrate to investors that they have strong fiduciary controls and transparency. This survey in fact clearly states and demonstrates that this needs to change,” says Kothari.

The report says just 18% of hedge fund investors think valuation policies are effective, and only 16% think IT security is good, compared to 67% of firms who believe they have “effective” reporting and 65% who think they have “effective” policies against fraud.

“If private equity players need this type of money to invest in, they will need to be more open,” Kothari says. “It’s not coming from regulators; the market itself is dictating it.”

Filed by Kate McCaffery Advisor.ca, kate.mccaffery@advisor.rogers.com

(03/20/08)

Kate McCaffery