Report Card on Alternatives

This report is intended to highlight the issues with different types of alternatives that have come into focus during these periods. To keep the list manageable, it focuses on broad indexes wherever possible and limits the asset classes to those listed in Figure 1. The emphasis is on strategies currently in use or being considered by many Canadian pension funds.

Figure 1: Alternative Asset Classes Graded

Source: Eckler Ltd.

As the summary performance comparison in Figure 2 shows, these alternative strategies had varying degrees of success in providing downside protection through this difficult period for capital markets. While many equity markets were down more than 30% for the one-year period ending in March, the best return during this period proved to be from Canadian fixed income. Let’s examine each of these asset classes in turn.

Currency
Currency has played an important role in this most recent period because of significant swings in the U.S. dollar relative to the Canadian dollar and other currencies. As noted in Figure 2, strategies that included non-U.S. dollar investments generally suffered against a strengthening U.S. currency.

Figure 2: Summary of Asset Class Returns as of March 31, 2009

Source: Eckler Ltd.

Listed Real Estate and Infrastructure
The magnitude of the decline in the listed global real estate and listed infrastructure categories may have caught some by surprise, as the ground lost exceeded that of the broad equity markets. Although these segments of the equity market have traditionally tended to be less volatile than other sectors, they were still exposed to some specific economy and market-related issues during this period.

Listed real estate, in particular, reflected the collapse of a bubble in the real estate market and sensitivity to the weakened credit environment. In addition, listed infrastructure proved very sensitive to the news of a broad-based economic downturn, as the deterioration in both credit markets and the transportation sector were key negative influences.

Unlisted Real Estate and Infrastructure
The performance of direct holdings in Canadian real estate, as gauged through the IPD Canadian Property Index, does demonstrate some downside protection. Where listed equity securities were decidedly negative for the one-year period, Canadian real estate eked out a return slightly above zero—a neutral result that would certainly have been welcome compared with equity returns.

Over this period, direct Canadian real estate appears to have delivered as a portfolio diversifier. However, lagged property valuations in the real estate market may simply infer that the full impact of the downturn has yet to be felt. Results for the second quarter saw total real estate returns turn negative.

Unlisted infrastructure is a slightly more challenging asset class to evaluate. Almost all funds are measured based on an internal rate of return over longer periods, and valuations may lag or may not be publicly announced. Unfortunately, few results for this asset class are a matter of public record, so the figures shown are based on a very small sample.

While it is clear that unlisted real estate and infrastructure have provided some downside protection, results for certain categories of assets have shown signs of stress due to the economic downturn. Specifically, assets related to the transportation sector and exposed to non-regulated volume or traffic flow have faced uncertainty in their valuations.

Investing in infrastructure does not come without risk or the potential for negative fluctuation in the short term. Overall, however, unlisted infrastructure investments have so far proved to be more resilient and better portfolio diversifiers than their listed cousins.

Hedge Funds
There are many unique strategies that fall under the hedge fund category, which makes evaluating performance more complex. One gauge is the Scotia Canadian Hedge Fund Index, which provides summary results across 34 Canadian hedge funds. Strategies within the index include long/short, market-neutral and a range of specialty macro and event-driven fund types.

The spectrum of experience within this group included returns as high as 18% and as low as -58%. Long/short funds that found themselves on the wrong side of the long or short generally experienced the largest negative returns for the period—though, on average, they were approximately 10% ahead of the equity market. A smaller group, market-neutral strategies, fared better, with some posting positive returns for the period. The difficulty in assessing hedge funds as an alternative comes from the degree to which results are dependent on the particular strategy and the ability to choose a strategy that can offer consistent expectations for diversification.

Private Equity
The range of private equity funds included in the State Street Private Equity Index includes venture capital and buyout funds, in addition to distressed debt and mezzanine products. Over this period, venture capital funds fared better than other alternatives, which tended to be more affected by negative credit conditions. While all exhibited negative returns over the period, the private equity group, in aggregate, outperformed the S&P 500 Index by a full 10%.

In terms of providing the greatest diversification through downside protection, direct unlisted Canadian real estate and global infrastructure came out well ahead of other alternative asset classes. Hedge funds and private equity followed a distant third and fourth, respectively. Listed real estate and infrastructure offered the least downside protection during a difficult period. In this sense, the stronger interest and greater allocations by Canadian pension funds to unlisted real estate—and, more recently, to infrastructure—appear to be well placed.

Since March 2009, there have been some significant rebounds in various asset classes. Taking a second look back in 2010 may prove even more enlightening, in terms of placing alternative asset classes within the risk/return spectrum and understanding the type of risk protection they provide.