Changing regulations and investor pressure shape alternatives sector

Research house Lonsec has released its Alternatives Sector Review, highlighting that a changing regulatory environment and investor requirements have continued to shape the alternatives sector during the past year.

Lonsec’s review of the alternatives sector encompassed 33 products covering both hedge funds and private equity. The report found that many alternatives products have failed to perform as well as traditional long-only equity products over recent years during a relative strong equity market coupled with historically low volatility.

“The alternatives sector is one of Lonsec’s most diverse sectors,” Lonsec’s senior investment analyst Stewart Gault said. “Over the last few years, the alternatives product space has faced significant regulatory change, both domestically and internationally.”

“This regulatory scrutiny has been accompanied by increased demand from investors for greater transparency from the alternative investment sector.”

Lonsec believes this has been driven by the institutionalisation of the hedge fund investor base.

“The traditional hedge fund investor base of family offices and high net worth individuals has been supplanted over time by large institutional investors, such as pension funds and sovereign wealth funds,” Mr Gault said.

“Institutional investors typically have statutory or legal reporting requirements and so require greater transparency from their investments,” he said.

As well as greater transparency, Lonsec also found that investors were demanding less complexity, better liquidity and lower fees from the alternative investment sector.

Lonsec notes that many funds have invested in additional legal, compliance and risk resources and launched new structures to address these investor demands.

“In the Australian retail segment, sufficient anecdotal evidence exists of financial advisors preferring less complex strategies which can be more easily understood and explained to clients,” Mr Gault said. “We do believe that issuers of complex products need to make a greater effort educating investors – more detailed Product Disclosure Statements are a good, but small, step in this direction.”

While Lonsec believes there is a strong case based on diversification to include an allocation to alternative assets within a multi-asset portfolio, investors should be aware of additional risks associated with such allocations – such as reduced transparency, less or no reliance on traditional market beta to drive returns, and sometimes illiquidity.

Other key findings of the report include:

The broad range of hedge fund strategies leads to significant variation in performance. In the 12 months to November 2014, product returns ranged from -25.1% to +24.8%.

Unlike traditional asset classes where management fees have been under downward pressure from competition and index-linked products, this is not the case in the Alternatives sector.

Only one product was upgraded in 2014 while three were downgraded.