The looming crisis in list stocks and bonds is driving interest in alternatives – but their inherent illiquidity can defeat risk managers’ comprehension.
Alternatives is becoming a busy market. It would appear the global asset allocation committees are waking up to the madness of zero interest rates and the insanity of negative bond yields. They need to generate real alpha returns if the firm is going to post any kind of meaningful gains. I’ve stood in front of them many times and explained the attractions of investing in real assets producing dull, predictable, market-beating real returns, and the appeal of investing in private debt and equity deals that are de-correlated from the approaching crisis in financial assets – or listed stocks and bonds as everyone else calls them. As a result, the fund and our clients have been buying.
I remain highly sceptical of bond and stock levels – both are massively distorted by QE and central bank buying programmes, foolishly low rates and fund managers blindly following the stock and bond indices higher. It’s a recipe for disaster. And it would appear our risk managers are waking up to the looming risk crisis – well, kind of. They have been listening to our strategists and their mounting concern about just how liquid bond markets will be when the market turns. Some analysts from risk management have been asking fund managers how they are addressing liquidity risk.
Their conversation with the alternative investment team was illuminating: “So how liquid are these assets – how quickly can you liquidate your positions in the event of market dislocation?” The portfolio manager explained to the bright young things that the whole point in these particular investments is the expectation that they are definitionally buy-and-hold investments. He gets paid a large liquidity premium to hold them precisely because they are illiquid and complex. That doesn’t work. They need to say where the alternatives team can sell them. Today.
In one case we’re looking at returns secured on a whole series of sector-specific loans – we don’t expect to ever be able to sell, no matter how strongly the underlying loans return. On another investment in commercial aircraft, it’s the same story – we will sit and hold until the deal matures. Trying to sell would be a waste of time and could trigger a mark-to-market loss. The risk management team is not particularly happy about this. They need to mark the assets to market for capital calculation purposes. I explain to them about the mandate to invest in alternative assets to boost returns and de-risk from financial assets. They counter that illiquid investments require higher capital allocations, and therefore the returns probably don’t justify the costs and liquidity risks.
When I protest, I get the Woodford lecture – the one about “We don’t want the reputational risks of having invested in illiquid assets in a market that might turn negative.” I try to explain that the point of the alternative de-correlated portfolio of private debt and equity real assets is that it is designed as a hedge against the financial asset portfolios turning red. With a sigh, they start explaining capital costs to me again…
This is the brutal reality of the financial world today. The logic of intellectually smart and clever investment decisions is overtaken by the blunt reality of financial regulations, rules and calculations. The moment I make a phone call to sell the aviation bonds, their value will fall. If I do nothing, they will stay the same. They will redeem in two years’ time at par (actually par-plus, depending on the value of the aircraft), whatever else the market does. If I make that call for a bid and ask for a mark to market, then it will be lower, and I will face yet more “Why are you so stupid?” discussions with risk management. I really can’t win.
