Diversification is universally agreed to be the most prudent portfolio management technique. However, to implement true diversification requires the ability to regularly and consistently compare a broad range of asset classes with their various expected returns and risks, as well as other idiosyncratic considerations such as levels of liquidity and embedded leverage.
One of the main advantages for an investor in using a real return fund is that this analysis of asset classes, and the resulting investment allocation decisions, are being made continually on your behalf and can often include investments which can be difficult to gain exposure to.
At Perpetual Investments, our approach to diversification is about ensuring your exposures to sources of returns are genuinely diversified. Some of the asset classes that appear at first glance to diversify portfolios may in fact have the same underlying drivers of risk, or drivers of returns; many of which are not immediately obvious.
To us, intelligent diversification is about firstly examining the underlying drivers of returns and ensuring diversity amongst the assets, in order to provide the investor with a collection of distinctly unrelated investment opportunities. This includes using both Perpetual’s asset management capabilities and when necessary, external managers, to capture the most compelling investment opportunities for investors.
An example of intelligent diversification
In addition to diversity of underlying sources of risk and return, effective risk management of portfolios must also take into account the ability to exit investments where the risk and return dynamics are no longer attractive. Put simply, how easily can an investment be sold if it no longer adds value?
Accordingly, the Perpetual Diversified Real Return Fund (‘the Fund’) has a maximum allowable exposure to less liquid (or private market) investments of 20%. At most times, the Fund’s exposure has been significantly less than this – for example, the exposure in June 2017 was 4.5%. That said, some of these less liquid investments do provide diversification and can generate attractive risk adjusted returns, so investing in them should not be ruled out simply because there is no formal secondary market such as a stock exchange.
It is with this in mind that we seek to achieve the right balance between firstly maintaining flexibility and liquidity to exploit opportunities when asset classes become cheap and secondly ‘locking in’ high confidence returns to meet your objectives. To balance these two aspects, we believe care needs to be taken to avoid the following mistakes when investing in an illiquid asset.
1. Confusing ‘non-daily transaction pricing’ with diversification.
Many investors believe that unlisted investments have low correlations to listed markets. This low correlation is often due to the fact that unlisted investments are infrequently traded and are valued on an appraised basis (similar to a bank providing a valuation on a house) rather than an actual market transaction (where a buyer and seller agree on a price). As such, we are careful to ensure that we understand the long-term determinants of future performance, as well as the key risks over the investment horizon.
2. Confusing the extra returns generated from gearing with an ‘illiquidity premium’
An investor should be rewarded for forgoing liquidity. But don’t be confused that a higher expected return is simply a liquidity premium and not compensation for some other form of risk. Some private equity funds (such as leveraged buy-outs) take public companies private in order to increase leverage and strip out costs, among other things. This may increase shareholder returns provided the strategy performs to plan, but it is not an illiquidity premium. Debt has never made a poor investment into a good one, but has often turned a good investment into a bad one. At Perpetual, we take a lot of time to assess that debt is conservative and that we are paid more to hold a less liquid investment than a more liquid comparable investment. This discipline has been well rewarded over the years.
3. ‘Proceed with caution’ when considering offshore illiquid investments
Whenever an investor buys an offshore asset they create a currency exposure as well. If the investor wants to eliminate the foreign exchange risk, then they usually enter into a hedging agreement where any gains and losses on the hedge must be settled in cash. If the investor’s portfolio has sufficient liquidity then any hedging losses are usually manageable. However if not, then assets may need to be sold, potentially causing problems where these assets are more illiquid investments. Some fund-of-hedge-fund managers were unable to sell underlying assets in 2008 in the early Global Financial Crisis (GFC) and therefore lost the ability to control the currency risk, resulting in a poor outcome for investors. Where we do consider less liquid investments, we have a strong preference for Australian domiciled assets.
4. Complexity and illiquidity – Is it worth mixing them together?
Certain types of portfolio risks don’t simply add together, they multiply exponentially the total risk experienced by the investor. This can often be the case when you invest in complex strategies that rely on the skill of the fund manager to handle the illiquidity. The end result is unfortunately then that an investor is unable to exit the investment if things don’t work out as intended, for example if a key person exits.
The potentially higher returns, if things go well, generally compensate you for the complexity of the strategy and illiquidity. However, when most needed, investors have found it exceedingly difficult to find a secondary market for assets that were highly geared or in a complex investment strategy such as structured credit and certain types of hedge fund strategies. If it is a predominately skill-based source of return which requires leverage to achieve return targets, then there is ample room for disappointment. Events outside of an investor’s control can overwhelm the thesis for making the investment. We avoid investing in complex structures, where it is difficult to have clear line of sight of the underlying assets and cash flow.
Our principles for investing in less liquid investments
At Perpetual Investments, our principles for investing in less liquid investments are:
- We seek out investments that offer genuine diversification of underlying return drivers and sometimes this has included less liquid investments.
- We have strict and conservative limits in place as to how much we can invest in less liquid investments. We currently have 4.5% allocated to less liquid investments.
- We predominately invest in Australian dollar domiciled we want to have full control over currency risk.
- Thorough due diligence is conducted so we select high quality unlisted exposures, with appropriate levels of gearing. These investments have an observable cash flow, strong competitive advantage and management, as well as tangible assets, which are valued by independent parties.
We currently have one unlisted investment exposure in the Perpetual Diversified Real Return Fund – unlisted industrial property. Three years ago when we made the investment, the key characteristics of the assets which attracted us were:
- Reliable cash flow with a high probability of meeting CPI+5%
- A portfolio capitalisation rate of 7.6%
- Very low tenancy vacancy rates
- Weighted average lease expiry (WALE) of over 7 years, and
- A highly conservative approach to gearing.
- Genuine diversification
Industrial property has very different characteristics when compared with the retail and office sectors of property. The retail sector continues to suffer structural headwinds from online retailers, which look set to intensify with the entrance of Amazon. Meanwhile, the economics of the office sector makes it less attractive as buildings age and prime properties require constant upgrading to attract top tenants; often financial services companies that are highly exposed to economic (and market) downturns. In contrast, the performance of industrial property is somewhat indifferent to whether goods are purchased online or not, the size and location of land can be key competitive advantages and maintenance costs are much lower.
- Illiquidity premium
At the time of investing, the unlisted property portfolio was valued at its Net Asset Value (NAV), compared with listed real estate trusts (REITs) trading at 15% premium to Net Asset Value.
- Australian domiciled
There were no offshore exposures which meant that we did not have to concern ourselves with the fluctuations of the Australian dollar.
Since the initial investment was made three years ago, the total return produced from this investment has exceeded 55% (total return, to April 2017). So despite our conservative allocation to less liquid investments, this exposure to industrial property has made a meaningful contribution to the overall portfolio’s returns. The key take out for investors is that it is important to use an illiquidity budget wisely, and to make it count.
In other areas, such as infrastructure debt and mezzanine mortgages, we have allowed these exposures to return our capital over time, to enable us to allocate to better opportunities elsewhere. Many less liquid opportunities today have lower expected returns, due to investors’ allocating significant amounts of capital to these types of assets, given the currently lower expected returns in listed markets. Rather than chase these opportunities, we are being patient and hold a combination of relative value opportunities and cash.
What does this mean to you?
Less liquid investments can provide large diversification benefits providing all risks are appropriately assessed given the prevailing economic conditions. At Perpetual Investments, our disciplined investment guidelines and rigorous portfolio construction process that sit behind the Perpetual Diversified Real Return Fund incorporates a very high hurdle to be met before less liquid investments are included within the portfolio. But we believe that investors are best served by having the widest available universe of assets from which to build an intelligently diversified portfolio.
Therefore, we do not limit our investment opportunity set unnecessarily, but rather diligently and continually adhere to our quality and value investment principles; buying attractively priced cash flows that are generated from high quality assets – whether from listed or unlisted investments. The right balance can be found between maintaining flexibility and locking in high confidence returns, culminating in what we believe ultimately helps investors achieve their investment objectives in the long run.
Perpetual Investments 1800 062 725
This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 and issued by Perpetual Trustee Company Limited (PTCo) ABN 42 000 001 007, AFSL 236643. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The PDS for the Perpetual Diversified Real Return Fund, issued by PIML, should be considered before deciding whether to acquire or hold units in the fund. The PDS can be obtained by calling 1800 022 033 or visiting our website www.perpetual.com.au. No company in the Perpetual Group (Perpetual Group means Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital. Past performance is not indicative of future performance. The Fund gains its exposure to Australian shares by investing in underlying Australian Share Funds which primarily invest in Australian listed or soon to be listed shares but may have exposure to stocks outside Australia. The investment guidelines showing the Fund’s maximum investment in international shares do not include this potential additional exposure. Currency hedges may be used from time to time.