by Richard Phillips, Chief Investment Officer
and Zachary Schwartz, Client Relations
Significant return dispersion amongst alternative asset managers underscores the importance of thoughtful selection and de-selection within our Alternative Yield strategies
The macro environment impacts both asset allocation and manager selection choices
A holistic approach to manager selection involves analysis of running yield, total return, liquidity, tax treatment, integrity, track record, risk, and collateral
Canadian investors are uniquely positioned to access outperforming managers in the Alternative Yield universe
The favourable risk/reward dynamics of the Alternative Yield universe are best accessed through a diverse set of active managers. In this report, we will outline some of East West’s key philosophical and practical views on manager selection.
In the interest of brevity and sanity, we are not going to delve too deeply into the thorny debate between active versus passive investing – at least not in the public markets. Suffice it to say, investors are voting with their wallets: Bloomberg reports that passive US equity funds’ assets will likely eclipse their active counterparts in 2019. One can observe the trend towards passive vehicles in the Morningstar graph below (passive in blue).
Given the limited dispersion between top-performing and mediocre managers in public markets, the shift is easier to understand. Even more so when coupled with the outsized fund management fees inflicted on investors.
The picture changes, however, when assessing the performance dispersion amongst active managers on the alternative asset side: it makes intuitive sense that managers might add more tangible value in less efficient markets. Cambridge Associates provides a clear picture of the dichotomy between active manager value-adds in long-only and alternative asset strategies.
As most readers know, at East West Investment Management we advocate replacing traditional bond exposure with Alternative Yield strategies. As we wrote in our report, “Too Late to Stop Now – The Case Against Bonds”, investors likely face low future real returns or, potentially, sizeable capital losses on traditional bond holdings – in other words, an unappealing risk/reward setup. In a subsequent report, “Canadian Alternative Yield Universe”, we outlined four broad categories within that universe: private lending, real asset, credit, and specialized funds. We believe that thoughtful allocations in these areas will meaningfully outperform traditional fixed-income products.
Having established that we wish to allocate to the Alternative Yield universe, we seek out managers that: generate high running yields; provide real capital growth; increase real diversification within each sub-category (e.g., private lending: mortgage (commercial/residential/construction), factoring, ABL, venture debt, etc.); exhibit limited correlations both to public markets and to other managers in the portfolio; produce meaningful tax efficiencies; and protect capital with tangible collateral, covenants, and hedges. Our ultimate selection is determined by macro considerations, individual manager characteristics, and specific client considerations. Put simply: when macro factors warrant a strategic allocation, we implement the strategy using diversified, seasoned managers who have an excellent track record of adding alpha.
Macro Considerations in Selection
The macro environment influences our allocation decisions and the characteristics of managers whom we include in our Alternative Yield strategies.
For example, last year we became broadly concerned about the credit space. At that time, East West published a research report, “Time for a Reassessment of a Popular Hedge Fund Strategy”, which focused on credit funds. Our view was that it was much easier to post positive returns when credit funds could ride the lift that all corporate bonds received relative to the risk-free rate. Considering the risks posed by the concern that the economic cycle was potentially nearing its end, we argued that credit spreads were trading too tightly. This would result, we believed, in some combination of material underperformance as well as funds assuming more risk (through additional leverage and lower-rated bonds).
We reduced clients’ exposure to credit strategies concurrent with the publication of the report. The graph above represents the average of five Canadian-based credit managers that East West actively monitors and validated our decision.
Our approach to selecting real asset managers conforms to our macro position as well: Asset prices have become broadly inflated driven by low real interest rates, and longer-duration assets are at greater risk of a correction. (For example, see the chart on declining cap rates in the Vancouver real estate market below). In this category we need to be judicious on where we allocate. For instance, we have allocated to a private REIT that focuses on apartments and student housing in secondary as well as tertiary markets, where valuations are less stretched and there is an undersupply of housing. The manager adds tangible operational value through property improvements and reduces costs across the portfolio through economies of scale. In many cases, rents lag area averages, which provides an additional margin of safety. These strong mitigating factors have allowed us to allocate capital to this real asset space.
Similarly, as we believe we are in the latter stages of the market cycle, we prefer to be higher up in the capital structure. This fuels our preference for private lending managers that assume senior, secured debt. A similar protection mentality has informed our allocation to a SPAC manager that offers cash-backed principal protection and a call option to capture equity upside.
In short, the manager selections and allocation sizing in our Alternative Yield portfolios reflect macro considerations.
Individual Manager Selections
Taking a holistic approach to evaluating managers allows us to assess their return profile both individually and as part of a portfolio – we find the whole is often greater than the sum of its parts. We consider the following parameters.
The discipline of yield is central to our strategies. Consistent cash flows provide a counterweight to equity market volatility. Predictable cash injections enable clients to avoid liquidating equity positions during periods of underperformance, particularly for those relying on passive income to meet lifestyle needs, and to take advantage of buying opportunities. This is the fixed income ballast that reasonable bond yields offered in previous years.
As we discuss later in the context of manager track records, stable yields also provide a useful indicator of manager performance given undynamic underlying asset valuations.
Our Alternative Yield strategies utilize managers that deliver solid and consistent real returns. The drivers of these returns are multifold and include exploiting inefficiencies, rightsizing strategies, and managing costs.
We need to understand the nature of private market inefficiencies and how managers sustainably profit from them. Contrast a public bond with an asset-backed loan made to a private corporation. In the former, rating agencies delineate between investment grade and non-investment grade bonds – noting gradations within each category – and the markets price them accordingly (arguably, efficiently). One might debate the wisdom of the rating agencies’ assessment. Still, the fact remains that market participants can make judgements based on readily available data.
When assessing a private loan, there is less transparency: we need to believe that the manager is reasonably valuing the collateral (both at issuance and over the term of the loan), accurately evaluating the borrower’s capacity to service the debt, and accounting for exogenous factors that could impair successful repayment. Of course, since such a transaction is negotiated privately, the lender likely sets a rate comfortably above a high-yield bond with much more robust collateral and covenants.
The manager benefits from information sourced through their networks. The skills and relationships of the team necessarily determine a significant portion of the value-add that a manager delivers in an inefficient market. Experience provides key decision makers with perspective when making decisions.
Assessing managers ability to take advantage of idiosyncratic markets ultimately adds alpha to Alternative Yield portfolios’ total returns.
A prejudicial embrace of liquidity at any cost may explain certain investors’ preference for investing in public rather than private markets. We also believe that forgoing some liquidity can add up to 5% return per annum. The notion of a “liquidity premium” is often misunderstood. Indeed, it is one of the last significant inefficiencies available in the capital markets.
We do not position our Alternative Yield strategies as money market replacements or cash equivalents; rather, we maintain that they are appropriate substitutes for traditional fixed income holdings. Our team constructs Alternative Yield portfolios that match each client’s liquidity requirements: a family that needs to draw down their portfolio in the medium term will have a different asset mix than one investing for future generations. Including short-duration private loans (factoring as an example) with more liquid credit strategies can help in improving the overall liquidity profile of an Alternative Yield portfolio.
Managers that add tax efficiency can materially improve the risk/reward equation. At East West, we consider after-tax returns. Strategies that utilize return of capital and capital gains are generally more attractive.
Integrity and Track Record:
Managers need to demonstrate integrity. Putting a significant portion of their own investable assets into the fund they manage, their reputation in the financial community, references, and a long term history of relationships are good indicators. Conducting site visits, regular reporting, and spotless regulatory records help. Trust but verify.
Reasonably evaluating managers’ track records is an important part of our diligence. Traditional measures of risk-adjusted performance are applicable to certain strategies. For instance, the Sharpe ratio equates risk with volatility. Accordingly, a higher number illustrates a manager’s capacity to deliver strong returns with muted volatility. It is a reasonable quantitative tool for assessing the relative strengths of credit funds and other managers trading in mark-to-market instruments – as we wrote in a previous paper, it helped attract us to a Special Purpose Acquisition Company (SPAC) manager.
Sharpe ratios are misleading metrics, however, in fairly measuring risk/return for many private market participants. For example, a private REIT periodically values its assets and, since the holdings are not actively traded, makes assumptions about their fair value (rarely showing meaningful markdowns); the Sharpe ratios would be off the charts and investors would be offside in relying on them. We assess risk in these scenarios based on the probability of permanent loss of capital and the potential impairment to distributions. As noted, the discipline of yield is one mechanism to ensure that at least cashflows are effectively marked to market.
Managers understandably present returns in the most favourable light. In strategies involving capital calls and irregular distributions, many funds calculate IRRs (Internal Rates of Return) on deployed capital. That may be appropriate for clients who use leverage (i.e. a line of credit); however, for clients investing out of cash, we assess returns on committed capital – more accurately reflecting the capital call structure’s cash drag.
Risk and Collateral:
We consider a manager’s investment strategy risk as well as their operational risk. As mentioned, in less liquid strategies, we are especially focused on the possibility of permanent capital losses and cash flow inconsistency. For example, one of the private lending managers we allocate to insists on double-collateralization in the
form of two separate (and generally uncorrelated) assets, which provides a level of comfort.
Managers also need to demonstrate operational capacity. Robust and cohesive teams help mitigate key person risk. We look at alignment both with investors and within the team through managers’ incentive structures. A related consideration is infrastructure, both human and operational. Certain strategies, such as complex lending and leveraged trading require an extensive risk management team.
East West’s Alternative Yield strategies, which replace traditional bonds, exhibit low correlation (beta) with public markets. As we wrote in our study, “The End of an Era”, in November 2018, the broadly accepted principle of a negative correlation between stocks and bonds may no longer hold. Beyond asset class choices, individual manager selection plays a vital role in creating a truly differentiated return stream.
We use quantitative metrics from managers alongside our own analysis to assess the beta between a strategy and public markets. Our allocations also seek to reduce correlations between each manager’s return drivers.
Managing the correlation amongst managers further differentiates the return stream and creates more reliable cash flows.
Unique Client Considerations:
Bespoke client portfolios need to reconcile manager choices with individual investors’ or families’ profiles. We can focus on a higher running yield to match a client’s cash flow needs and match funds’ liquidity profiles with a client’s requirements. We are also cognizant of diversification and correlation in the context of a family’s other investments and/or operating businesses. The risk profile of the portfolio and of the client also need to align. Our strategies’ muted volatility tends to help clients sleep more soundly.
We believe that for Canadian investors and families, accessing the Alternative Yield universe through underlying fund managers, rather than (or in addition to) direct allocations allows for more efficient capital deployment – the ability to access a much wider universe of underlying assets/strategies.
Indeed, families and individual investors are uniquely positioned to access outperforming Alternative Yield mangers. Large institutional investors, on the other hand, such as pension plans and insurers, more easily move markets and are unable to make reasonable allocations to capacity-constrained strategies that move the needle for their portfolios.
This report outlines our philosophical views and some key considerations (but not an exhaustive list) of East West’s manager selection criteria. Employing a holistic approach to capital deployment, East West selects top-tier managers to access inefficient markets. Dispersion of returns amongst alternative asset managers underscores the importance of thoughtful manager selection and de-selection. We capitalize on the idiosyncratic challenges and opportunities in the Alternative Yield universe to generate consistent absolute returns through diverse portfolios at both the macro and individual fund manager levels. Since its creation, the East West Alternative Yield Fund Model Portfolio has never returned less than 9.5%.
Each individual component of the strategy is robust and the portfolio in the aggregate is stronger and less correlated than the sum of its parts. Strong protections for capital, stable cash distributions, and low correlations make our Alternative Yield strategies a compelling replacement to a high risk/low reward traditional bond portfolio.
 East West Investment Management does not provide tax advice. Clients should consult with their tax advisors/accountants regarding taxation matters.
 East West Investment Management does not provide tax advice. Clients should consult with their tax advisors/accountants regarding taxation matters.