Download Deepening diversification in trust portfolios

June 2015
Deepening diversification in trust portfolios
with alternative investments
Leo M. Zerilli, CIMA
Head of Investments
John Hancock
Investments
As banks embrace open
architecture investing in
earnest, alternative
investments are playing
a more prominent role
in client trust portfolios.
Key takeaways
ƒƒ For more than 60 years, alternative investments have provided investors with
differentiated sources of returns and risk management beyond those available
through traditional stock and bond strategies.
ƒƒ Until recently, many bank trust departments have managed client portfolios almost
exclusively with proprietary equity and fixed-income offerings, a long-standing
practice reinforced by a historically conservative culture.
ƒƒ However, the market’s demand for open architecture has prompted many banks to
tap the specialized expertise of external asset managers, particularly those proficient
in alternative investments, for trust department and wealth management platforms.
ƒƒ Today, when contemplating potential managers, bank trust departments first seek
those that can adhere to a consistent investment philosophy, a prerequisite that we,
as a manager of managers, share at John Hancock Investments.
Executive summary
Since the middle of the last century, what we now call alternative investments have provided capital market participants with
unconventional sources of return along with risk management techniques beyond those available through stocks and bonds alone.
Once exclusive to institutions and other accredited investors, alternative investment strategies have recently drawn a much broader
following through liquid and easily accessible vehicles such as 1940 Act mutual funds. While university endowments and corporate
defined benefit pension plans have made extensive use of alternatives for years, bank trust departments have historically emphasized
proprietary products, which have tended to focus on more traditional equity and fixed-income investments. Still, the market for bank
trust asset management services has grown more insistent upon open architecture arrangements since the financial crisis. In recent
years, clients have sought more specialized, innovative styles of investing approaches that target specific portfolio goals. Bank trust
officers have responded to the market’s demand and have increasingly embraced external managers that have demonstrated an
ability to apply a consistent philosophy to alternative investing, a trait that becomes more important as the mandate becomes less
conventional. If implemented properly, one can make a strong case for the merits of alternative investment exposure within trust
portfolios. Indeed, bank trust officers are now incorporating liquid alternative investments into client portfolios to help address gaps in
traditional asset allocation that fail to address current market challenges such as stock market volatility, low bond yields, and high
correlations across investments of all types.
History of alternative return sources, risk management techniques
At the most basic descriptive level, alternative investments are
strategies other than long-only stock and bond styles. The chief
virtue of alternative investments is that they do not necessarily
move in sync with the traditional assets that dominate most
portfolios. Because they tend to behave differently than stocks
and bonds, alternative investments are typically used to
address a specific need, such as greater diversification. Some
alternative investments have an explicit return-seeking
mandate, designed to supercharge a portfolio’s performance.
However, most of the alternative investment styles we’ll discuss
in the context of bank trust portfolios actually seek to hedge or
limit certain market risks and therefore emphasize volatility
control and consistency of returns rather than attempting to
amplify them. In pursuing the strategy of the tortoise rather
than that of the hare, it’s this latter group that seeks success
through the compounded effect of a consistent, albeit modest,
return stream over time.
Alternatives to long-only stock and bond investments are not
new. The hedge fund traces its roots to 1949, when Alfred
Winslow Jones formed an investment partnership that included
leverage and short selling, techniques designed to generate
returns while reducing market risk. Jones was ahead of his time;
these types of private partnerships, which sought total return
while hedging the risks of market declines, didn’t gain traction
until the 1980s. Early adopters of alternative investments
included charitable foundations, defined benefit pension plans,
insurance companies, and other institutional investors.
Already enthusiastic, university endowments’ appetites for
alternatives grew even more voracious following the 2000
publication of Pioneering Portfolio Management, by David
Swensen, Yale University’s chief investment officer. Swensen
argued that an endowment fund—designed to support the
scholars of today and tomorrow with intergenerational
­neutrality—has an inherent advantage over other types of
investors. Endowments can invest with a time horizon extending
into perpetuity. This makes it possible for Yale and its peers to
fund large allocations to alternatives, including illiquid assets
such as private equity, venture capital, and direct real estate.
Such investments offer the potential to capture an illiquidity
premium, which compensates an investor for holding an asset
that lacks an active trading market. Investing in alternatives
proved an enduring trend in higher education. Today, the
average university endowment has the majority of its assets
allocated to alternative strategies.
Alternatives have displayed different patterns of returns than those of the broader market
Rolling 12-month return
60%
n S&P 500 Index
n HFRI Macro Index
30
0
–30
–60
2
5/01
5/02
5/03
5/04
5/05
5/06
5/07
5/08
5/09
5/10
5/11
5/12
5/13
5/14
5/15
Source: Morningstar, as of 5/31/15. For illustrative purposes only. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The HFRI Macro
Index is a benchmark designed to reflect macro hedge fund industry performance by constructing equally weighted composites of constituent funds, as reported by the hedge fund managers
listed within HFR Database. Macro investment managers trade a broad range of strategies in which the investment process is p­ redicated on movements in underlying economic variables and
the impact these have on equity, fixed-income, hard currency, and commodity markets. Managers employ a variety of techniques, both d­ iscretionary and systematic analysis, combinations of
top-down and bottom-up theses, quantitative and fundamental approaches, and long- and short-term holding periods. It is not possible to invest directly in an index. Past performance does
not guarantee future results.
replaced HFRI data w/new file
June 2015
Endowment fund asset allocation in 2014
The rise of liquid alternatives
Survey of 831 universities
As we know from 2008, traditional stock and bond asset
allocation has not always provided investors with sufficient
insulation against market volatility. During the global financial
crisis, correlations—measurements that show the relationship of
one asset’s price movement to another’s—across the capital
spectrum surged as all but the safest investments declined en
masse. The breadth, scale, and speed of wealth destruction
prompted many investors to question age-old assumptions
about diversification. While 2008 may have been an anomaly,
taking a multidecade view of the market’s behavior reveals that
big moves within a single trading session have been on the rise
for some time.
100%
80
58% Alternative strategies
60
40
17% International equities
20
13% Domestic equities
7% Fixed income
0
5% Short-term securities
Source: National Association of College and University Business Officers, 2014.
Unlike a university endowment, the average person has a finite
investment horizon, and a prolonged lockup period is not a
viable option for most individual investors. Fortunately, not all
alternative investments rely on an illiquidity premium to drive
their returns. Opportunities to introduce alternative investments
into the portfolios of individual investors have expanded in
recent years with the migration of high-quality managers from
the hedge fund arena to that of the 1940 Act mutual fund.
Elevated volatility during and after the crisis has made it more
difficult for the average investor to stick with an investment
plan. Studies have shown that long-term investors respond to
sharp market drops by switching portfolio holdings. Emotion
often dominates investor behavior, and research suggests that
the fear of further losses often motivates investors to sell near
market bottoms, an impulse that can turn a temporary bout of
market volatility into a permanent portfolio loss. Fund researcher
DALBAR, Inc., publishes an annual study that puts the average
holding period for stock and bond mutual funds at little more than
three years. The result of all this gratuitous, ill-timed trading is that
investors, on average, underperformed broad market indexes.
Recognizing an unfulfilled need for risk-reducing strategies in
the wake of the global financial crisis, a number of talented
hedge fund managers and mutual fund families began working
in partnership to offer alternative investments to individual
investors. Today, many liquid versions of strategies that were
Traditional vs. alternative investments: some generalizations for bank trust portfolios
Traditional investments
Alternative investments
Limited to long stock and bond ­positions
Can include derivatives, short sales, and leverage
Deliver a wide range of possible results
Aim for a target range of outcomes
Return oriented
Risk managed
Underscore the magnitude of returns
Emphasize consistency of returns
Market return dominates the result
Manager skill dominates the result
3
Stock market volatility has become more prevalent in recent years
Number of trading days per year with returns +/– 2% (S&P 500 Index), 1950–2014
80
70
60
Trading days
50
40
30
Volatility regimes increasing
Global economic dislocations
and greater connections
between markets around the
world have led to more trading
days with big market swings.
20
10
0
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2014
Source: Morningstar Direct, 2014. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index.
Past ­performance does not guarantee future results.
successful within hedge fund structures are now available to a
broader audience of investors through 1940 Act mutual funds.
Managers of these liquid alternative investments are able to
execute hedge fund-like strategies without many of the risks
inherent in hedge funds, such as lockup periods, a lack of
transparency, little regulatory oversight, excessive leverage,
and illiquid holdings. Alternative styles that lend themselves
well to mutual funds include those with a volatility-dampening
aim such as absolute return, currency management,
global macro, long/short equity, listed infrastructure, and
multi-alternative allocation strategies.
As U.S. equity market valuation measures look fuller with each
new record high, and with 2008 still a vivid memory, mutual
fund investors are taking notice. In fact, the alternatives category
is the fastest-growing segment of the mutual fund market today,
with several hundred unique alternative i­nvestment offerings
now available. In 2008, alternative mutual fund asset levels
were negligible; today, liquid alternatives are approaching an
aggregate $300 billion in assets across the alternative categories
that Morningstar tracks.1 Morningstar estimates that net inflows
to alternatives totaled more than $20 billion in 2014 alone.2
4
Industry researchers Cerulli Associates and Strategic Insight
predict substantial growth in liquid alternative assets
over the next several years. According to Strategic Insight,
liquid alternatives may reach $490 billion by 2018. Cerulli’s
estimates suggest alternative mutual funds may represent
10% of the industry’s assets before the end of the decade,
up from the current 3%.3
Growth of liquid alternative funds over three decades
Number of alternative mutual fund offerings
500
400
300
200
100
0
1985
1988
1992
1996
2000
2004
2008
Source: Strategic Insight, Forward, and Morningstar, as of 6/30/14.
2012
2014
June 2015
Mutual fund vs. hedge fund structures
Structure
Mutual funds
Limited partnership hedge fund
Liquidity
Daily
Varies—lockups are common
Typical fees
1%–2%
2% + performance incentive
Transparency
High
Low to none
Regulation
High
Low
Investment minimums
Low
Often high
Accredited investor
No
Yes
Lower
Unrestricted
Form 1099
Schedule K-1
Leverage
Taxes
Conservative culture, proprietary offerings yield to open architecture
Despite their growing accessibility and prevalence, alternative
investments have lacked a strong presence in the market for
bank trust asset management services. Steeped in tradition and
approaching change carefully, private banks have been cautious
in adopting alternative strategies, instead relying primarily on the
diversification potential of long-only stock and bond holdings
for client portfolios. Until recently, many bank trust departments
constructed client portfolios almost exclusively with proprietary
offerings—generally limited to traditional equity and fixedincome styles—managed by an affiliated fund family or by the
bank’s own internal investment staff. This long-standing practice
has been reinforced by the historically conservative culture
shared by most banks in the trust business.
However, growing competition from registered investment
advisors with a wide range of wealth management services has
put pressure on the bank trust channel. Additionally, according
to a Morningstar study of industry data conducted for the New
York Times, the majority “of the funds run by each of the four
largest banks in the business … have underperformed their
basic benchmarks over the last 10 years,” making an exclusively
proprietary approach to trust asset management less tenable
still.4 It’s hard for one investment firm to be good at all things,
and the market’s demand for a greater range of choice has
prompted many private banks to engage the specialized
expertise of unaffiliated external asset managers, particularly
those proficient in alternative investments. According to Cerulli
Associates, bank trust departments “have increasingly adopted
open architecture to offer their clients more products and
services and to maintain their fiduciary status.”5 As banks
embrace open architecture investing in earnest, alternative
investments are playing a more prominent role in client trust
portfolios. Cerulli’s research suggests that more than 80% of
bank trust executives expect to increase engagement with
third-party asset managers during the next 3 years. While 27%
of banks still maintain a largely closed architecture arrangement,
even those “use external managers for selective needs, such
as gaining exposure to alternative investments.”5 In essence,
many banks are beginning to acknowledge that meeting the
needs of today’s high-net-worth investors via trusts can be
accomplished through other channels as well; being a bank
trust organization is no longer a relevant differentiator in and of
itself. As banks grow more comfortable with open architecture,
they’re also gaining comfort with more complex investments,
including alternatives.
5
Bank trust approaches to third-party asset managers
36%
36%
27%
n C
ompletely open architecture
n L argely closed architecture,
but using external managers
for selective needs
n M
ix of open and closed
architecture
traits of alternative mutual funds may merit a higher fee.
For example, when contemplating an alternative exposure
for a trust portfolio, bank trust officers might consider the
­likelihood of the investment helping the portfolio achieve
one or more of a number of specific goals, including:
ƒƒ Lowering a portfolio’s correlation to the stock market
ƒƒ Improving portfolio performance potential in
a rising-interest-rate environment
ƒƒ Reducing manager concentration risk by diversifying
beyond the bank’s proprietary funds
Source: Cerulli Associates, 2013. Numbers are rounded and may not total 100%.
ƒƒ Weathering macroeconomic or geopolitical shocks
with resilience
Like any good fiduciary, bank trust officers owe portfolio
beneficiaries the duty of loyalty, acting with the care, skill,
and diligence of a prudent expert. This includes incorporating
a broad range of different investments when constructing
and maintaining a portfolio for a diversified investment mandate.
Conservative banking culture has historically fostered an attempt
to judge the merit of a particular holding on a stand-alone
basis; however, rather than evaluating an asset in a vacuum,
fiduciaries need to consider each investment in context, in light
of its role within the portfolio as a whole. This more holistic
view supports the inclusion of alternatives in the universe of
potential investments; indeed, because of their complementary
features, alternative investments may actually reduce a trust
portfolio’s aggregate level of risk.
Higher expenses for access to special investments that can
smooth returns in uncertain markets may be worth it; ultimately,
it’s the net result of the trust portfolio’s performance that
matters to the beneficiary.
Alternatives offer trust officers more tools to meet
fiduciary responsibilities
Fiduciaries have broad latitude in selecting, removing, and
replacing investments for discretionary trust portfolio mandates.
The main requirement for bank trust officers is to select investment
options through a prudent process that applies in prevailing
investment industry practices. Alternative investments have been
a part of the prevailing practice in other channels for years, if not
decades. With the growth of liquid alternatives, the prevailing
industry practices are now changing for trusts and individual
investors as well.
In acting solely in the interest of a client, a fiduciary has a clear
obligation to mind the costs of implementing an investment
program. While liquid alternatives tend to carry higher fees
than traditional mutual fund investments, certain distinguishing
6
Consistent philosophy is key
When searching for external investment talent, professional
manager research teams across the bank wealth management
channel look for portfolio teams with consistent investment
philosophies. A commitment to style purity is another crucial
factor. Over the years, through an exchange of best practices
with manager research professionals at banks across the
country, we’ve learned that most bank trust departments expect
their third-party managers to generate patterns of performance
consistent with their mandates, a core tenet of our investment
model at John Hancock Investments as well.
Indeed, with a unique manager-of-managers approach to
investing since 1988, John Hancock Investments is structured
for manager research and oversight, and our lineup covers
a range of traditional and alternative asset classes, with 104
investment strategies managed by 72 portfolio teams at 27
different asset managers around the world. With the insight
and resources of a diverse asset management network and
a commitment to financial stewardship, we manage nearly
$130 billion for bank trusts, individuals, and institutional clients
of all types—more than $15 billion of which is invested in
goal-­specific alternative and specialty investment mandates.
June 2015
In selecting managers, we outline an appropriate set of
­characteristics we call a performance blueprint—an objective,
measurable template for the patterns of risk and return that
we expect from a fund through different market conditions.
A key part of building that performance blueprint is isolating the
attributes that matter most. For example, when we analyze an
investment manager’s performance, we look at the underlying
factors that have driven those returns. We also examine how a
portfolio’s composition has changed over time and how the
manager’s allocation decisions have affected performance. This
kind of attribution analysis helps us gain deeper insight into the
strengths and weaknesses of a particular manager, which, in
turn, helps us understand what’s driving the results.
However, past performance, no matter how rigorously it’s
evaluated, is no guarantee of future returns, and relying too
heavily on historical data can cause one to overlook skilled
managers. Similarly, if we rush to replace managers for weak
short-term performance, there is a good chance we will miss
some long-term opportunities. We are likely to stick with
investment managers when they have periods of weak performance if we understand the reasons for those results. However,
we have replaced managers whose patterns of performance—
good or bad—proved inconsistent with their mandates.
In our efforts to serve the best interests of our fund shareholders
over the long term, we conduct direct, in-person meetings with
portfolio managers and seek to understand the risks they take
in order to achieve results. Face-to-face meetings with senior
decision makers help us assess critical items such as investment
process and culture and, by extension, judge the potential for
repeatability of past performance. Specifically, we work to
determine whether a manager’s strong historical returns are
simply a result of chance or if there is something else in place, be
it a superior philosophy, a winning team dynamic, or a proprietary
edge in the investment process that competitors don’t have.
Case studies in alternative manager selection
If alternative investments serve an important role in deepening
diversification of a portfolio, what is the best way for a trust
portfolio to benefit from them? We think an examination of our
approach to alternatives might be instructive. Using a­ lternative
and specialty investment strategies in asset allocation portfolios
for more than 15 years, John Hancock Investments manages
over $15 billion in alternative assets today.
One of the benefits of our model is that we can scour the globe
to find managers with the skills to manage a particular strategy.
As a manager of managers, we can go anywhere in the world to
find proven portfolio teams, an approach that now resonates
with more bank trust advisors as they seek to fulfill their
fiduciary obligations to their clients.
For example, our search for a uniquely qualified absolute return
manager led us to Standard Life Investments, based in Edinburgh,
Scotland. Standard Life Investments developed its flagship
absolute return investment strategy in 2005, and the firm is one
of the few absolute return managers with experience managing
the full range of market environments of the last decade.
Emphasizing risk management, the team can use a variety of
strategies designed to maintain a consistent performance target
through both up and down markets. This experience and record
in managing absolute return strategies were key factors in our
decision to select Standard Life to run John Hancock Global
Absolute Return Strategies Fund, which we launched in December
2011. The fund combines traditional sources of expected returns
such as broad market beta and security selection with more
advanced relative value and directional strategies, which have
the rare potential to make money in down markets. We expect
the fund to target positive returns over all market cycles with
significantly less volatility than global equities.
For investors seeking instant diversification across alternative
asset classes and investment strategies, John Hancock
Alternative Asset Allocation Fund is a bundled approach within
one portfolio. The industry-leading asset allocation team
we’ve hired at John Hancock Asset Management invests
with 16 underlying ­managers—including Standard Life
Investments—specializing in alternative markets, alternative
investment approaches, and absolute return strategies. For
return enhancement potential, alternative markets such as
those in global real estate or commodities provide exposure
to drivers of performance often unrelated to traditional stock
and bond holdings. For risk-reduction potential, alternative
investment approaches such as long/short equity or multi-sector
income use unconstrained, opportunistic strategies that can
tactically alter market-level exposure. And, as we’ve seen,
absolute return strategies offer diversification potential and
are designed to generate consistently positive returns in a variety
of environments.
7
Conclusion
Alternative investments have provided unconventional
sources of return and unique ways to manage risk beyond
those available through the traditional trust portfolio staples of
stocks, bonds, and cash. Once primarily limited to institutions,
alternative strategies have become popular with individual
investors through liquid vehicles, such as 1940 Act mutual
funds. While initially slow to adopt alternatives, bank trust
officers are beginning to turn to them for help in carrying out
their fiduciary responsibilities to trust beneficiaries.
The global financial crisis of 2008 and the migration of
talented hedge fund managers into the mutual fund world
have made bank trust officers more open to refining their
recommendations by incorporating alternatives into client
portfolios. In our view, the most appropriate way to approach
alternative investments is with an asset allocation mindset.
1 Josh Charney, alternative investments analyst at Morningstar, Ignites exclusive interview, 6/19/14.
2 “Morningstar Direct U.S. Asset Flows Update,” Morningstar Direct, 1/14/15.
3 “Alts to Move From Fringe to Core, Fueling Growth: Cerulli,” Ignites, 5/14/14.
4 ”Wall Street Banks’ Mutual Funds Can Lag on Returns,” the New York Times, 4/12/15.
5 The Cerulli Edge, U.S. Asset Management edition, October 2013.
Diversification does not guarantee a profit or eliminate the risk of a loss.
Portfolios that have a greater percentage of alternatives may have greater risks. The fund’s performance depends on the advisor’s skill in determining asset class allocations, the mix of underlying funds, and the performance of those underlying funds. The fund is subject to the same risks
as the underlying funds and exchange-traded funds in which it invests: Stocks and bonds can decline due to adverse issuer, market, regulatory,
or economic developments; foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and
political and social instability; the securities of small companies are subject to higher volatility than those of larger, more established companies;
and high-yield bonds are subject to additional risks, such as increased risk of default. Certain market conditions, including reduced trading
volume, heightened volatility, and rising interest rates, may impair liquidity, the ability of the fund to sell securities or close derivative positions
at advantageous prices. Currency transactions are affected by fluctuations in exchange rates. The fund’s losses could exceed the amount invested
in its currency instruments. Please see the fund’s prospectus for additional risks.
A fund’s investment objectives, risks, charges, and expenses should be considered carefully before investing. The prospectus
contains this and other important information about the fund. To obtain a prospectus, contact your financial professional,
call John Hancock Investments at 800-225-5291, or visit our website at jhinvestments.com. Please read the prospectus
carefully before investing or sending money.
Connect with John Hancock Investments:
@JH_Investments | jhinvestmentsblog.com
John Hancock Funds, LLC Member FINRA, SIPC
601 Congress Street Boston, MA 02210-2805 800-225-5291
jhinvestments.com
NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE. NOT INSURED BY ANY GOVERNMENT AGENCY.
MF234061
ALTSBTWP 6/15