Funds that promised diversification look worryingly vulnerable to rising market volatility.
I’ve been a fan of the ideas behind alternative funds for a while. They invest in everything from renewables to aircraft leasing, offering investors a steady income plus the promise of diversification (ie, the shares should go in a different direction to mainstream markets). Unfortunately, in recent months, we’ve started to see signs of systemic trouble throughout the sector.
The first hints came in late 2017 when many big peer-to-peer funds failed to hit their dividend targets. Then came the sell-off of infrastructure funds earlier this year amid fears a possible future Labour government might renege on financing deals.
More recently we saw a meltdown at alternative lender Ranger Direct Lending – a new board was put in place to wind the fund down after unexpected losses emerged at one of its lending platforms.
This reliance on ‘trusted’ partners who then fail is an issue seen in other alternative sectors, as we’ll see. Ranger’s travails also highlight another challenge common to several alternative lenders – after the first few years, we start to see a cross-section of loans going bad, which encourages investors to sell out, leaving the funds to trade at chronic discounts to book value.
Social housing is another troubled area. Several investment trusts have raised money to invest either in supported living or affordable housing. From a political perspective I applaud this, but these funds have always traded on a misconception – that the UK government stands behind all the cash flows. Yes, the government is on the hook for the rental payments, but in recent weeks a number of smaller housing associations (mainly focused on supported living) have run into trouble.
Regulators have intervened and the funds that have worked with these associations have had to take a hit to net asset values. Notice the common theme – the risks of working with “trusted” partners to deliver investor outcomes.
But the biggest meltdown has been in a fund called Catco, which promised an income from underwriting reinsurance contracts, based around catastrophe insurance. The fund is only on the hook if losses from big disasters shoot past, say $5bn. Otherwise, existing insurers and reinsurers have to pay. It apparently offered true diversification – there’s no reason for natural disasters to correlate with stockmarket cycles. So institutional investors piled in, hoping that recent hurricane losses would drive up premiums and dividend payouts.
But in the past week or so that narrative has crumbled. First, the fund admitted to heavy losses from the Californian wildfires. Then the bombshell – regulators were looking at how the managers had been reserving losses. The recently issued C-shares have slid in value and investors must now be starting to ask whether the fund should be wound up.
What are the common themes here? The first is that investors have focused on the wrong risks – tending to worry about liquidity rather than more obvious risks. Infrastructure assets depend on government policy and public sector agencies. In Catco’s case, the intensification of damage claims in the developed world from natural disasters has been obvious for years. As for lending, who can say they’re surprised when lenders default? The problem is that managers don’t detail “worst-case scenarios”, which frequently turn out to be rather more likely than investors realise.
The other problem with these funds is that institutions often already have the best assets; retail-orientated funds get the leftovers, which often go sour quite quickly. Expect fears over alternative funds to intensify as we head into a more volatile market environment – which of course, is exactly when these funds are supposed to be providing diversification.
Swiss automation company ABB will sell a majority stake in its Power Grids division to Japan’s Hitachi and return the proceeds to shareholders, bowing to pressure from Swedish activist investor Cevian, says Reuters. The acquisition of the $11bn unit, which makes transformers and converters, will make Hitachi one of the largest players in the power-grid industry, while allowing ABB to offload its least profitable division and focus on automation instead. However, the decision to sell the unit represents “a U-turn” for ABB’s chief executive, who just two years ago ignored calls to sell from shareholders such as Cevian. Cash proceeds of as much as $7.8bn from the deal will be returned to shareholders via buybacks or similar means, says ABB.
Short positions… the investment trust of the year
• Nick Train’s Lindsell Train investment trust was the best-performing closed-ended fund in 2018, according to the Association of Investment Companies, says Jayna Rayna in Investment Week. The trust was up 44.5% between the start of the year and the end of November. The top-performing sector was biotech and healthcare, which returned 16.9% for the 11-month period, and was the only sector to have more than one trust in the top ten. The £1.7bn Syncona trust was up 31%, while the £410m BB Healthcare trust, launched two years ago, returned 23%.
• The share prices of traditional fund managers were hammered in 2018, says Chris Flood in the Financial Times. In the toughest year for the investment industry since the financial crisis, listed European asset managers have fallen by roughly 27% in dollar terms, while US firms are down 24%, according to figures from data provider Refinitiv.
• China’s clean-up of its shadow-banking system is fuelling a record number of liquidations in its $1.9trn mutual-fund market, says Bloomberg. More than 600 funds have been closed this year, surpassing all liquidations in the previous 12 years combined. The Chinese government’s crackdown on entrusted loans (a way for cash-rich companies to lend to other firms by using banks as middlemen, but which has often involved banks using the process to make the loans themselves to risky borrowers), the number two source of shadow banking, as well as an ailing stockmarket, have contributed to the record liquidations, according to analysts from Morningstar and Z-Ben Advisors.