Illiquid assets, liquid vehicles

Putting illiquid assets into investment companies makes them easily tradeable. But to what extent does it dilute their diversification benefits? Nick Britton examines.

The rapid growth in investment companies that target alternative assets is one of the most remarked-on trends in the industry over the past decade. Much of the growth is down to investors’ hunger for yield, which is so voracious it can barely be met by traditional assets such as equities and bonds.

But there is another less talked-about benefit of investing in alternatives, which is diversification.

It is argued that assets such as property, infrastructure projects and even aircraft can provide returns less correlated to equities, helping to dampen volatility across a portfolio. With several ‘alternative’ AIC sectors now approaching their tenth anniversary, or celebrating it this year, I thought it might be a good time to take a look at how far these benefits of non-correlated returns have been delivered.

It’s a fair question to ask, since depositing these assets within an investment company might be expected to make them behave more like equities. To put it another way, the equity ‘wrapper’ of an investment company provides convenient access to illiquid assets, making them easy to trade, but to what extent does it also dilute the expected benefit of less correlated returns?

I have looked at the correlations of investment companies investing in illiquid assets with the FTSE All Share over the past five years – ignoring all those less than five years old. The results are summarised below, with the UK Equity Income sector included for the purpose of comparison.

AIC sector (no. of companies with five-year history)

Average correlation with FTSE All Share

Sector Specialist: Infrastructure (5)

0.18

Property Direct – UK (5)

0.20

Sector Specialist: Debt (5)                       

0.21

Private Equity (18)

0.27

UK Equity Income (22)

0.70

Source: AIC using Morningstar (five years to 31/8/16, based on monthly share price total returns, ex-3i)

It seems these asset classes are still delivering returns with a low correlation to equities, even within an equity wrapper. Private equity shows the highest degree of correlation, which isn’t surprising when you consider that it is closest in nature to quoted equities. Returns depend largely on the ability of companies to grow their profits, though the means used to unlock those returns is different.

Infrastructure shows the least correlation, which again is no surprise – there is little relationship between the fortunes of quoted companies and the government-backed income streams from the contract to maintain a motorway or build a hospital. It is conceivable both might be affected by a third factor, such as a rise in interest rates, but less likely they would be affected in the same way at the same time.

The result for the Property Direct – UK sector is interesting. You’ll sometimes hear closed-ended property funds criticised on the assumption that they fail to provide the benefits of diversification that investors want from property, instead delivering equity-like returns. Yet the correlation between closed-ended funds investing in UK property and UK equities over the past five years is minimal.

I chose a five-year window for looking at these correlations for the simple reason that not many companies in these sectors (with the exception of private equity) have been around longer than five years. But five years is a short time in investment companies, barely fit to be considered long term – and importantly, excludes the financial crisis, when correlations between asset classes spiked.

If we extend the window to ten years, it doesn’t make much sense to talk about sector averages, but we can look at the few individual companies that have been around for that long. For the Private Equity sector, I have included the five biggest companies with a ten-year history. I’ve also added the biggest three UK equity funds for comparison purposes.

Company

AIC sector

Correlation with FTSE All Share (last 10 yrs)

Correlation with FTSE All Share (last 5 years)

Real Estate Credit Investments

Sector Specialist: Debt

0.22

0.30

Standard Life Investments Property Income

Property Direct – UK

0.31

0.09

F&C UK Real Estate Investments

Property Direct – UK

0.31

0.14

HICL Infrastructure

Sector Specialist: Infrastructure

0.33

0.07

Schroder Real Estate

Property Direct – UK

0.34

0.28

F&C Commercial Property

Property Direct – UK

0.38

0.31

HgCapital

Private Equity

0.44

0.30

Electra Private Equity

Private Equity

0.46

0.58

Standard Life European Private Equity

Private Equity

0.47

0.24

Pantheon International

Private Equity

0.51

0.34

ICG Enterprise

Private Equity

0.59

0.42

Edinburgh Investment

UK Equity Income

0.71

0.62

Mercantile

UK All Companies

0.73

0.59

City of London

UK Equity Income

0.86

0.91

Source: AIC using Morningstar (to 31/8/16, based on monthly share price total returns, ex-3i)

Again, infrastructure and debt, being fixed-income asset classes, show low correlation to equities, at least for the two examples with a ten-year history. And again, it’s private equity that has the highest degree of correlation.

In almost all cases, the correlations do tend to be higher over ten years than five years, no doubt partly due to the financial crisis when there was plenty of blanket selling of equities across the board (tracker funds are clearly a factor, particularly for investment companies that find their way into the FTSE 250). Nevertheless, the correlations do remain fairly low especially for UK property funds – perhaps surprising when we remember how hard property was hit by the financial crisis and how strongly it bounced back afterwards.

Though there may be short periods when diverse assets move in step with each other, this perhaps shouldn’t bother the long-term investor. If you can avoid being a forced seller, there is ample evidence to suggest that closed-ended funds investing in illiquid assets provide precisely the sort of diversification benefits you would expect, with the added advantage of being able to get in and out when you want to.