Property Crushes Hedge Funds in Alternative Markets
“Why would anyone invest in the stock market?”
Hamilton “Tony” James looked up from his notes and peered out at the audience over the rims of his glasses. The investors seated in the chandelier-adorned meeting room of New York’s Waldorf-Astoria hotel had been in their chairs for hours. Yet James paused to let his point sink in. Someone laughed. James, president since 2005 of Blackstone Group LP (BX), was stone-faced.
The occasion was Blackstone’s third annual investor day, Bloomberg Markets magazine reports in its August issue. The firm is the world’s largest manager of so-called alternative investments, with $218 billion under management. It runs private-equity funds and hedge funds, invests heavily in credit securities and owns vast expanses of real estate. One of its properties is the Waldorf itself.
When James finally answered his own question about stocks, he told the audience they were a fool’s game compared with Blackstone’s investment funds, which have returned at least 15 percent annualized during the past 26 years, according to the firm. A good investment lately is Blackstone. The firm’s shares returned 89.4 percent during the 12 months ended on June 10, while still trading below their initial offering price in 2007.
Alternatives such as those managed by Blackstone have gained in popularity during the past 20 years as investors searched for alpha -- returns uncorrelated with and higher than those offered by the broad stock and bond markets.
The people who run companies specializing in alternatives - - including billionaires such as Steve Cohen, Henry Kravis, John Paulson and Blackstone co-founder Steve Schwarzman -- have become celebrities. Assets overseen by hedge funds alone increased to $1.87 trillion this year from $118 billion in 1997 -- much of it from pension funds, endowments, family offices and sovereign-wealth funds.
Virtually every alternative category crashed in the financial meltdown of 2007 to 2009 -- none more severely than property, with housing and commercial real estate prices falling as much as 40 percent.
Yet as markets have recovered, it’s real estate that has led the way. The sector dominates Bloomberg Markets’ ranking of alternatives, which shows that real estate investment trusts -- which pool investor money to buy property and are sold like stocks -- have gained more than any other alternative category in the past three years. Large-capitalization REITs returned 17.3 percent annualized in the three years from March 31, 2010, to March 28, 2013, besting private equity, which returned 15.2 percent.
To find the best-performing unconventional investments, Bloomberg searched its own indexes covering hedge funds, funds of funds, commodities and REITs. Bloomberg’s Rankings team also drew on outside indexes in search for the best-performing private-equity funds and collectibles, such as vintage cars, stamps, contemporary art and wine.
The best bets ranged from corn and silver futures, which returned 33.8 percent and 20.5 percent annualized over three years, to a Chateau Pavie Bordeaux and a 1957 Ferrari 250 Testarossa, which recently sold for $16.4 million.
Among the worst-performing alternatives were hedge funds, which returned 3.3 percent, and funds of hedge funds, which lost money overall. Most alternatives struggled to beat the Standard & Poor’s 500 Index (SPX), which returned 12.7 percent annualized over the three years ended on March 28 and was up more than 15 percent this year as of July 10.
James says that investing in alternatives makes sense even when they underperform.
“If you can put a bunch of money into these idiosyncratic investments, then you get a lot of diversification benefit because the returns are very uncorrelated” to the broader markets, he says, speaking from his office 44 floors above Park Avenue in Manhattan. “So even though you are putting a riskier asset in your portfolio, because it’s not correlated with everything else that you own, the portfolio volatility actually comes down.”
For investors in real estate and REITs, valuations fell further and faster than other assets and have in the past three years jumped higher than the S&P 500.
“If you wind the clock back to 2009, real estate had just been through a tremendous crash that helped bring down the global economy,” says Bob Rice, managing partner at New York-based merchant bank Tangent Capital Partners LLC and author of “The Alternative Answer” (HarperBusiness, 2013). “Things that are way down are going to come back. On top of that, central banks have given people a prevalence of cheap money to borrow and get back into alternatives such as real estate.”
Glimcher on Top
The return of consumer confidence has helped drive up REIT share prices by sending shoppers back to the stores. REITs that invest in shopping malls boasted the best performance for the three years ended on March 28, with an annualized return of 25.3 percent, according to data compiled by Bloomberg. Leading the list of best-performing mall investors was Michael Glimcher, whose Columbus, Ohio-based Glimcher Realty Trust (GRT) gained 38 percent.
Other categories of REITs that produced 20 percent-plus three-year annualized returns included self-storage units, industrial plants, health care, retail and Asian real estate.
Although REITs are still largely a U.S. phenomenon, they’re also a growing asset class in Europe and Asia. REITs globally raised $22.6 billion in the first quarter of the year, on pace to surpass the record $73.3 billion they collected in 2012.
“You’ve had tremendous gains in the assets that REITs are investing in, which is driving enthusiasm and performance,” says Brian Hargrave, chief investment officer at ZAIS Financial Corp. (ZFC), a mortgage-focused REIT run by Red Bank, New Jersey-based asset manager ZAIS Group LLC. “It’s a theme among investors to get exposure to the recovering housing economy.”
For U.S. investors, the advantage of REITs is that they’re required by the Internal Revenue Service to distribute at least 90 percent of their taxable earnings to shareholders as dividends, in exchange for paying little or no corporate income tax.
“That’s probably the single biggest benefit to the investor,” Hargrave says.
Yet real estate is a volatile and cyclical investment, with REIT prices rising and falling along with movements in the larger economy. That became clear in May, when U.S. Federal Reserve Chairman Ben Bernanke’s announcement that the Fed might slow its debt-buying program sent bond prices plunging. Shares of mortgage REITs fell 11.2 percent for the month ended July 10.
Meanwhile, the real estate moguls whose heavy borrowing helped fuel the 2008 financial crisis are back at it, taking advantage of Federal Reserve-driven low interest rates to amplify their returns through leverage. In an April report, the U.S. Treasury’s Financial Stability Oversight Council cited the borrowing of mortgage REITs as a source of instability in the economy.
“You’re starting to see more and more REITs that are borrowing to pay their dividends,” Tangent Capital’s Rice says. “That’s a bit of a yellow flag in terms of whether you want to be chasing the asset class right now.”
When central banks finally start raising interest rates, that could put a quick end to the new property boom, says David Fann, chief executive officer of TorreyCove Capital Partners LLC, a La Jolla, California-based firm that advises investment managers.
“Real estate has been a huge beneficiary of quantitative easing,” he says, referring to the Federal Reserve program to keep interest rates low by buying mortgage securities and other bonds. “When interest rates begin to rise, that’s going to curtail the longer-term appeal of real estate investing.”
Hedge funds, once the quintessential alternative investment, have been disappointing investors for years. The poor performance of macro funds, which make bets on movements in the broad economy, has been a reason for hedge funds’ overall mediocre 3.3 percent return.
Fund-of-funds operators, who try to find the best performers, have done even worse: Those funds lost an annualized 3.8 percent over three years. More than 600 funds of funds, or 25 percent of the total, have gone out of business since 2007. And assets under management in hedge funds have declined 13 percent in that period.
Even as the hedge-fund universe has shrunk, pension funds and other institutional investors have moved their money into the biggest, most successful funds.
“Hedge funds in aggregate are going to look more and more like the broader market as their asset base continues to grow,” says Carl Friedrich, chief investment officer at Woodbury, New York-based investment adviser Piermont Wealth Management Inc. “You get an S&P 500-like index effect.”
Hedge-fund investors smart enough to bet on a rebound in housing via mortgage-backed securities fared well. Those funds gained more than 20 percent annualized during the three-year period. And the best of them, Metacapital Mortgage Opportunities, run by Metacapital Management LP’s Deepak Narula, returned more than 30 percent.
Commodities investors found the best returns in their breakfast cereal bowl: corn. While overall commodities gained a paltry 3.1 percent, corn futures returned 33.8 percent in the three years, as the U.S. government raised the required ethanol content of gasoline. Also, rising incomes in emerging markets increased meat consumption and thus grain purchases to feed the livestock.
“Corn’s been going up in price over the last few years,” says Paul Ashworth, chief North America economist at London-based research firm Capital Economics Ltd. Ashworth said he believes corn and other agricultural commodities are overpriced and that what he calls a bubble will burst in the next few years. “We’re talking about low interest rates to buy farmland and also higher yields for corn per acre,” he says.
For wealthy individuals, alternative investing isn’t just about hedge funds and commodities. They also sink their money into collectibles such as stamps, coins, art and wine. Among those more-exotic investments, the top performers were classic cars and coins, with indexes that track prices of those collectibles up more than 15 percent annualized over three years.
Art connoisseurs lucky enough to own paintings by the late American artist Adolph Gottlieb (1903 to 1974) saw the value of his works rise by 65.5 percent annualized over three years. One Gottlieb painting, Balance, was sold at a Christie’s auction on May 15 in New York. The auction house’s projected sale price was $800,000 to $1.2 million. It sold for $3.3 million.
Meanwhile, wine investors who had been holding on to a bottle of 2004 Chateau Pavie Bordeaux saw its value rise 107.3 percent over three years. The wine sold in June for as much as $400 a bottle.
The alternative asset class that has made Blackstone a hot stock, private equity -- aka leveraged buyouts -- has benefited greatly from the post-crisis low-interest-rate environment.
“It’s one of the consequences of the great financial crisis,” TorreyCove’s Fann says. “In many cases, the large deals that were undertaken during the boom period got salvaged because of quantitative easing.”
One beneficiary was Apollo Global Management LLC (APO), the New York-based firm run by Leon Black. Apollo was able to refinance crisis-era debt in companies such as Harrah’s Entertainment Inc. that the firm bought at high prices during the bubble.
Today, private equity is bigger than ever. Global private-equity holdings surpassed $3 trillion of assets under management in 2011 for the first time, according to London-based research company Preqin Ltd., and have continued to grow. KKR & Co. (KKR) -- run by billionaires Kravis and George Roberts, his cousin -- owns companies that employ about 980,000 people. Blackstone’s portfolio of companies boasts more than 730,000 workers, while Apollo companies employ 370,000.
Despite the buyout industry’s benchmark-beating returns, fundraising has lagged in recent years. Private-equity funds in the first quarter had taken an average of 18 months to close, the most in three years, according to Preqin. First-time funds secured just $4 billion globally in the quarter compared with $32 billion in the second quarter of 2008.
Private equity’s solution to the funding problem is to aim lower.
Blackstone, KKR and Carlyle Group LP (CG), the Washington-based buyout firm that manages $176 billion in assets, usually open their doors only to clients willing to commit at least $5 million. In the past year, all three have introduced offerings such as mutual funds and exchange-traded funds to cater directly to individuals.
One goal is to penetrate corporate retirement funds, which will hold $5 trillion by 2016, according to Boston-based research firm Cerulli Associates.
“We definitely would like to be part of 401(k) platforms,” says Mike Gaviser, a KKR managing director.
In January, Carlyle started a fund with New York-based investment firm Central Park Group LLC that will accept as little as $50,000 from individual investors. It’s called the CPG Carlyle Private Equity Fund. CPG will allocate money from the pool to Carlyle-managed buyout funds.
“These things are selling like hot cakes right now,” Tangent Capital’s Rice says. “This is the next wave of alternative offerings.”
“Should this start to take hold, there needs to be either a licensing, a seal of approval or some level of higher oversight so people don’t find that they are investing in something that really isn’t suitable for their stage of life,” he says.
For both institutions and individuals looking for benchmark-beating returns, the world of alternative investing remains alluring.
“We are reaching a point when institutions are basically saying, why shouldn’t we allocate more money to an area with more return?” Blackstone’s Schwarzman told the audience at a Morgan Stanley conference in June. “And the answer is: Any rational person would.”
Get your free issue of Bloomberg Markets! SUBSCRIBE TODAY
To contact the reporter on this story: Devin Banerjee in New York at email@example.com.