Risks in Alternatives

Celia: Asian private credit has concentration risk as it tends to be more concentrated than a public credit strategy due to the opportunity set and ticket sizes. Due to possibly early prepayments of principal on loans, there is re-investment risk. Given that underlying loans are expected to comprise of both USD-denominated and local currency loans currency risk is also a factor of consideration. Lastly, there is principal / default risk although we expect yield erosion in the case of defaults but do not expect principal loss given low starting loan-to-values (LTVs) and covenants.

Mark: Our belief is that more traditional funds will struggle to make positive returns as the global economy recovers from the pandemic, monetary policy is tightened, and as inflation is higher than in the last decade. The track record of sourcing returns from interest rates, spread and currency markets on both the long and short side puts the fund in a good position to outperform in this environment. If the recovery falters and there’s a slide into deflation, then the risk is that more duration-heavy funds would perform better. However, the fund can take market directional positions and look to keep pace with long-only funds in a falling yield environment as the recent track record shows.

Craig: Operational risk remains the key risk in our fund and wider business. People, process and systems must be of a high standard. Currently our team is the largest and most experienced in our 14-year operating history and we continue to invest both in people and systems, to help improve our decision-making process and mitigate risk, but also to remediate problems faster.

It is important to recognise that none of our Funds are UCIT daily dealing / market-based equity or bond funds. Therefore, liquidity can often be quite ‘variable’ from time to time and cannot be guaranteed although, we have successfully operated this fund for over 12 years. Our investors accept that there is a ‘liquidity’ premium.

John: There are four drivers of gold’s performance: economic expansion, uncertainty, opportunity cost, and momentum. Gold can be quite sensitive in the short term to the direction of interest rates and the overall direction of monetary policy. While interest rates are expected to remain low for some time, tighter monetary policy whether through higher rates or lower asset purchases will likely create headwinds for gold. In the end, the magnitude of these headwinds will depend on how other variables such as inflation concerns or currency debasements impact investor decisions.

Celia: BlackRock’s Asian private credit team has boots on the ground in all the countries we are active in and focus on understanding counterparty risk and promoter selection, structuring bespoke solutions based on the legal framework in respective countries and maintaining a high margin of safety, with average LTVs of 50%. The successful strategies are those that can tap this opportunity set through a strong local, onshore presence to understand the nuances of each market in Apac and have the breadth and depth of expertise to understand how to structure and create tailored solutions.

Mark: A key part of the process is the team’s study on market price action to more accurately market time the implementation of medium-term strategic views. This active risk taking approach helps the team avoid unnecessary drawdowns without excess turnover and acts as a stop loss mechanism. To support this, the team favours a highly liquid portfolio to maintain high flexibility in their approach. This means that the team can change strategy or reduce risk quickly and cheaply if necessary.

The team’s key aim is to hit periodic performance targets using the risk budget applicable to achieve a high Sharpe ratio for the product. Due to this and the fact there is no benchmark, good portfolio construction is essential for this type of investment product and so the team have a construction process to aide position sizing. This risk budgeting technique ensures risk is not too high, but also not too low to hit the fund’s return and risk targets. It also ensures risk is spread reasonably evenly so no position or theme dominates the portfolio.

Craig: Protecting against downside risks is something that is constantly reviewed and analysed. Clearly, from the start of an investment approval, the asset allocation at credit committee and investment committee is important. But the ongoing monitoring of underlying customer / sector risk is also important.

Each investment approval has an “investment plan” which is supported by significant due diligence and evaluation. It will also look at how, when and where the investment can be exited. This all comes back to the operational risk and the people, process and systems developed over many years. Experience counts for a lot, as does corporate memory.

John: At the portfolio level, gold is a well-established tail risk hedge. As a high quality, liquid asset, it can help investors mitigate the impact of significant pullbacks in the stock market. For example, gold’s average correlation to stocks is very close to zero over the long term. However, it tends to turn negative in periods of financial turmoil with the gold price generally going up as stock markets tumble. Thus, gold is often used as strategic asset to protect against downside risks.  Having said that, as any other investment, gold itself can experience volatility and is not immune to price pullbacks. Some investors tend to use options strategies to more effectively manage their gold allocation when they expect potential headwinds.