Regulations Hindering Wider Use of Alternative Investments

Regulation may be slowing the push for alternative investments by retirement plans and other institutional investors, Cerulli Associates finds.

According to Cerulli’s September 2014 issue of “The Cerulli Edge – U.S. Edition,” increased allocations in institutional channels such as defined benefit (DB) pension plans and endowments, expectations for greater use among financial advisers, and interest within defined contribution (DC) plans are increasing the role of alternative investments.

However, Michele Guiditta, associate director at Cerulli, says, “The percentage of managers that rate revenue potential as a driver of interest in alternative assets dropped to 83% in 2014 from 93% in 2013. This decline can partially be attributed to heightened regulation in increasing barriers to entry.”

Regulatory requirements have increased the cost of running alternative funds, with additional resources needed for operations, compliance, reporting, and risk management, the Cerulli publication notes.

“Further regulation is one reason for slowing in the process of adoption,” Pamela DeBolt, associate director at Cerulli, adds. “The time required for institutions to perform due diligence and make an allocation is lengthy. Manager selection is a crucial component of alternative investments, and the due diligence process is time-consuming.”

Cerulli finds half of managers report that it takes between seven and 12 months to perform due diligence and make an allocation to a single hedge fund product, and 25% say it takes more than 12 months, according to DeBolt.

Cerulli notes that corporate DB plans’ allocation to alternatives grew from 4% at the end of 3Q 2010 to 7% as of 3Q 2013. Endowments steadily increased their alternative exposure during the past five years, and as of year-end 2013 maintained an average allocation of 53% in alternative assets, up from 51% in 2009.

“As new regulations such as Dodd Frank go into effect, operational due diligence performed by institutions and consultants has become more intensive, including a deeper review of an investment manager’s operations and compliance procedures. This evaluation of front- and back-office operations, accounting systems, technology, and client support activities requires onsite visits and extensive background checks of key personnel,” Cerulli says.

“The Cerulli Edge” points out how hedge fund development has been affected by regulations. Investors look to hedge funds and “hedge fund-like” products to play multiple roles within their portfolios: provide low correlation with public equity and debt markets, reduce volatility, generate attractive risk-adjusted returns, and present current income. According to Cerulli, the most notable regulations currently impacting hedge fund investments include the Alternative Investment Fund Managers Directive affecting funds marketed and developed in the European Union, the U.S. Foreign Account Tax Compliance Act, and the adoption of the JOBS Act to remove advertising restrictions on alternative investments. “Given the heightened regulatory scrutiny, the barriers to entry into the alternatives space have increased. In particular, additional regulatory requirements have added to the cost of running hedge funds, with additional resources needed for operations, compliance, reporting, and risk management.”

Infrastructure a Growing Interest  

The Cerulli publication, focused on alternatives and other strategies, says investing in infrastructure has become particularly attractive to pension funds, endowments, foundations, and insurance companies. Positions in long-life physical assets, such as airports, roads, and bridges, generate stable revenue streams that may be linked to the rate of inflation and help to fund long-term liabilities.

Cerulli notes that, particularly for institutional investors, which are by far the biggest source of capital for the asset class, there are a large number of investment vehicles which can enable them to better match their unique resource capabilities, knowledge, experience, ambitions, and objectives. The choices typically include listed funds or exchange-traded funds (ETFs), unlisted funds, co-investing, or direct investing.

Cerulli's September 2014 issue of “The Cerulli Edge - U.S. Edition” examines product development within hedge funds and alternative investments, investment opportunities within global infrastructure funds, and analyzes the client demand for environmental, social, and governance strategies. Information about subscribing to the publication is here.