Different thinking required
The focus has shifted toward the ‘what and the where’
A FEW YEARS AGO Joe Average investor would have had little opportunity to diversify his assets into hedge funds, private equity, real estate investment trusts (REITs), physical commodities or exchange traded funds (ETFs). That was strictly the domain of the institutional and corporate market but today, given the explosion in private wealth and worldwide glut of capital, alternative strategies have become relatively commonplace investment vehicles.
Everybody, from private investors, pension funds and endowments, has introduced allocations to these types of investments in an effort to build more efficient investment portfolios. In particular, active traditional managers have embraced the use of different combinations of available techniques and instruments in order to add value.
And as with most investment trends, because they are more accessible, the focus has shifted from whether or not to include them in an investment strategy and more towards the ‘what and the where’. In that regard it can be difficult to avoid hype and separate promises of marketing spin from real and suitable opportunities.
Mark McCarron, senior client portfolio manager at global investment management group SEI Investments, says investors also need to be aware of the risks of these strategies and avoid the temptation to time the market: “Risks associated with hedge funds, property funds and private equity funds lie in their use of leverage or other speculative investment practices. They can be highly illiquid and do not necessarily provide periodic pricing or valuation information to investors.”
He suggests that they may also involve complex tax structures, while many alternatives are also outside the normal regulatory realms and requirements that govern traditional investments such as mutual funds.
Warren King, Chief Investment Officer of Investec Private Bank, says investors also need to be aware of higher fees, increased layering in terms of costs and lack of transparency. “When used properly, alternative investments can have excellent portfolio diversification benefits, while offering the potential to match the risk-return profile of the investment with the investors’ specific needs more accurately, through use of a wide range of asset classes as well as use of downside protection and leverage.”
King says that while this alternative range of investments plays an important role in the tailor-making of larger, more sophisticated portfolios, they’re not as well suited to the retail market, and advisers may not have the requisite skills and experience to help investors become aware of all the risks.
“Even the most basic benefit of these investments can be eroded by ‘correlation drift’, since assets that may hold a certain correlation relationship to each other at one point, may later have a completely different relationship.”
McCarron believes that in view of their lower correlations to traditional asset classes, alternatives offer increased diversification benefits, allowing investors to broaden their opportunity sets and access a wider range of alpha sources to enhance return per unit
Risks associated with hedge funds lie in their use of leverage or other speculative investment practices.
But, he says, it comes down to how investors try to gain exposure to these benefits: “While certain hedge fund strategies may come into their own if the environment the bears are predicting arises, selecting a single hedge fund strategy can bring significant risk. Often the most simple and effective way to achieve the benefits offered by alternatives is through a fund of hedge funds. In this way, investors are more likely to gain exposure to a variety of funds and strategies with different return patterns. This provides risk diversification during different market cycles and provides access to certain funds that may be out of reach if they were to try and invest directly.
“While the argument of double fees stands true, most investors do not have the time or the expertise to conduct sufficient due diligence, research and monitoring of traditional investment funds, let alone specialist ones. Fee negotiations tend to be more effective where there are economies of scale.
“In addition, even though financial derivative instruments have certainly become more widely used and talked about in recent years, as hedge funds have gained headlines and popularity and changes in legislation have allowed for their use in traditional asset classes, some alternative strategies are now closed to new investments.
McCarron says that if the bears do get it right and 2007 turns out to be a down market, allocations to skilfully run hedge funds should come into their own. “With an increase in volatility, strategies such as convertible arbitrage could be set to outperform, as spreads widen. If investment banks continue in their relatively solid history of picking the next winners, the one to watch could be event-driven strategies, given global debt levels are high and interest rates are rising.”
as well suited to the retail market. Warren