Dif­fer­ent think­ing re­quired

The fo­cus has shifted to­ward the ‘what and the where’

Finweek English Edition - - Creation and preservation of wealth -

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.

of risk.

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.”

Al­ter­na­tive range

in­vest­ments not

as well suited to the re­tail mar­ket. War­ren

King

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