Dominic McCormick looks at alternatives to mainstream investments and the role they can play in a diverse portfolio.
Alternative investments received a bad rap as a result of the global financial crisis (GFC). The perception seems to be that they failed to produce the absolute returns expected by many investors, suffered liquidity problems, were highly correlated with falling equity markets and have in many cases struggled to keep up with returns generated by equity markets so far in the 2009 rally.
As in most complex situations, the above is true to an extent.
But concluding that alternatives should be abandoned completely is flawed thinking that risks leading to insufficient diversification and poor returns — especially if the dramatic rally in equity markets has already front-loaded gains for that asset class for the next few years.
First, let’s correct some of the wrong perceptions. Some alternatives did actually deliver excellent returns in 2008.
For example, managed futures, certain long volatility strategies, some market neutral funds and gold bullion all produced strong double-digit returns through this period. Further, they did so while providing strong liquidity throughout (but some of these areas have lagged in 2009).
Additionally, many of the alternative areas that suffered in 2008 have delivered strongly in 2009, especially in risk adjusted terms (eg, many hedge funds and listed private equity).
Of course, some alternative investments and products did fail in the sense that they didn’t deliver the returns expected in either 2008 or since, and have also suffered significant liquidity problems.
Take most alternative structured products, such as fund of hedge funds (FOHFs) that offer partial or full protection.
Although we never considered these as serious candidates for a proper alternative investments exposure, many planners did and these products have generally failed on all fronts: poor performance in 2008, liquidity problems/lock-ups and poor performance in 2009 as many were forced into cash.
In some cases, investors will eventually get their initial money invested back. But this is not much comfort if they borrowed the full amount and were paying 10 per cent per annum in interest.
Structured products made up of most alternatives, and especially those without constant liquidity (thereby excluding some funds that focus on managed futures), may find it difficult to justify a place in most investors’ portfolios.
Outside the structured product area, I wonder if even standard FOHFs will survive as a retail offering in Australia — even though performance and liquidity has improved (despite the opportunities in, and desirability of some exposure to, hedge funds within portfolios discussed below).
Concerns about the liquidity risks, resulting increased redemption periods, their vulnerability to large exchange rate movements and the poor results as a result of the GFC are likely to turn investors, advisers and platforms off these funds for years.
This is despite the continued use of these products by some institutions and the desire by some FOHFs to enter the retail market. This is even before considering the risk that regulators will start making some of these investments harder to access for retail investors.
Of course, not all of the blame can be laid on the FOHFs themselves. Problems at the underlying hedge funds led to many of the FOHF problems (albeit driven in part by FOHF redemptions).
Further, 2008 was no ordinary bear market but rather a credit/liquidity crisis with some government interventions (eg, short selling bans and government guarantees) creating additional pressures — along with the extreme fluctuations in exchange rates.
Indeed, some of the issues for FOHFs are no worse than for other liquidity constrained product offerings (eg, mortgage funds, direct/hybrid property funds, certain high-yield debt funds) that I believe will also fail to survive in their previous forms as retail offerings.
Arguably, some FOHFs have been the quickest among these various product structures to come up with plans to return investors’ money in the near term.
Note that this includes the FOHFs managed by Gottex that were offered by Select. Any FOHF that is still not providing full access to redemptions (or at least a detailed plan for doing so in the near future) should be asked whether it is acting primarily for business reasons.
It may be retaining funds under management and management fees under the guise of continued liquidity issues with the underlying hedge funds (which have slowly but largely thawed over the last year).
The GFC has also highlighted that diversified alternative vehicles may be a much more robust way for investors, especially retail investors, to gain exposure to the full alternative investment universe.
These funds, of which there are only a handful in the Australian market (including in the interests of disclosure, one offered by Select), enable easy diversified access across the alternative investment spectrum and across the liquidity spectrum.
Therefore, they were affected less by the underlying liquidity issues and large exchange rate movements that impacted most FOHFs during the GFC.
These diversified alternatives funds can cherry pick certain strategies/funds across the entire alternatives universe instead of always maintaining exposure to one broad area (as FOHFs tend to), and because of their diversification they can also allocate to some volatile investments that many retail investors might be less comfortable holding directly.
In my view, these diversified alternative vehicles will be an increasingly accepted way to gain exposure to alternative investments in coming years in a way that is attractive to the retail investor.
Hedge funds, being one of the largest components of the alternative investment spectrum, are likely to continue to have a role — albeit accessed differently by investors.
The current dynamics of the hedge fund industry suggest that 2009’s attractive returns may continue for an extended period.
Competition has lessened (creating alpha opportunities), fees are coming down, liquidity is returning and previously closed high-quality managers are increasingly available.
Even low-cost ‘hedge fund beta’ products are becoming available that allow exposure to opportunities across the hedge fund space in a transparent, liquid and cheap way — with appropriate leverage.
So-called trading/global macro managers generally invest in very liquid and regulated markets and have the ability to make money in equity, currency, commodity and interest rate/debt markets.
The ‘full kit bag’ at their disposal offers the potential for them to take directional positions in either rising or falling markets, in a very risk-managed and liquid way.
The better of these managers typically do well in periods of market stress or fundamental market/paradigm shifts and are a useful addition for diversification — and as mentioned above, these strategies tended to do well in 2008.
Outside the hedge fund component there are still plenty of other opportunities in the alternative investment space.
Gold and gold equities have been an under-used alternative exposure in portfolios and are coming into the limelight now, despite having been in a long developing bull market for almost 10 years.
Some suggest that the increased focus on gold suggests we are in a bubble, but much of the focus is still represented by talk rather than actual investment in the area.
I suspect gold will end in a bubble — and we are getting closer to that phase — but that is only likely to happen after gold is once again accepted as a necessary (and even ‘must have’) component of mainstream investment portfolios. We are certainly not there yet, and the returns still available (albeit with high volatility) may surprise many.
Many of the drivers of the gold market (very low interest rates, US dollar weakness, major fiscal imbalances etc) are also driving broader commodity prices although, without the increasing ‘monetary’ characteristics of gold, these are typically more susceptible to periods of economic weakness.
Still it makes sense to have some broad exposure to commodities as part of a diversified (or alternative) portfolio and there is an increasing array of vehicles that provide different types of exposure.
There are many other areas in the alternative space that offer opportunity.
Despite (or even partly because of) the troubles in the local tax driven managed investment schemes, there are some good opportunities in the agribusiness/agricultural land space for those with a long-term perspective (and a focus on costs).
Private equity certainly doesn’t offer huge diversification benefits to traditional equity markets, but it can do well in a period where the disparity between private and public market valuations is high — as is currently the case.
The shake-up in the infrastructure area is also creating opportunities for the better-positioned funds (ie, those that didn’t get caught up in the debt binge over the last five years or so, made sensible acquisitions at prudent prices and have strong cash flows).
Listed infrastructure companies have also lagged the recent equity market rally (although there is a clear distinction between the inclusion of some in indices which are questionable in terms of their classification as true infrastructure/utility companies) and still offer attractive value.
Clearly, a lot of what has happened in the alternative investment space in the last few years actually makes it a more appealing area to invest in.
The occasional fraud may still emerge, but the Madoff debacle has made industry participants more sceptical and demanding — making it much more difficult for frauds to develop.
Access to alternatives is becoming cheaper, liquidity offered is increasingly more appropriate to the true nature of underlying investments, transparency is improving and capital withdrawal from the area has increased market inefficiencies and opportunities. Investors should not shun illiquid alternatives completely, but they need to be structured correctly.
After all, most investors don’t need immediate access to their full portfolio.
The appropriate allocation to alternatives continues to be subject to debate (and also depends on what your definition covers).
Using a broad definition, as much as one third of a portfolio may still make sense; and anything less than 5-10 per cent is unlikely to add significant long-term diversification benefits.
Of course, if you are convinced 2009 has just been the first year in a multi-year bull market for growth assets, similar to much of the 1990s and 2000s, then the alternative investment story is unlikely to be that compelling. On the other hand, you could be wrong.
There are plenty of factors that could weigh on or have consequences for growth assets for years (such as deleveraging, higher interest rates, increased sovereign debt/potential for default, inflation, etc), and these make betting everything on a renewed and extended bull market a big risk.
If any of these factors come into play, you want to be well diversified — not only across mainstream assets (fixed interest, property), but also across carefully selected alternative investments in robust fund/product structures.
There are clearly lessons to be learned from last year, but simply extrapolating 2008’s experience in selected alternatives to the future is like extrapolating the experience of a geared share investor in 2008 to one in 2009.
In today’s uncertain environment we need to be prepared to at least consider everything in the investment toolbox — both mainstream and alternative. In a dynamic world, deciding which of these to use and which to discard is the hard part for investors and advisers.
Dominic McCormick is chief investment officer at Select Asset Management.
