Alternative assets are no fad

The investment and planning world seems to be dividing into two camps with respect to ‘alternative’ investment strategies and assets (hedge funds, managed futures, commodities, gold, private equity and so on [see diagram for one way to categorise alternative investments]).

There are those who believe alternatives have a key role and are actively pursing the best ways to incorporate them in portfolios.

Then there are those who are unconvinced and generally reject alternative investments, preferring to focus almost exclusively on mainstream investments (mainly listed shares — mainly Australian — and to a lesser extent property, with some listed and unlisted fixed interest for conservative clients).

Both sides are convinced they have strong arguments.

Proponents for alternatives point to the potential benefits of attractive, non-correlated returns and the ability of alternatives to help a portfolio produce a smoother path of returns for investors over time.

The critics

The opponents point to an array of issues relating to alternatives — their complexity and relatively poor transparency, high fees, low/variable income yields, tax inefficiency, uncertain returns, illiquidity, and restrictions on access.

A number of these issues have some validity (and are briefly addressed below) but, interestingly, the opponents tend to focus on the negatives of alternative investments without having to justify why the conventional approach to portfolios that they are implementing (without alternatives) makes sense.

This is despite considerable challenges in recent decades to modern portfolio theory (MPT) and the efficient market view of the world it assumes, which has provided the underpinning for conventional portfolioconstruction.

Lack of diversification

Indeed, the fundamental problem with the conventional approach is that it results in portfolios that are poorly diversified and hostage to one primary risk — equity risk.

A typical diversified balanced or growth fund or model portfolio investing in the major mainstream asset classes (via passive indices) will end up with a correlation to the local equity market of around 0.90 and the MSCI World Index of around 0.80.

Of course, one can improve the diversification marginally by using different fund styles and going beyond the major indices (for example, emerging markets, small companies), but in today’s globalised world the diversification benefits of these other equity exposures are limited, especially when global markets go through periodic crises when correlations across all equity markets tend to increase.

Equity risk

Of course, there are periods where the excessive exposure to equity risk is largely hidden or works in the investor’s favour. The experience of the Australian sharemarket, which forms the bulk of most Australian conventional portfolios (normally 40-80 per cent), is the obvious example.

However, investors need to recognise how abnormal the past 15 years have been for Australia with no major bear markets and no extended multi-year periods where equities performed badly.

There are now a very small minority of planners who have experience prior to this benign period when the occasional savage bear market was the norm.

It is therefore not that surprising that advisers and investors question the wisdom of including alternatives in portfolios.

“Why are they needed when a portfolio of industrial equites will deliver strong dividend and share price growth in the long-term?”

This sounds compelling, but hindsight makes everyone a great investor and this approach has some significant problems looking forward.

Indeed, this equity-dominated strategy is flawed for all but the most hardened long-term investor. Firstly, most investors are not hardwired to ride through the sort of draw-downs that are likely in equity markets (even if they have not occurred recently).

Even if one is confident that equities will deliver over the long-term there are few investors who can actually live through the pain that is a true bear market (with falls of 25 to 50 per cent) without at least partly giving up on the overall strategy.

Because of this, they often end up with much worse returns than someone with a lower exposure to equities but who is able to ride through this volatility.

The fact that such bear markets have been absent in the past 15 years in Australia should not provide comfort — it probably makes them more likely going forward.

Long-term returns

Secondly, there is no guarantee that equities will deliver in the long-term anyway. Ultimately, the equity risk we need to diversify away from is not just about short-term volatility (although this is clearly part of it), but about the probability that equities will deliver poor returns even over extended periods.

There is nothing to stop equities being priced at levels where they can be expected to make little return even over three, five, seven or 10 years. For evidence of this one only needs to look at the US stock market, where the S&P500 index has returned less than term deposits over the past five to seven years.

Of course, alternatives offer no guarantee of returns either, but the point is they are subject to different risks than equities and it is this diversification of risks that is the key.

Indeed holding a significant component in a well-structured alternatives portfolio can actually make you more comfortable taking equity and other risks with the balance of a portfolio.

We live in an uncertain world — if one knew a few stocks that were guaranteed to make 15 per cent plus per annum over the next 10 years with little risk, then alternatives would not have much of a role in a portfolio.

Unfortunately, such ‘buy and hold sure things’ are not readily apparent in advance and if they come up they generally are not available for long.

Having touched on some of the issues relating to the conventional approach, let’s return to the perceived problems of alternatives. While there are issues to consider they should not preclude the serious investor or adviser looking to build robust diversified portfolios.

Complexity/lack of transparency

Yes, some alternatives are complex. But good investing is sometimes complex and investors or even advisers don’t have to fully understand all these complexities. This is why quality fund of fund structures exist and why more packaged broader alternative funds are being developed.

However, they do need to know that the people selecting the investments understand the complexities and have sufficient transparency to make decisions.

High fees

Fees are generally higher partly because of these complexities and the difficulty in accessing alternatives. However, in the end it is after-fee performance that matters and this is the basis on which most alternatives (and conventional investments for that matter) should be assessed.

Low/variable yields

This is an overrated concern. Investors, even retirees, do not actually need yield — they need cash flow — and cash flow can come from the total portfolio return as long as it is structured to hold enough in cash or replenish cash by selling assets when it is required. Alternatives can help by providing a smoother total return to structure such a strategy.

Tax inefficient

Many alternatives are not renowned for their tax effectiveness. However, investors need to treat them like other tax inefficient investments such as fixed interest — that is, put them in the lowly taxed entities (super/allocated pension, low marginal taxpayer).

Uncertain returns

Most alternatives have more consistent returns than mainstream investments, particularly when combined. There are no guarantees with alternatives but nor are there with conventional assets.

It is true that in some areas (for example, hedge funds and private equity) it is not just good enough to be exposed to the area. You really need to ensure you are getting access to above-average managers. This will typically require accessing a skilled consultant or using a fund of funds.

Liquidity and access

Some alternatives are less liquid, but this is partly where the extra return or low correlation come from. However, why do long-term investors need full liquidity on investments that are probably only 10 to 30 per cent of their overall portfolio?

Finally, restrictions on access. While this is changing slowly, the characteristics of many alternatives do not make them easily accessible in today’s platform dominated industry.

The last two issues are important ones for the local investment industry. Platforms are not making it easy for suppliers of, and investors in, alternatives because most do not have the same degree of flexibility as other investments.

For example, some platforms that allow regular rebalancing exclude many alternatives that do not offer daily liquidity. Some also limit the exposure to alternative investments on the basis that they are more ‘risky’ even though there are clearly many other equity sector funds that are more likely to lose clients’ money.

Listed investments

Some fund managers are reacting to this access problem (and their illiquidity) by launching ASX-listed vehicles investing in hedge funds, private equity and other alternatives.

For the contrarian investor willing to be opportunistic these can be attractive ways to gain alternative exposure (at a price) with greater liquidity.

However, those blindly putting money in new floats without understanding the complexities of the listed structure will almost certainly be disappointed.

Floating a $100 million alternative vehicle may solve the fund managers’ problem in dealing with platforms and provide easier access for investors, but it may not deliver the risk and return profile desired by investors.

A poorly-timed investment in a listed vehicle may even taint their ‘alternative’ experience as some of these funds drift to substantial discounts to asset backing, given that most new floats offer no discount control mechanisms.

Furthermore, they are likely to be less effective diversifiers as listed funds will have a higher correlation to the equity market on which they are listed.

The industry seems to have reached a point where administration requirements are a major factor driving what ends up in client investment portfolios. This can hardly be described as a healthy situation.

Indeed, the major criticism several years ago — that research houses were not covering alternatives adequately — is no longer valid, although the quality of research varies widely.

Investing in alternatives is not a passing fad, nor can one talk about an asset class bubble in alternatives because alternative strategies, like hedge funds, are not an asset class themselves and there are a broad range of alternative asset classes.

Rather, astutely selected alternatives have a permanent role in a well diversified investment portfolio.

Some progressive investment institutions, such as US endowment funds, have as much as 40 to 50 per cent invested in alternatives.

Surveys from major asset consulting groups suggest many leading institutional investors plan to invest more in alternatives going forward.

Are Australian retail investors going to be left behind again?

Dominic McCormick is chief investment officer of Select Asset Management .