Alternative investments: more important than ever

As 2004 draws to a close with the Australian sharemarket achieving new records, there seems to be an emerging tendency to think that the easy investment times are back for good. Rosy investment forecasts for 2005 are coming out. Money is pouring into equity funds. Complacency amongst investors is rampant. While property prices have come off, they have hardly shown the bust many have anticipated (at least to date).

Some of the lessons that were reinforced by the 2000-2002 weakness in equity markets have already been forgotten. These included the need for better diversification, a willingness to look at investments from a contrarian/value perspective and the incorporation of lowly correlated alternative investments in portfolios.

These seem to have been replaced by other ‘lessons’ — that Australian shares are all that is needed in portfolios and any setbacks will always be quickly recovered. Many seem to have even learnt that one doesn’t even need fund managers (or advisers) — just buy a few leading stocks and watch the dividends roll in and the capital gains accumulate.

There is a danger that many of these investors (and some advisers) are creating a distorted view of reality and setting up themselves and their clients for some major disappointments going forward. It needs to be understood that what investors have been through is not normal. The Australian sharemarket has been on a dream run — not just the last few years but since 1994 at least.

Some think 2001-2002 was tough, but to investors with most of their portfolio in Australian shares, this period was a picnic. The Australian All Ordinaries Index fell by around 20 per cent at worst and high dividend yields helped lessen even this impact (see graph below). This pales into insignificance compared to the 35-50 per cent declines that the UK, US and European markets experienced and which were true bear market experiences. Volatility of the Australian sharemarket over the last five years has been almost half the 20 per cent volatility of these markets over the same period.

Having recently been to the UK, I gained a quite different perspective and realised how shell-shocked investors and advisers still are as a result of this period. Australian investors experienced nothing of the sort. It suggests the next period of major market weakness in Australia will burst a lot of investors’ over-optimistic expectations, if only because those expectations have been shaped by recent experience.

That is not to suggest that the recent strength cannot continue, especially in the short-term. There is still plenty of cash and relatively cheap money looking for a home and we are not yet seeing the ebullience that often signifies a top. However, one of the indicators that we have been waiting for to suggest that we are getting close to the end of the run — a strong run in small resources — is now firmly in place.

The point is that portfolios should be constructed with a three to five year view in mind and the risks of most equity markets over that time frame have risen considerably. One needs to be careful in using current modest Price Earning Ratios (PERs) compared to history as cause for complacency. The main medium-term risk is not a de-rating in PERs (although this could compound a falling sharemarket later), but pressure on the earnings component in more difficult economic conditions, as current profit levels and margins reflect an almost perfect operating environment.

Given this it seems surprising that we have heard next to nothing from research houses about whether or not now is an appropriate time to reduce exposure to equities or make portfolios more diversified and defensive. There is no doubt that the research houses’ coverage of alternative investment products has improved dramatically in recent years but where is the much required assistance in asset allocation and incorporation of such alternatives in portfolios?

Perhaps we need to consider opinions such as those of GMO chairman, Jeremy Grantham, writing in his October 2004 quarterly newsletter: “There has never been a more broadly overpriced mix of assets. Hide in conservative hedge funds. Buy some foreign (non-US) and emerging equities but be reconciled to periods of negative returns. Look closely at diversification into commodities including forestry and if you can stand the low returns, hold some cash. But whatever you do, and however desperate you may be, do not reach for return; do not try and get blood out of stones.”

How many investors and advisers are heeding such words? Not enough, I would suggest. Instead, good sharemarket returns seem to be encouraging investors and advisers to breathe a sigh of relief as they decide they don’t have to look further at how they approach portfolio construction or consider incorporating alternatives investments in portfolios.

Hedge funds, managed futures, commodities, gold, agribusiness — “they are all too hard,” many seem to be saying. “Too hard to understand, too hard to research, too hard to access.” By contrast, it has never been easier to simply buy major industrial stocks or equity funds and point to their good returns in the last one to two years. But no one said investing was supposed to be easy and when it seems that way (as with Australian shares now), you can be sure that there are some major problems looming.

Having said this, the number and flexibility of vehicles that enable investors to obtain exposure to alternative assets and strategies is increasing and is likely to continue to do so in the near future. Of course, in my current role, there is a risk that I could be accused of ‘pushing our book’. Perhaps, but I am in the fortunate position where ‘our book’ is largely one and the same as what I truly believe in from an investment perspective. Building a properly diversified portfolio with exposure to alternative assets and strategies is crucial to providing attractive absolute returns versus cash and capital preservation over a range of investment environments. Isn’t this what the vast majority of investors are seeking?

Alternatives in portfolios and alternative approaches to portfolio construction should never have been seen simply as a response to poorer market environments such as 2000-2002. Rather, alternatives have a permanent role in most portfolios that allows investors to ride through such periods more easily. The US endowment funds have been leaders in incorporating alternatives into portfolios, with some investing as much as 30 to 40 per cent of their portfolios in such investments. Writing in 2000 in Pioneering Portfolio Management, Yale University chief investment officer David Swensen said: “Alternative asset classes contribute to the portfolio construction process by pushing back the efficient frontier, allowing the creation of portfolios with higher returns for a given level of risk or lower risk for a given level of returns. Investors treating alternative assets as legitimate tools in the portfolio allocation process reduce dependence on traditional marketable securities, facilitating the structuring of truly diversified portfolios.”

A simple message, but the fact is still relatively few investors and advisers are embracing alternatives to anywhere near these levels and some of those that were considering doing so seem to have used the recovery in sharemarkets in the last 18 months as an excuse to defer it again. Some time in the next couple of years I suspect, they will once again regret this decision.

Dominic McCormick is chief investment officer of Select Asset Management .