Asset allocation and alternative investments - finding the right fit

Dominic McCormick takes a look at alternative investments and what they mean for investors.

The industry press recently reported the comments of Schroders’ head Greg Cooper from an investment conference stating that “alternatives including private equity and hedge funds are not separate asset classes and do not provide diversification in portfolios”.

“Only equity and debt are asset classes”, he was also quoted as saying.

Schroders has been vocal in challenging some of the flaws in conventional diversified portfolio management and promoting better approaches — many of which we agree with and have been pursuing for much of the last decade.

These include the need for more dynamic asset allocation approaches and the limitations of traditional risk measures.

However, in this case I believe they are off track. Some of these statements, if correctly reported, represent an overly simplistic view of the alternative investment universe and particularly hedge funds.

Anyone beyond hedge funds 101 has long moved away from seeing hedge funds as a separate asset class.

In our view they have always been better categorised as alternative strategies i.e. utilising the major asset classes but in different ways to a long only approach (through leverage, shorting, arbitrage, derivatives) and in the process producing a different risk/return outcome.

Therefore, just because a particular investment is not an asset class doesn’t mean it can’t provide diversification.

As the hedge funds universe is itself made up of a range of these alternative strategies with quite varying approaches and risk/return characteristics, it is wrong to generalise that hedge funds can’t provide diversification.

At one extreme, a pure equity short selling hedge fund (even though it is using only the equities asset class) offers excellent diversification benefits, as it will be negatively correlated to long only equities exposure.

Whether the returns from such a strategy justify their inclusion in portfolios is a separate question.

Managed futures funds and long volatility hedge funds proved extremely good diversifiers in 2008. The diversification benefits of hedge funds to a portfolio will therefore depend on which ones are used and how.

It is true that hedge funds “in aggregate”, (those hedge fund indices or large, broad based fund of hedge funds), showed poor diversification benefits through 2008 and a high degree of correlation to equity markets, although to be clear almost every risky asset/strategy did.

But, in our view, the key lesson of 2008 is not that hedge funds should be abandoned because of this but rather they should not be approached from an “in aggregate” perspective in the first place.

It simply does not make sense for investors to seek broad diversification to the total universe of full fee charging hedge funds and the full range of hedge fund strategies in this way.

Instead, there are two approaches to hedge funds that we believe make sense going forward.

1. A targeted approach identifying certain hedge fund strategies and particular managers that we believe can add value and complement a broader investment portfolio, consistent with one’s overall views on the investment outlook and market dynamics.
2. A broader approach focused on accessing a range of hedge fund betas at low cost and structured in a way that does indeed produce very low correlation to equity markets.

A combination of these two approaches, using the latter approach as a core exposure, can be, we believe, an appropriate approach to hedge funds for many investors.

Some of the hedge funds selected under the former approach will always have high correlation to equity markets such as long biased/long short equities for example.

However, this is not a reason not to use them in portfolios.

The key in assessing funds in this category is whether they offer after-fee returns and risks that are an improvement and a complement to a much cheaper long only exposure, and in this case they would appear in the equities asset category.

This is no easy hurdle for such hedge funds to pass and since 2008, hedge funds have had to do a better job demonstrating whether and how they can provide appropriate added value for their significant additional fees.

The declining number of hedge funds suggests that many will fail this hurdle and the closer the investment strategy is to lower fee/passive strategies, especially an issue for equity long/short approaches, the more difficult it will be to justify the higher fees.

A significant benefit of this approach to hedge funds is that one doesn’t have to spend time reviewing all the hedge funds available or even all available hedge fund strategies.

Rather, the aim is to consider from a top down perspective by looking at market dynamics and current outlook the types of hedge funds that make sense and will complement a broader portfolio.

From there one can develop a short list of specific funds that implement this strategy and might be appropriate.

I am not suggesting this process is easy or doesn’t require dedicated and skilled resources but it certainly doesn’t require the same level of resources and infrastructure to run a large fully diversified global fund of hedge funds many of which allocate across a significant number of underlying strategies.

However, it is also worthwhile noting that what went wrong with hedge funds as a group and also fund of hedge funds, had less to do with too much market beta inhibiting diversification and more to do with too much money under management, crowded strategies, excessive leverage, mismatched liquidity in difficult times and poor communication.

Some of these issues have since been addressed although sometimes in ways that have lessened some of the appeal of hedge funds (eg, extended redemption terms).

It is true that the diversification benefits of private equity are quite limited and so I agree with Schroders’ views here.

However, that does not mean private equity cannot be a valuable return-enhancing component of portfolios if one can get access to some of the high quality managers.

I don’t think anyone investing in private equity is particularly focused on diversification and risk reduction - they are focused primarily on return enhancement.

In theory, private equity benefits from the re-rating potential of developing and on-selling a business either via trade sale or initial public offering and this is an additional source of return generally not available to an already publicly listed business.

Of course, it is important to assess whether such potential added value is not more than offset by the higher fees applicable in the private equity space.

I would also take issue with Schroders’ comments that there are only two asset classes: equity and debt. What about commodities?

Even Roger Gibson who wrote a book on asset allocation has always believed commodities have a role.

Again, accessing commodities the right way is crucial but denying their existence as an asset class is hardly conducive to arming investors with the tools to build well-diversified portfolios.

Even within the major asset classes there are wildly divergent sub-asset classes that provide diversification.

For example, while inflation linked bonds appear in the fixed interest asset class their risk and return characteristics can at times be completely different to those of nominal bonds that dominate that category.

Oversimplifying the world by suggesting there are only two asset classes - equities and debt — risks missing out on or at least downplaying the diversification benefits of many of these sub asset classes.

Then there is gold. A number of fund managers have stayed away from gold and have been suggesting it has been in a bubble for a number of years.

They may ultimately be proven right, indeed even we believe the current gold bull market will eventually end as a bubble, but irrespective of the way and when that end occurs it is an irrefutable fact that gold has been a valuable diversifier and return enhancer for portfolios over the last decade.

However, if your starting point is that there are only two asset classes: equity and debt - it would have been near impossible to fit some gold exposure in portfolios.

It is not surprising that a specialist investment manager that offers a diversified product is going to spend time promoting arguments against utilizing those asset classes and strategies that they don’t have exposure to.

However, multi-asset, multi-managers should make an objective assessment of the full opportunity set, especially among alternative investments, and whether the prospects from alternative assets and strategies are worth the usually higher fees charged.

Most alternative investment categories offer widely varying quality within them and attempts to label them either good or bad with simplistic overreaching arguments are hardly helpful.

Some investors and advisers may still come to a conclusion to avoid alternative investments, perhaps based on the difficulty in assessing, selecting and accessing them, but they need something more sophisticated than simplistic and overly generalized arguments to justify this.

Indeed, even proponents of including alternative investments in portfolios believe there are times when mainstream, long only asset classes offer particularly attractive value and subsequently lower risk, with the value of the diversification benefits of alternative investments therefore being reduced, although in our view some diversification almost always makes sense.

On the other hand, there are times when some mainstream asset classes look excessively valued and risky and where investors should be actively seeking a significant exposure to diversifying assets and strategies.

Even if the diversifying benefits of some of these asset classes/strategies has sometimes been exaggerated.

While equities don’t seem overly expensive in the current environment, and so deserve a solid role in portfolios, the key problem is that most traditional portfolios already have much of their exposure in equity risk, because of the greater risk of equities this risk exposure is significantly more than the dollar exposure.

On the other hand, a significant component of the other major asset class —debt/bonds — does look expensive and vulnerable in all but a deflationary scenario and therefore is not a particularly valuable diversification tool currently.

Some exposure to other strategies and assets are therefore needed to build a well-diversified portfolio in the current environment.

Trying to dumb down the investment world with simple platitudes such as there are only two asset classes and alternatives don’t help diversification, may appeal to some investors and advisers battling the complexity of the investment world and particularly the current environment.

However, it is likely to damage the desire and ability to build and seek properly diversified and robust investment portfolios.

If the investment world really was as simple as sometimes promoted, investors wouldn’t need fund managers, researchers or advisers to guide them, a proposition we reject.

In the real world, investing is often complex.

Learn to live with it or find people who can help you along the way.

Dominic McCormick is chief investment officer at Select Asset Management.