Taking the alternative route

With equities, bonds, and cash going through a rough patch due to market volatility and a low interest rate environment, Jassmyn Goh finds out whether investors are dipping their toes back into alternative investments.

The markets saw bouts of volatility in 2015, and although industry experts do not expect a repeat of the volatility levels seen during the Global Financial Crisis (GFC), they still expect frequent small market movements of a few per cent this year, rather than large one day falls.

But advisers should look for opportunities rather than fear market volatility — this could be the optimal time to increase allocation to alternative investments.

Advisers could invest in non-traditional assets like hedge funds, managed futures, and alternative real estate, where returns are independent of market changes.

We're all in this together

Advisers should work together to be successful in this arena, rather than opting to work independently, according to AMP financial planner, Tony Rigby.

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He said it was critical for advisers to collaborate with clients, licensees, and portfolio peer groups when researching to get the best outcome, rather than going it alone.

"Planners should be working with a group to share ideas. So when you're putting together a model you're not on your own," Rigby said.

"Often we put together maybe a discussion paper and bounce it off a research house and licensee team to get a point of view on it. Then, when we construct a model portfolio for retirees or accumulators; we have a pretty reasonable basis behind the portfolio that we're recommending."

Rigby said clients also needed to be educated in the space as having a good grasp of the sector would engender trust between the adviser and the client.

"At the end of the day the clients have to sign off on the portfolio and need to be happy with the decisions they make. When a client doesn't have a good grasp and understanding of what they're getting into, that's where there could be a risk, and that is why education is critical," he said.

Rigby noted he would meet with clients two or three times before introducing any alternatives into a portfolio to ensure they understood the investment.

"Then, if we're bringing in dynamic asset allocation it might only be 15 to 20 per cent exposure. It's giving a client a bit of a taste of it. If they have it for a year or so, they'll have a much greater understanding of how it works and then the client and planner can agree to increase exposure over time," he said.

"You're not trying to put a client into something like dynamic 100 per cent and hoping for the best. You are just slowly introducing that into the portfolio.

"Clients are a lot more accepting of that because they understand what the planner is doing — that's the trust factor, and it is critical."

Rigby noted that advisers should avoid overpricing their clients.

"Otherwise you can disappoint them. Have empathy, and spend the time to get to know them. The other thing is you have to be a tough friend; during the tough times you have to hold their hand," he said.

Blue Sky Alternative Investments' chief investment officer, Alexander McNab, said advisers needed to consider investment objectives and how they related to capital growth and yield, investment time horizon, investor's preference, and manager selection when introducing alternatives.

"Liquidity appetite is an important one. We also encourage people to think about liquidity as not a binary thing," he said.

"The reality is that you need a certain amount of liquidity in your portfolio to meet things that might come up but you don't need it across your whole portfolio."

Reluctance to hedge

McNab said it was important to ask what the right level of liquidity was for a particular portfolio.

He said that during the GFC, many hedge fund investors believed they had a level of liquidity that they did not have.

Hence, hedge funds were perceived to be risky and their growth levels were less than stellar.

"On the whole, investors have a better understanding of liquidity now and the things they're actually investing in," McNab said.

"I don't think they'll have the same issues and frankly I'm not expecting anywhere near the level of market structure we had back in 2008, so I'd be very, very surprised if we saw liquidity drop in some of these markets. But there is an impression, for better or for worse, that some of these products' liquidity wasn't there when people were expecting it."

Lonsec general manager for specialised research, Michael Elsworth, said hedge funds had gained acceptance in the institutional space, but were a mixed bag in the retail space.

"As far as institutional take up is concerned, there's certainly been some acceptance of the role hedge funds can play and the benefits they can bring to a portfolio in terms of diversification, and in terms of providing a source of return that is uncorrelated to traditional asset classes. That's sort of gained acceptance in the institutional space," Elsworth said.

"In the retail space it's taking a bit longer, there's probably more turnover of funds, probably greater propensity for funds to open and close the hedge funds in the retail market.

"So some find it difficult to gain traction, others such as the managed future funds have been quite successful in gathering assets in the retail space, it's a bit of a mixed bag."

Rigby said while the popularity of hedge funds had varied, it was important to have an allocation.

"But like any alternative, don't have an over exposure to it, and use a range of managers. Don't keep relying on the same fund managers all the time," Rigby said.

McNab said agriculture, alternative real estate, private equity, and venture capital had a lot of investor interest.

"I think a lot of the growth in alternatives in the last couple of years has been outside the hedge fund space," he said.

"The agriculture interest is from the ongoing economic growth in Asia. What that implies for patterns of consumption, and therefore commodity prices, is that people are becoming more aware of the long-term structural change in commodity markets.

"The second thing is that the depreciation of the Australian dollar is very beneficial for agricultural enterprises in Australia as it is largely an export based industry," McNab said.

In the alternative real estate space, McNab said purpose built structures such as student accommodation was gaining traction.

"In the international markets like in the US and UK, university students live in purpose-built buildings very close to campus but designed with very specific student needs in mind. It's a very, very underpenetrated class in Australia at a time when international education is a big industry here and is only going to get bigger if the dollar depreciates," he said.

"There's almost no existing stock of purpose-built student accommodation, so you're starting to see a number of players coming into the market and securing a site close to the university."

Other alternatives

Rigby noted that financial planners were turning their focus to infrastructure, despite the availability of options like private equity and hedge funds.

"Some are quite capital intensive upfront like tunnels and airports, but are long-term and are often strong yielding assets. Utilities like power, water production supply, and transport also provide diversification," Rigby said.

Lonsec senior investment analyst, Nicholas Thomas, said the popularity of infrastructure, or global listed infrastructure had increased over the last few years.

"One reason is the attractive characteristics of these assets, such as their long life, companies with a strong headed, monopoly position, assets that have low volatility in their earnings, and inflation protection that helps dampen the market volatility," Thomas said.

"The other factor involved is the fact that they've had strong returns over the last few years (in fact, double digit returns), and it's also been a beneficiary of the thematic global search for yield."

Man Group managing director for Asia-Pacific (ex. Japan), Hersh Gandhi, said the most popular alternative investment in the country were managed futures.

"I think any strategy that can cope with some of the swings and volatility in markets is going to be looked at seriously. For us, it's the range of quantitative strategies, particularly, managed futures," Gandhi said.

"Managed futures are a strategy that looks to identify and trade as major trends in market places. In January for example, some of the prevailing trends were short equities, long US dollar, short energy and commodities, and those are trends that a managed futures trader can capture.

"Although the year is young, it's starting to look like a reasonable year for the managed futures' community."

The year ahead

McNab predicted a period of market volatility across a range of asset classes for the rest of the year, and said those investors with allocations to alternatives would be served well by these conditions.

"Some alternative asset managers have strategies that are deliberately designed to perform well during periods of volatility or market dislocation so we've got the example of hedge fund strategies that trade on volatility," McNab said.

"Those products are often designed to perform well during periods like this, other products perform well in periods like this by accident, and merely because the drivers for returns are unrelated to drivers of returns in traditional asset classes."

Gandhi said this year would see the continuing trend of investors allocating more to alternatives because of the general macroeconomic and investment uncertainty.

"So any investment like an alternative investment gives clients the right tools to cope with some of the macroeconomic trends and the volatility we're probably going to see," he said.

"We would expect the trend of people allocating more alternative sources of return to continue. In general I think people are going to look at sources of return other than long-equities and long-bonds."

McNab said allocation to alternatives would rise if people realised they were overweight in equities, or because they were discomfited by the risk profile in their portfolio.

"But the counter argument is that in market periods like this, people's risk radar becomes more attuned and their risk appetite drops and some alternative products are viewed as being risky even though they're not," McNab said.

Sensible investors were taking a medium-term perspective on their investment decisions and strategic allocation, rather than being reactionary to market volatility, he added.

"That's what the good investors will be doing."