It’s just not easy being alternative

The lot of the average alternative investment is not easy.

First, there is the name. The word alternative refers to something that is non-traditional and outside the norm. While from an investment sense this may make them seem a bit hip and groovy, the words low risk/high return is what you really want in an investment name.

Also, unlike their more traditional counterparts, alternative investments do not just refer to one investment type. Rather, it covers a variety of investments including such things as private equity, venture capital, hedge funds, mezzanine debt, and commodity investments like gold.

Finally, there is the fact that alternative investments are non-conformists. That is, they often have a negative correlation with the more traditional asset classes such as equities, property, fixed interest and cash.

So when these asset classes are not performing, alternative investments can be experiencing the ride of their life.

However, it is the above three characteristics of alternative investments that can make them a worthy inclusion in a client’s portfolio.

Further, the fact that the economic outlook is volatile, both planners and clients are looking around for another investment option.

According to Coastal Capital managing director Peter Frohlich, the market-linked approach that many investors and planners have been taking, has not been working since the international market took a turn in March 2000.

As a result, an absolute return strategy is a highly attractive option for investors wishing to outperform the market.

Impeding the development of absolute return strategies, as Frohlich prefers to refer to alternative investments, is the way they challenge financial planners thinking of diversification.

Frohlich says the increasing globalisation of markets has made markets more interrelated and brought global economies closer together. This means that while planners and clients strive for diversification, it is not being achieved effectively when markets are moving in the same direction.

“Diversification the old way doesn’t work well when all the markets don’t perform well together,” he says.

This, he says, is the upside of hedge funds, because they correlate with equities on the upside and less so on the downside.

Frohlich says this point is precisely the crazy thing about alternative investments. That is, while it is this sort of relationship between investments and markets that planners and clients want, prevailing investment theory does not support it.

While Rothschild Australia Asset management’s head of alternative investments Richard Keary says financial planners are not currently allocating a large amount of client’s funds to alternative investments, he says this is because they are confused over the investment category.

“They’re not allocating because they don’t know what to do, and good on them,” he says.

Keary says the unpredictable nature of some alternative investments and lack of a track record means financial planners are not jumping into alternative investments head first.

However, in taking this cautious approach, they are demonstrating their responsibility to their clients.

“Why would anyone expect to recommend them when they can’t explain them,” he says.

Haintz Financial Services director David Haintz says the stumbling block for planners to invest clients’ money into alternative investments is the researching of them.

He says due to the lack of research material and the resource it takes for financial planners to get up to speed on alternative investments, Haintz is more likely to suggest clients invest more in super as their first strategy and then look for tax-effective and gearing opportunities.

The current indemnity insurance crisis has also heightened this concern, an issue which Frohlich is all too aware of.

“The whole [financial planning] business is about not getting sued. It is giving a client advice that is robust and accepted,” he says.

Haintz admits particularly in this insurance environment, planners are wanting to advise only on investments that are well researched.

As a result, if clients do have surplus funds, Haintz says he would advise them to invest in superannuation first and then turn to gearing and tax-effective investments.

However, that said, Haintz says planners do recognise that alternative investments do have a capacity to make money in a low return environment.

Deutsche Asset Management regional head of absolute return strategies Asia-Pacific David Zorbel says people have different views on exactly what alternative investments are.

“They are an extension of a simple investment, with a broadened scope, and are not benchmarked against an index but against an absolute return,” he says.

In the case of hedge funds, while they are an extension of an equities-based investment, depending on the strategy that is used, they could sit either within the equities allocation of a portfolio or be considered an alternative investment.

“For long/short hedge fund strategies, they could sit in the equities section of an asset allocation. Whereas a more broadly diversified hedge fund-of-fund’s bonds investment could sit within a fixed income profile,” he says.

Zorbel says despite the fact that in the above example, a hedge fund investment can either be an allocation from a fixed interest or equities asset class, at the end of the day, an alternative investment does deliver diversification benefits to an investor’s portfolio.

Deutsche has two alternative investment products and manages $11 billion in hedge funds. Its products include a highly hedged fund known as the Strategic Value Fund and the Global Equities Long/Short Fund that takes a fund-of-fund approach.

Zorbel says both these products could be used as part of an equity allocation to achieve diversification as they have a fully hedged currency approach and a negative correlation to equities.

Over the past year, there has been a rush to market with new hedge fund products. Zorbel says while this has brought more people to the market and led to greater awareness of alternative investments, Keary is more cautious.

“People hold out hedge funds as an example, and that is not true,” he says.

Keary says hedge funds are expensive, costing managers a lot to manage them, and creating higher fees for investors.

“Is there anything left for the retail investor?” he says.

Add to this that unlike equities, where the All Ordinaries Index provides investors with an indicator of what their stock is doing, hedge funds have no such tool.

“Retail investors have to be careful. For investors who don’t exercise the right discretion, it is a case of buyer beware,” Keary says.

Zorbel says such a warning is important because while hedge funds attract “some of the best minds, it also attracts the me-toos because of the fees”.

While Keary says planners’ take-up of alternative investments is modest, Zorbel says it is increasing, particularly in the fund-of-fund type of investments.

He says the market environment is putting pressure on returns, as well as expectations for single digit returns, fuelling greater interest in alternative investments.

However, despite this, Zorbel says investors need to understand and respect the cyclical nature of alternative investments such as hedge funds.

“Hedge funds have come down due to interest rates. The absolute level of interest rates has come down and drives down returns. Hedge funds do go through cycles,” he says.

Keary agrees: “With the economic outlook, there is heightening interest. But it is dangerous to say hedge funds are the answer to all our problems.”