A lternative investments are meant to be a safe haven for investors who want returns that don’t depend on market performance.

Spruiking positive returns that are uncorrelated to the market, alternatives were where investors placed part of their funds as a safeguard in any market environment. But in this financial crisis, alternatives have been battered and bruised along with every other asset class, and questions are being raised as to what security they can provide in the current environment and their role in the future.

Performance

The global financial crisis has had a mixed effect on different strategies in the alternative sector, causing massive losses for some, while others have seemed immune to the volatility.

Hedge fund performance plunged into negative territory, recording minus 19 per cent for 2008, according to the Credit Suisse/Tremont Hedge Fund Index, while property groups are losing tens of millions of dollars in assets due to writedowns of listed property investments and the collapse of the property market.

However, other alternatives are doing extremely well considering the extent of the economic crisis.

Managed futures posted positive returns of more than 18 per cent for 2008, while dedicated short bias funds generated nearly 15 per cent. Global macro is also performing relatively well, having recorded negative returns of only 4.6 per cent in 2008.

Many hedge fund strategies that lost enormously in 2008 have been returning positive gains since the start of the year, with hedge funds returning 0.14 per cent in March. Event-driven strategies, which lost more than 17 per cent in 2008, recorded 0.44 per cent in 2009.

Spencer Young, chief executive at HFA Holdings, said even though they posted negative returns in 2008, those returns were welcome compared to returns in the equity markets during the same period.

“I think any reasonable, rational investor who achieves a return in the worst market crisis in 75 years [of] negative 3 per cent when markets are down 50 per cent, and property is getting smashed, [would be giving] excellent feedback.”

HFA’s platinum funds were down 3 per cent in December compared to a market return of 40 per cent to 50 per cent.

Levels of liquidity

Liquidity, and to a lesser extent transparency, was a big issue for the alternatives sector in 2008.

Earlier this year, Money Management reported that financial planners were shying away from investing in the broader alternatives sector because of the redemptions freeze over liquidity problems.

Up to 50 alternatives funds were forced to freeze redemptions after the Government guarantee caused a rush of investors to withdraw their money, and many planners came to the conclusion that alternatives were too difficult to invest in.

Joe Bracken, head of macro strategies at BT Investment Management, said these issues, which were not such a focus before the financial crisis, hurt fund managers at the end of 2008.

“Firstly, they didn’t have much transparency — fund of fund managers couldn’t see what they were investing in. Secondly, strategies that they were investing in were not as liquid as they thought they were, so that really came back to bite them at the end of the year,” he said.

Shawn Richard, chief executive of Absolute Alpha, believes that the bad press arising from a lack of liquidity has put investors off alternatives.

“Liquidity has been a major factor in getting people offside in relation to alternatives. I think their perception of liquidity versus what actually happened has been way off, and maybe some of the product providers are at fault for not making it clear to investors what potential liquidity issues could arise in an adverse market environment.”

With credit markets starting to loosen, the performance of the funds are returning to normal.

“What happened last quarter was that you had a freezing of credit markets — they didn’t trade — and in that environment if you can’t trade, you can’t protect the portfolio,” Young said.

“Now that credit markets are slowly getting back liquidity, the funds have returned to their expected performances.”

Changing sector

The extent to which liquidity and transparency issues will affect the way people invest in the sector in the future is uncertain.

Some in the industry believe the increased focus on liquidity from investors will lead to a change in the way the alternatives sector operates.

The financial crisis will force a new focus on those alternatives that offer more liquid investments, Young said, and the industry itself will change to offer those alternatives.

Any investment portfolio has a combination of more and less liquid investments, Young noted, and there will be a categorisation of products around liquidity to address their concerns more accurately.

“I think there will be a shake-out. I think people going forward in 2009, when they’re allocating to alternatives will be allocating to strategies that have transparency, liquidity and capacity, because that’s what you didn’t have in 2008,” Bracken said.

He said the alternatives strategies that offer more liquidity for their investors are already being added in the platform space, while in the superannuation space they no longer blindly allocate assets to the alternatives segment, taking a much clearer approach to investing in alternatives by looking at specific strategies to see how they fit with their needs for liquidity.

However, Fiona Trafford-Walker, managing director of Frontier Investment Consulting, said she hasn’t seen a drift to more liquid alternative strategies, but it was important to keep track of the liquidity allocations in alternative investments.

Richard said those liquidity issues would affect the structure of the alternative products themselves.

“Investors will require evidence of liquidity, far beyond what’s just put in the Product Disclosure Statement,” he said.

Transparency issues during the financial crisis will also change the way hedge fund alternatives operate in the future, according to Young.

It will no longer be acceptable to hand over control of their accounts to an underlying hedge fund manager, he added. HFA is increasingly moving to a model of holding funds in their accounts and inviting a hedge fund manager to administer a portion of it, thereby staying in control of their investor’s funds. This model will provide total transparency for every transaction, and an underlying hedge fund manager will no longer be able to negate or refuse to return funds, Young said.

“In my opinion, if fund of hedge fund managers don’t have the ability to offer that capability in their products, they have a limited future.”

Opportunities

> There are widely differing views in the industry on what role the alternatives sector will play in the current financial crisis and beyond.

“We don’t really expect phenomenal growth in equities for the next year or two, they’ll probably trade reasonably within a range,” Bracken said.

“This is actually a really, really good opportunity for alternative funds because they don’t typically depend on any kind of market beta. They look to make money regardless of what the market is doing.”

Bracken believes that considering the amount of risk that remains in the equities market, alternatives will play a big role in guarding against any investment losses.

Before the financial crisis, investors allocated 80 per cent to equities and 20 per cent to cash or bonds. Now investors will allocate up to 20 per cent to alternatives, with 50 per cent going to equities and 30 per cent to cash and bonds.

“For the general retail investor, I think they were much less exposed [to alternatives] and, frankly, didn’t care all that much about alternatives — and why would they? They can simply put their money into an equities index, and get roughly 10 per cent to 12 per cent.

“Obviously, with the market crash, people are looking around for a new way of investing,” he said.

However, Richard believes while 20 to 25 per cent to the right kind of alternatives is the correct allocation in the current environment, the reality will be very different. The mainstream thinking in the financial services industry at the moment makes it very difficult for investors and advisers to recommend such a high allocation, he said.

“[Financial planners] automatically associate alternatives with higher risk. There are certain types of alternatives that actually would lower the risk of an overall portfolio, and if you just stick to that theme of risk management and lowering volatility, there is no reason why you can’t put a much larger allocation in that space.”

Alternatives will most likely represent between 5 per cent or 10 per cent of someone’s portfolio for many years to come, Richard said.

“Every time I ask an adviser his opinion of what he thinks he should have in alternatives, I get the answer, ‘Between 5 and 10 per cent’. That’s what the research houses tell them; it’s what the media tells them; it’s what everything tells them.”

However, Trafford-Walker said the allocation varied widely for different funds.

For an average fund, an allocation of roughly a third of their portfolio should be in unlisted or illiquid investments over time. That number has varied from a 20 per cent allocation for some funds. Other funds have put up to 40 per cent into alternatives over the past 12 months. As the equity markets perform better and returns come back, allocations are shifting around a fair bit, she said.

Young said over a three to five-year period, allocations toward hedge fund alternatives would definitely increase because of the diversification benefits available.

van Eyk managing director Stephen van Eyk said there was no doubt the market was going to experience continuing volatility due to the huge amounts of liquidity being pumped into the economy by the Government, and investors should use alternatives to take advantage of it.

“The one thing you can make more money out of is volatility,” van Eyk said.

“You want to be in alternatives that can take advantage of volatility, so that’s hedge funds, macro funds, fixed income … but [during] liquid markets. I think the illiquid stuff has been burnt.

“Now, [when] beta is doing 8 per cent or 9 per cent per annum, with much more volatility it leads to a change in your investment pattern, so you have less in equities and put that money in alternatives, but you’re trading on the volatility [in the market]. One way or another, I think that’s the way it’s going to happen,” he said.