There is an ever-growing list of ‘alternative’ investments available to investors, but this term can be confusing. The definition of alternative investments is a loose one and ranges from the more traditional heartland of credible investments that are not dominated by equities, bonds or cash, to more unusual investments, including art, wine, antiques and even stamps.
Any potential investment must have a sound case that will stand the test of time rather than it being a strategy born out of fashion or disillusionment with the status quo. We do not often find a meritworthy long-term investment case for many of the more opportunistic or thematic strategies.
For us, potentially credible alternatives include investment plans that make use of hedge fund strategies, derivative-based strategies, direct property investment, commodities, private equity/venture capital and their ilk.
Using this definition, well thought-out alternative investment strategies can still be beneficial for investors today.
The alternative view
The two most often cited benefits for alternatives is that they are lowly correlated with other traditional markets – therefore a diversifying asset class – and that they are return-enhancing because they outperform other asset classes.
First let’s look at the correlation argument. The table shows in sterling terms the correlation between UK equities and UK bonds with various alternatives (also in sterling terms).
It is important to note this analysis uses specific indices for these various markets rather than particular managers. The performance of individual managers could be materially different from these indices, either better or worse.
From this, we can see that most alternative indices do provide a reasonable level of diversification from the 50:50 UK equity and bond portfolio. Direct property and commodities have a low, but positive correlation with the balanced portfolio and the hedge fund index is only moderately correlated. Private equity is the most correlated to the composite, which is understandable given its high correlation with the equity market (75%).
Now let’s consider return enhancement. For this argument to hold true, the returns provided by alternatives must be higher than those of traditional asset classes. Furthermore, it would be even more advantageous if they were to do this with less volatility and hence the risk-adjusted returns would be superior.
Historically, there have been a number of occasions when particular alternatives have significantly outperformed traditional equities and bonds.
In such periods, having an allocation to alternative assets, such as funds of hedge funds, has materially enhanced returns. Also, many genuinely long-term, sophisticated investors (such as pension funds and endowments) hold a structural allocation to alternatives.
Remain vigilant of risk
One of the main characteristics of alternatives is the variation within this categorisation between different investment types, the managers within each asset class, fund terms and other peculiarities. The key is having an expert to do the due diligence for you and we believe in blending a range of different strategies to maximise return and diversification potential.
Investors must always ensure that any given strategy is appropriate for them and bear in mind the number-one rule of investing – if you don’t understand it, don’t buy it.
For our hedge fund exposure, for example, in order to create an optimal blend of strategies, we have a specialist in-house fund of hedge fund team whose role is to navigate these difficult waters for our investors.
Investors considering such investments must remain vigilant to the potential risks, such as possible illiquidity of underlying assets, irregular pricing, the difficulty of trading in and out, costs and the need for highly specialised due diligence.
Alternatives are a complex and technical area, but with judicious strategy and manager selection, they can be extremely rewarding. Investors must always ensure that any given strategy is appropriate for them and bear in mind the number-one rule of investing – if you don’t understand it, don’t buy it.
