Christopher Salih charts the rise of alternative investment strategies, and examines the regulation and market forces that have influenced their uptake
The use of alternative investment strategies has come to the fore in recent years. This has been driven by both regulation and investment forces. The arrival of Non-Ucits Retail Schemes (Nurs), multi-asset portfolios and the growth in Sipps has been instrumental in pushing alternative investments into the forefront.
Also, the equity bear market followed by questions over the sustainability of bond prices have amply demonstrated that a portfolio comprised of equities and bonds is insufficiently diversified.
But while the possibility of increasing returns and diversifying risk in a portfolio is appealing, alternative asset classes need extra care. So what do advisers need to consider? Are these asset classes actually more accessible than they used to be? And what can alternatives do to the risk and return profile of a portfolio?
Are alternatives worth it?
The advantages of diversifying away from traditional asset classes should not be underestimated. Those who took advantage of hedge funds in the bear market of 2000-2003 were fortunate enough to reap the benefits of what was, at the time, a relatively untapped source of portfolio flexibility.
Patrick Armstrong, fund manager at Insight Investment, says: "Hedge funds have their own appealing statistics that separate them as an asset class. They offer an ability to make money regardless of the direction of both stocks and markets. They offer wider opportunities because they are uncorrelated with other asset classes."
Kier Boley, fund of hedge fund manager at GAM, says hedge funds have garnered their reputation over a sustained period. He says: "Hedge funds have been a good investment for investors for quite some time. In the 1990s people got success through equity hedge, but they really set their reputation in stone in the 2000-2003 bear market, as they did with the 1987 crash. There was a lot of late money into hedge funds in 2002-03 and as the market recovered the hedge market struggled in 2004. But in 2005-2006 the market began to recover once more as people began to embrace risk once again."
Dispel the myth
Despite performing in difficult market conditions, hedge funds have a reputation in the industry for being both secretive and risky. Boley is keen to dispel those myths, he says: "Those stereotypes of being risky and secretive are unfair. To be successful hedge funds need an element of secrecy, but that is exaggerated. As far as risk goes you only have to look at the long-only traditional funds and compare the amounts they lost on the back of the tech bubble to what hedge funds lost. People's view of them is also about six to 12 months out of date, leading to a battle of perception against performance."
Hedge funds have traditionally been an investment for sophisticated, high net worth investors because minimum investment levels were high and advisers could not recommend them directly. But this is democratising. Funds of hedge funds have grown up, along with multi-asset portfolios, and now provide easier ways for investors to get a proportion of their portfolios into hedge funds.
Alan Smith, director at Capital Asset Management, says: "Clients are becoming more demanding, as they look to add value quickly. Hedge funds and private equity were traditionally the home ground of the very wealthy and sophisticated. But that is definitely moving as the barriers to entry in funds decrease.
"There are also changes in investment markets as people look for different things. The market is sitting on the back of a bull run, with all the assets fully valued and, as a consequence, there is a strong argument for holes appearing in the bottom of every sector. Advisers now know they have to be both careful and creative on where they put their money, opening the door to alternatives even further."
Regulation has also made alternatives more widely available to investors. A-Day has allowed increased pension investment in alternatives. From April this year, advisers could invest in property within an Isa wrapper. Many of the Nurs and other multi-asset portfolios now have Isa status, bringing them into the mainstream.
Armstrong says: "While high net worth clients remain the target audience, the pensions and endowment market still have gaps, and the pension's side is seriously underweight. This will mean millions will go into alternatives to breach that gap."
Smith says: "The key issue behind A-Day is the transfer of Sipps from a niche to a mainstream product. Looking at pension funds and property investment there will be a move from being insurance-led to alternatives-led with a degree more risk. It has also freed up significant assets that are traditional to insurance companies."
Loosening the reins
Ucits III is probably the main legislation that has affected alternative asset classes in recent years. It gives funds a far greater scope to invest in non-mainstream asset classes as well as allowing funds to indirectly hold 'short' investment solutions through cash-settled derivatives like hedge funds.
Another feature of the Ucits III legislation is that derivatives are no longer confined to 'efficient portfolio management', meaning they can be used as discrete investments to make a profit and do not need underlying asset backing. Nurs were a spin-off from this. That said, most fund managers are still using their new found flexibility for risk management rather than profit generation.
Marcus Brookes, deputy head of multi-manager at Gartmore, says: "Nurs was the UK's response to the spirit of Ucits III. It allows us the extra freedom of going as high as 100% cash, although our Cautious Managed fund only goes as high as 30%. It increases our flexibility in the market."
Smith says the progress of alternatives will depend on the fragility of the market. He says: "There is no doubt that these alternatives are moving in the right direction, but the grey area remains the higher degree of risk and the limited understanding of what is integral to their running. Retail investment has always been a reactive rather than proactive, so with a strong market over the past couple of years it has had a good case but that can easily change."
So does the adoption of alternatives significantly change the risk and return profile of a multi-manager portfolio? Brookes says: "I should hope so or there would be no real point in going there in the first place. ISMA research looked at the efficient frontier of funds, comparing the use of long-only funds with fund of hedge funds. The latter came out favourably. There is a strong argument for using both in a portfolio but concentration and respective risk become bigger issues."
From an adviser's point of view Smith says alternatives are unlikely to be a core investment simply because of the complications involved. He adds: "From the adviser perspective you are always aware of the litigation side, and are equally wary of recommending an area where you probably are not an expert. For the majority of advisers this is not their expertise, and the worry of being sued by clients often scares them away from doing anything more than dipping their toes in the water. It will always be the realm of the sophisticated, well informed and well-to-do clients."
Efficient portfolio theory suggests that the use of alternatives can produce additional returns and/or reduce risk. It can certainly even out a client's return, ideal for pension planning. Alternatives are slowly shifting into the mainstream, but mostly through the back door, such as via multi-asset portfolios, for the time being. It is likely that the next stage of development will be led by regulation rather than by advisers and consumers. The diversification arguments are sound; providers just need to convince the FSA.
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