18-08-2008: Thinking of alternative investments? by Aisyah Lam
There has been a lot going on in global financial markets. With volatility likely to continue, and general consensus of a slowdown in major economies, the question most frequently asked is: Where and what should I invest in next? Given the uncertainties and increasing challenges, investors are exploring various investment options to stay ahead of the curve, and opportunities to improve long-term returns.
This article will cover some of these investment choices known as alternative investments, which complement traditional investing and have been attracting a growing interest from institutional, high net worth individuals as well as retail investors.
Alternative investments
Investments in our market comprise mainly equity, bonds and property. These are traditional investment vehicles. Over time, with innovation and increased understanding of the markets, other alternatives have started gaining popularity.
Many alternative investments with minimal correlation to traditional benchmarks have proven to be resilient in volatile markets and uncertain economic conditions. This formula has worked well supporting the investment rule of thumb — portfolio diversification — and increasing resilience against risks.
An understanding of alternative investments may be helpful in supporting more informed investment decisions, for exposures to other than just equity and bond markets.
Alternative investments include familiar products such as private equity, real estate and structured products; whilst examples of more sophisticated options include managed futures and hedge funds.
In contrast to traditional investments, alternative investments seek absolute performance and depend on advisers’ skills for performance. They may use leverage and have historically low to moderate correlation with market indices. Typically, it is not as easy to liquidate such investments as there may be fixed periods ranging from monthly to yearly, and may include possible lock-up periods. Charges may generally be higher and in the form of performance fees.
Traditional investments, on the other hand, would seek relative performance where returns depend primarily on market performance. They have historically high correlation with market indices. These forms of investments generally do not employ leverage, offer daily liquidity and charge fixed management fee on assets under management.
Why invest in alternative investments?
Alternative investments offer opportunities to qualified investors to diversify their portfolios by combining alternative strategies with traditional holdings, aimed at generating steady returns and preserving wealth through fluctuating market conditions.
Over the years, while the risk-adjusted returns in the stock and bond markets have become less, modern investment instruments such as alternative investments have helped realise consistent returns over time, as they tend to move in opposite directions to traditional strategies.
Alternative investments have helped preserve opportunities for positive returns even during times when stocks and bonds under perform.
Types of alternative investment
1. Private equity
Private equities are privately negotiated deals that are invested in mostly non-public companies that may be in different business phases or categories. This would include start-ups, companies in the development stage or expanding, a buyout situation, perhaps restructuring. Investments could be in form of venture capital (VC); leveraged buyouts (LBO); mezzanine or distressed debt.
Private equity managers could be stand-alone or fully integrated organisations that may take an active role in a target company’s management with the objective of creating value during the period of investment, and to exit profitably.
2. Real-estate investment
This is probably one of the most commonly known forms of alternative investing. Real-estate investment would have an internal rate of return objective although there is no guarantee of the return objectives being met. Leverage could range from 0-75% and the investment has low correlation with market indices.
There is less volatility compared to equities and fixed income as investments are in physical assets, though investments would be relatively illiquid. Real-estate investment could offer an advantage in the form of potential inflation hedge.
Real-estate investment can be public and debt-based like commercial mortgage-backed securities (CMSB) or public and equity-based like real-estate investment trust (REIT) stocks or real-estate mutual funds. Other forms of investment include private and debt-based like mezzanine debt or senior loans or private equity like open and closed-end funds.
Investors should note that commercial real estate can offer portfolio diversification as historically it has low correlation with other asset classes and has provided steady returns over the long term. It has proven performance versus other investments. It is different from family homes and there is risk/return trade-offs in various real-estate investments.
3. Structured products
Of late, structured products have become popular in the market as it can offer the security of principal protection with the opportunity of further income upside. Structured products can be performance-linked, leveraged/arbitrage products and principal protected.
Performance-linked products may be linked to the performance of a basket of assets such as stocks, bonds or hedge funds; or to indices like Morgan Stanley Capital International (MSCI), FTSE or S&P Indices. They are usually illiquid and have no leverage.
Principal-protected products offer capital assurance with potential upside from returns linked to performance of predetermined assets. Principal protection is only valid if the investment is held till maturity.
Leveraged/arbitrage products are investment products that generate returns based on the spread between assets and financing costs. They normally have limited liquidity, with potential for high returns, which comes with association of high risk.
Structured products can be customised to fit the unique requirements of individual investors and can offer potentially higher yields than of market norms if certain scenarios materialise. The underlying structure could be in forms of various exposures to diversified market sectors — they could be offered in one packaged security or maybe repackaged as credit-enhanced/principal-protected products to be managed actively with the aim of improving the risk/return profile of the investment.
4. Managed futures
Managed futures are essentially an alternative investment strategy that offers access to global futures market via professional money managers called commodity trading advisers (CTAs).
CTAs use trading strategies and money-management techniques to attempt to achieve profits and control risks. They trade in global markets including futures, options and forwards on traditional commodities like gold, crude oil, soybean and crude palm oil. They also trade in financial instruments such as the US Treasury Bond, British Long Gilt and NYSE Stock Index as well as currencies, which include but are not limited to the euro, Japanese yen, Czech kroner and Thai baht.
As in any other forms of investment, there are risks involved. Due to the use of leverage, a small change in market price of a futures contract can produce major gains or losses for a managed futures contract.
Nevertheless, from January 1994 till June 2008, managed futures generated an average rate of return of 7.25% compared with the S&P 500 of 8.65%, Nasdaq of 12.6%, Global Stocks of 7.49% and Global Bonds of 7.83% (Credit Suisse Tremont Hedge Fund Index LLC, Lipper as at July 2008).
Given the sophistication of this investment class, fees are higher than that of traditional funds.
5. Hedge funds
Hedge funds aim to make absolute returns regardless of market conditions. They offer greater flexibility than traditional investment managers and can go long and short on stocks. Use of derivatives and leverage is allowed and normally hedge funds impose a higher minimum investment amount. Performance fees are charged based on returns generated by the managers.
Hedge funds do have liquidity restrictions and are moderately regulated with limits on capacity.
Here are several facts about hedge funds.
i) In the early 90s, the hedge fund industry was dominated by high-risk, aggressive macro players. It has since evolved significantly in terms of AUM as well as sophistication, and in 2007, there were over 10,000 hedge funds with many more diversified strategies. Hedge funds do not apply the same investment strategies as other funds.
ii) Hedge funds are not only for bear markets as they seek low or negative correlation to traditional long-term investing.
iii) Hedge funds do not always lack transparency. Whilst skill-based investing may be less transparent than traditional investing, some hedge fund managers make transparency their selling point.
Generally, hedge funds offer opportunity to improve portfolio efficiency with enhanced returns while potentially reducing risk. It also advocates diversification with low correlation to existing asset classes and the chance to participate in investments managed by top-rated hedge fund managers, using different strategies and employing a wide range of instruments.
A fund of hedge funds is a multi-manager hedge fund that has dedicated and expert teams of managers. The assembling funds of hedge funds create a significant advantage over private investors as it offers the opportunity of exposure to a diverse set of strategies in a single investment.
Multi-manager funds have access to the best managers, who often close quickly and limit allocations to long-term clients who buy and hold. Very importantly, fund of hedge funds offers diversification, as it minimises risks by combining funds and strategies.
Minimum investments are lower than single-strategy funds, hence reducing the strain of high-value investing. Transparency is not an issue as they are able to obtain and interpret complex information, which could be a challenge to private investors.
In a fund of hedge funds, strict due-diligence processes facilitate identification of quality managers, while continuous monitoring and reviews are enforced.
Portfolio construction and readjustments of positions are made throughout the life of the portfolio. These efforts are resource intensive and could not possibly be conducted by a private investor.
It is important for investors to read, research and understand the features, liabilities and benefits offered by alternative investments such as private equity, real estate, structured funds, managed futures and hedge funds. A well-diversified portfolio, which incorporates some form of alternative investment, could help increase returns and lower portfolio volatility overall.
Aisyah Lam is the head for wealth management products, Citibank Berhad
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