This article first appeared in Professional Adviser.
The definition of alternative is fairly simple. An alternative should offer something different to the traditional. Within investments that means an alternative to equities and bonds. We should accept, and indeed embrace, the fact that this makes for a broad church which captures a vast array of different types of investments, approaches and strategies. Some of those investments are considered to be non-traditional but will be familiar to many, such as commodities; infrastructure; private equity; and real assets such as property. The common denominator is that they can display different return characteristics to those of equities and bonds. Alternatives also encompass funds, often referred to as hedge funds or absolute return funds, which adopt non-traditional investment approaches in a variety of asset classes, primarily the ability to short. This approach, if used effectively, allows investors the opportunity to benefit from falling asset prices to create a different return profile to simply buying and holding those assets. The ability to go long (buy and hold) as well as short, creates the potential to deliver a positive return regardless of the prevailing market environment.
It’s important to note here that, while all absolute return funds can be considered alternatives, not all alternatives are absolute return funds. Even within absolute return investing there is a vast of array of different assets, approaches, strategies, skills and abilities to be aware of.
All this is important because the introduction of an alternative within a broader investment portfolio creates additional portfolio diversification and, as you probably already know, diversification is widely accepted as being the only free lunch in investment. True diversification, combining investments that behave differently to each other, reduces the reliance on only one or two types of investment for returns. It can reduce the ongoing ups and downs normally experienced in the world of investments and can provide another source of, positive, return should either (or both) of the traditional assets fail to deliver. What’s not to like?
Well, attitudes towards the world of alternatives vary. For some, the experience of alternatives has not been good. Some alternatives, hedge funds in particular, have over the years (and often justifiably), gained a poor reputation. They have been associated with speculation, high fees, dodgy domiciles, greedy managers, poor liquidity, poor execution and spectacular failures. They are also viewed as overly complex and opaque. This has created a certain, understandable, wariness amongst investors.
Some mainstream hedge funds have been able to attract huge inflows from the retail market but have failed to meet expectations. This is a serious problem in the UK retail market where a handful of funds have been able to capture the bulk of the money allocated to this asset class. Unfortunately, those funds have also disappointed and led many to conclude that absolute return specifically and alternatives generally don’t work and should therefore be avoided. That would be a grave error.
In many instances, the poor experience investors have had with alternatives to date has been down to poor implementation practices as much as the performance of individual funds. It hasn’t helped that we’ve also enjoyed a sustained bull run in both equities and bonds, an environment where alternatives have not really been required nor had the opportunity to shine.
We now look to be approaching a more difficult spell for traditional assets at a time where cash is paying less than inflation and therefore guaranteed to lose money in real terms. Alternatives are going to be an increasingly important asset class for those long-term investors seeking to navigate a more volatile environment. It’s therefore imperative that they are approached in the right way to avoid further disappointment.
The most disappointed investors I come across are those with unrealistic expectations. Those expecting equity-like returns for bond-like risk are setting themselves up for disappointment. And those expecting positive returns, over all timeframes, and all market conditions are demanding the impossible. To get the most out of this asset class you need to be realistic both in terms of what can be achieved by the underlying investment approach being adopted and the timeframes over which you measure success.
Alternatives, particularly absolute return funds, like most investment strategies tend to perform better when a discernible trend pans out over time. Alternatives give you options when other traditional assets are in a period of decline. In market corrections, which tend to happen quickly and unexpectedly, funds that outperform are those already positioned to benefit from market falls or they price in such a way that short term market fluctuations take time to feed into their valuations. The short seller would have likely lost money up until any correction, whilst the latter might well experience a significant fall in value in the future. Very few funds will have outperformed as a consequence of perfect market timing and it would be foolish to assume that, even if they had, such a skill is consistently repeatable.
Where are the key risks?
Manager risk is elevated in the world of absolute return. For us, this is one of the key risks. When you give fund managers the tools to isolate their skill from the market and leverage their positions, you magnify both the upside and downside potential. The only way to ensure you mitigate this risk is to access more than one manager. Limiting your exposure to one manager, and therefore one approach is very risky.
Lack of diversification
When every manager is promising cash plus returns regardless of the market environment it is easy to question the benefit of diversification. That would be an error as these objectives are aspirational and by no means guaranteed. In addition, there are many different approaches to achieving them. This is a much more diverse asset group than is sometimes immediately apparent. It is therefore vital that your allocations should reflect that.
The largest five funds in the IA Targeted Absolute Return Sector, the current home for most absolute return funds, account for 70% of the assets under management. You’ll know the names. It isn’t unreasonable to assume the majority of retail investors accessing absolute return funds will be using one or two of these funds. From our perspective that not only suggests that the selection decisions are potentially questionable but more importantly the approach just doesn’t offer enough diversification or do justice to the opportunities that exist.
At the core of the issue around how investors approach alternatives is the size of the allocation. Many investors recognise the importance of alternatives but only allocate a small percentage of their overall portfolio to them. That’s completely reasonable. Where the allocation is small then it is hard to justify spending the time and effort required when the overall contribution is so small. We understand that. That is why so many portfolio managers invest in global emerging market funds, for example, rather than implement their own regional allocations. No doubt they could add value doing so but the gain doesn’t justify the effort. The alternatives asset class is far greater in terms of the breadth of opportunity set. More time and effort is required to get the most out of it. Either that or a complete change in approach. In many instances clients and their advisors would do well to consider outsourcing this component of their portfolio to a professional manager or specialist just as they might emerging markets or even global bonds, allowing them to focus more on areas in the portfolio that are likely to have a far greater impact on overall returns. Multi manager is an investment approach we believe is perfectly suited to this arena and an obvious solution to the implementation issues we have highlighted.
Top tips for approaching alternatives
- Be clear about the rationale for including alternatives in a portfolio
- Retain realistic expectations on performance
- Look beyond the objective and understand the underlying approach. Monitor positions frequently
- Recognise the need to diversify across asset class, region, approach, manager and management group
- Consider outsourcing options in the space, particularly where allocations are too small to justify the attention and diversification required
For journalists in their professional capacity only. The value of an investment, and any income from it, can fall as well as rise. Investors may not get back the full amount they invest. Personal opinions may change and should not be seen as advice or a recommendation. We do not offer investment or tax advice. We recommend investors seek professional advice before deciding to invest. Investors should read the Prospectus, the Key Investor Information Document (KIID) and the Supplementary Information Document (SID) before investing as they contain important information regarding the fund, including charges, tax and fund specific risk warnings and will form the basis of any investment. The Prospectus, KIID, SID and application forms are available in English at octopusinvestments.com. Issued by Octopus Investments Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: 33 Holborn, London, EC1N 2HT. Registered in England and Wales No. 03942880. Issued: February 2019.