Avoiding the pitfalls of alternative investing

Investors need to find both yield and potential diversifiers that have the prospect of offering non-correlated returns

‘But allocation to alternatives cannot simply be an exercise in ticking boxes, and instead calls for careful analysis of existing risk and return profiles’

Investing is never easy but few would deny that, for a decade after the global financial crisis, overall conditions were highly favourable. The ongoing support from central banks that began after 2008 pushed asset prices ever higher, leading to the longest sustained S&P bull run in history. A simple 50/50 equity/bond portfolio mix provided returns that, by historical standards, were anomalous.

But these exceptional returns, by definition, could not be sustained. Even before the coronavirus pandemic took hold, there were fears over excess debt1 in the system and trade war tensions.

While it’s impossible to second-guess the effects of the Covid-19 crisis, the recent 30% falls in markets are likely to place equity risk more than ever at the front of investors’ minds.

In portfolio asset allocation terms, this now means investors need to find both yield and potential diversifiers that have the prospect of offering non-correlated returns in the event of a market downturn.

The growing interest in alternatives is a natural consequence of the situation. While pension funds and other institutions have traditionally been the cornerstone investors in alternatives, other segments of the market are now looking to capture their potential to enhance overall returns, mitigate volatility and offset the effects of rising inflation and interest rates.

According to a survey of 600 EMEA investor portfolios undertaken by Blackrock Portfolio Analysis & Solutions in 2018, alternatives were popular with investors of all risk profiles. Across the entire range, alternatives of some kind made up an average allocation of 22% – ahead of fixed income (19%) and second only to equities at 31%.

The biggest single category was hedge funds, which spans a wide range of strategies, from global macro to managed futures and long/short equity. As an asset class, this posted strong returns in 2019. According to industry monitor HFRI2 , a composite index that aims to mirror the industry was up 10.4%, the industry’s strongest calendar year since 2009.

But while big name hedge fund managers might grab the headlines, there’s far more to alternatives investing than this might imply. Indeed, alternatives are not really a single asset class at all, and are more of a catch-all term encompassing anything that doesn’t sit within the relatively narrow confines of traditional investment categories.

Other alternative assets include private equity, infrastructure and real assets, commodities, fund of funds and private placement debt. All have varying return streams, risk/return profiles, liquidity prospects and investment horizons – creating the possibility of using them in various combinations within investor portfolios to best mitigate the risks of existing asset allocation decisions.

But allocation to alternatives cannot simply be an exercise in ticking boxes, and instead calls for careful analysis of existing risk and return profiles, as well as an ongoing commitment to a dynamic understanding of the shifting conditions and liquidity trends within each discrete asset class.

Marcos Camhis, CEO of FOS Asset Management, highlights the main challenges of alternative investing as being relative lack of transparency, varying liquidity profiles, and the need for in-depth due diligence.

‘As a long-standing hedge fund investor, I have seen cases come to light where, for example, illiquid real estate or private equity holdings were held in portfolios with monthly or quarterly liquidity,’ he said. Such liquidity mismatch is a red flag and investors should be able to have an insight into portfolios during the due diligence and monitoring process, he added.

Access can create challenges of its own, he added: some of the best-performing vehicles are closed to new investors.

All of these lead to an understandable wariness among investors. And while the market has evolved in various ways to address these concerns, the very lack of heterogeneity among alternative asset classes means that a number of pitfalls still exist for unwary investors.

1 https://www.theguardian.com/business/2020/jan/08/world-bank-global-debt-crisis-borrowing-build-up

2 The HFRI® Indices are broadly constructed indices designed to capture the breadth of hedge fund performance trends across all strategies and regions.