Moving away from the mainstream

You have to find really good fund managers to create a stable portfolio

Michele de Michelis
Frame Asset Management

The starting point needs to be: what level of risk are clients prepared to assume?

Jack Inglis
Alternative Investment Managers Association

There is a growing sense of unease among wealth managers when it comes to investing solely in mainstream asset classes. ‘Honestly, I think that, right now, investing simply in equities and bonds may be really dangerous,’ said Michele de Michelis of Frame Asset Management.

‘If you buy government debt or highly rated corporate bonds, you are required to pay interest rates to the issuer- and to find a little bit of return, you would be forced to buy lower quality bonds. On top of that, equities and high yield bonds are positively correlated and therefore, you can’t achieve real diversification using those two asset classes,’ he added. ‘In my opinion, these are the reasons behind the strong interest in alternative strategies that can potentially offer diversification, lower volatility and decent returns,’ he said.

In particular, DiMichelis believes that investment strategies such as mergers and acquisitions, event-driven, volatility arbitrage, long/short bonds and equities can offer these features, but he stresses the vital importance of manager skill in these areas. ‘You have to find really good fund managers to create a stable portfolio,’ he said.

But moving into the alternatives spectrum presents very specific challenges that wealth managers must consider on behalf of clients. The recent problems at mainstream fund managers such as Woodford and GAM have shone the spotlight on liquidity.

Liquid and illiquid

Within the very broad range of alternatives available, definitions are hard to come by, but the role of wealth managers in understanding the liquidity profile of an individual alternative asset class remains vital. ‘In my opinion, alternatives simply means alternative sources of return that cannot be found in listed equities and tradeable bonds,’ de Michelis said. ‘However, I would rather make a clear distinction between liquid alternatives and illiquid alternatives, because their respective purposes are very different,’ he added.

The variance in liquidity profiles must be factored in relative to expected returns, and also to the client’s overall portfolio and risk tolerances, he stressed. ‘When you invest in a liquid strategy – especially in UCITS1 funds – you know that you can withdraw from that investment at any moment. But at the same time, the return should be compared with other liquid investments, so you can’t expect double digit performance from them,’ he said.

At the other end of the scale, investing in long-term closed funds such as private equity or debt means placing an emphasis on the illiquidity premium. ‘That is what you sign up for when you invest in those asset classes. You have to accept the lower liquidity in the expectation of greater performance,’ he said.

Jack Inglis, CEO of the Alternative Investment Managers Association, agreed that the current market environment is seeing investors reassess allocations, in particular equity risk, within their portfolios. ‘The bull market environment that prevailed for a decade after the global financial crisis saw investors reaping great rewards from a simple 60/40 equity/bond portfolio. But that paradigm now seems to have changed,’ he said.

In this environment, the key discussion for investors should be diversification and allocation of risk, he argues. ‘The starting point needs to be: what level of risk are clients prepared to assume? Most would agree that risk is currently higher than it has been for a very long time. Timing markets is a fool’s game, but structuring portfolios to deliver better risk-adjusted returns over the coming years makes sense, and alternatives have an important role to play in that,’ he said.

But Inglis agrees that risks also exist within the alternatives world and that Woodford and other scandals in long only funds have brought liquidity more than ever onto the agenda.

‘This is an important area for wealth managers because clients are relying on them to screen different alternative investment classes for appropriateness,’ he said.

Most hedge funds, he pointed out, will not have daily liquidity – quarterly is more the industry norm – while liquid alternative vehicles, often structured as a UCITS, will offer daily redemptions.

‘It’s an essential part of due diligence to make sure that the structures are appropriate for and it is important to make sure that this matches the liquidity profile of underlying investments, and this is an area where wealth managers can really add value for clients,’ he said.

He emphasised that post-2008, institutions who became a core client base for hedge funds in particular, placed a huge emphasis on liquidity analysis. ‘Many alternatives managers have a deep and dynamic understanding of liquidity built into their processes. They have listened to their investors and know this is something they will demand to see, whether they are institutions or wealth managers,’ he said.

1 Undertakings for the Collective Investment in Transferable Securities