A relook at alternative investments

WITH the S&P 500 and other global indices reaching record highs at the start of 2018, many thought we'd see a repeat of the 2017 bull run. But global markets have pulled back substantially of late, and investors now look to manage risk in this more volatile period.

Investors are torn: Do I lock in earned profits now or hold out for future gains?

You can understand the conundrum. After all, if they've been listening to the morning talk shows, this half-decade bull run is coming to a close, and yet markets have continued to grind ever higher.

What if there were a way to continue in much of this upside while partially protecting your downside?

Alternative investments are a possibility but a few misconceptions need to be picked off and addressed first.

Investors have to bear in mind that alternative investments may not be for everyone, as many of them are available only to experienced and financially sophisticated investors.

First misconception is that the purpose of alternative investments is to seek outsized returns by taking excessive risk. On the contrary, effective alternative investments can reduce risk in portfolios and in turn help to drive higher, smoother and less volatile returns over time.

The second misconception relates to the sub-optimal returns generated by hedge funds in recent years. While true, hedge funds tend to perform best when market volatility is increasing and asset correlations are low. For many of the bull market's recent years, we saw both low volatility and high correlations as investors sought outsized returns across all asset classes. The market we have seen so far in 2018 is showing a tendency towards higher volatility and lower correlation.

One hedge fund investment strategy that can be beneficial in today's markets is equity long/short. An equity long/short hedge fund will simultaneously hold long positions that will increase in value if markets rise, and short positions that will increase in value if markets fall. One key metric to look for in selecting such a fund is their track record of upside and downside participation.

A good manager might have a track record of achieving 80 per cent of the broader market's gains as markets rise, but in bad times will incur only 40 per cent of the losses. Many investors feel it is sensible to give up a mere 20 per cent of participation on the upside to protect their portfolio from up to 60 per cent of the possible downside should markets fall.

The third misconception is that hedge funds are the only type of alternative investment that can add value and reduce portfolio risk in today's more volatile markets.

For investors with a long-time horizon, private equity can also enhance returns and lower volatility. Top-tier private equity managers, for example, have shown consistent outperformance over listed equity markets. We call this the "illiquidity premium" generated by private equity over liquid stock markets.

Private equity's additional benefit is its relatively lower short-term value fluctuations compared to assets like stocks, therefore helping to lower volatility in portfolios. There is no free lunch in investing, and the trade-off for this enhanced return and lower volatility is long lock-up periods of typically 10 years, although that can change depending on the opportunity.

While 10 years may sound daunting, many investors have already made illiquid investments when they bought a home or an investment property, and these can be held often for decades. Just like property or any other illiquid investments, we recommend that investments in private equity be sized correctly such that an investor's near-term life needs can be met from their liquid portfolio without having to sell illiquid assets.

The benefits of less liquid investments are also available in credit markets, where private credit can offer a good alternative to traditional bonds.

Unlike traditional bond markets which are easily traded by individual investors, private credit markets are not directly accessible to individuals due to their complex institutional nature. As such, investors can access private credit funds much like private equity funds, where a specialist manager makes the underlying investments. These managers invest in private loans that are less liquid and typically pay a higher yield than public bonds, and are also often better protected in the event of default, given their superior position in the capital stack and better recourse to collateral.

Additionally, these private credit instruments are usually entirely floating rate - investors' concerns surrounding rising interest rates are fully mitigated by this investment, since the underlying loans will simply reset upwards in the event of rising rates. In contrast, most public bonds are fixed rate instruments, meaning they will fall in value if rates rise.

The key to investing in any alternative investment is careful selection of the manager and the fund. There is a wide dispersion of performance between the top and bottom quartile of alternative managers.

Before making any investments, you should ensure that the manager has been carefully vetted and has passed a rigorous due diligence process. We recommend that private investors use a reputable wealth advisor or other trusted professionals with strong capability in manager selection in order to reduce risk and increase the chance of investing in the best-performing managers.

In light of the current market environment, there is increased interest by investors in alternative investments as an opportunity to diversify and risk manage portfolios.

With the right guidance from your trusted financial advisor, the alternative investment space might be something worth considering when used appropriately and within an overall portfolio-based approach.