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Alternatives: where best to invest?

Finance : Alternative Investments

Alternative investments are increasingly becoming essential elements of an investor's portfolio. But what current trends should you be aware of? James Freeman explores what's hot and what's not in the world of alternatives.

James Freeman is a senior relationship manager at Key Asset Management in London.

The tectonic plates of the fund management industry are beginning to shift and the accepted norms of the last 20 years will undoubtedly change as a result. But what is causing this shift? Regulators in many countries are increasingly requiring investors not just to think about returns, but to consider those returns within the context of the risk being taken.

However, what is encouraging for both private and corporate investors is that there are now more asset classes to consider and more tools available to assess and manage the risk within these asset classes.

Alternative investments are the talk of many fund managers. David Swensen, who has managed the Yale Endowment Fund (YEF), is a standard bearer for AIs. YEF has an asset allocation that many investors, both corporate and private, would not recognise: as of 30 June 2006 it had only 27% in traditional equities (both domestic and foreign).

If one were to compare this to a typical pension scheme or private client portfolio in the UK, the average allocation to equities would be nearer 50–60%. What has drawn investors' interest to this reduced reliance on equities has been the clear diversification benefits that produced a far better risk/reward pay-off.

In 2002, at the height of the bear market, YEF did not lose money; in fact, when one looks at its track record over the last 10 years, the fund has managed to produce an annualised return of 17.2%, and an annualised return of 15.4% over the last 20 years.

Why should investors consider an approach that includes a much wider use of asset classes? The major reason is that it centres around the common sense principle of "not having all your eggs in one basket". Relying on equities as your sole source of return is a high-risk strategy – as those investors who saw 30+% of their investment value destroyed in 2000–03 will testify. By spreading the risk across multiple asset classes, investors can substantially reduce the overall risk without limiting the upside potential.

The net result for investors is that the approach will produce a superior risk adjusted return or, put another way, for every unit of risk taken, more return is produced.

But if there is such a strong case for diversifying the asset classes that investors employ, why are many investors still so reluctant to move away from equities? Financial advisors have tended to stick with a very high exposure to equities and, as long as the client can stomach the volatility and the potential short-term capital losses, that advice has been appropriate during an unprecedented bull market. Equities have delivered substantially better returns than bonds.

However, as we have seen, the downside risk that conventional equities expose clients to is real and can be very painful. Advisors are slowly but surely accepting that in order to meet client return objectives a more diversified approach is more likely to yield results.

So, what are the major asset classes that should currently be considered as substitutes to conventional bonds and equities, and what are the current opportunities?

Private equity
Private equity is a broad term that commonly refers to any type of equity investment in an asset in which the equity is not freely tradeable on a stock exchange. There are several broad categories of private equity, including leveraged buyout, venture capital and mezzanine capital. Private equity funds typically control management of the companies in which they invest and often bring in new management teams that focus on making the company more valuable.

The major drawback to this asset class has been the severe liquidity constraints it generally imposes on investors. Typically, investors have to commit to locking their money away for up to seven years. The exit for private equity investors is either through selling the business to a trade buyer or floating the company via an Initial Public Offering (IPO).

In recent years, private equity has attracted record funds to invest on behalf of institutional investors using cheap debt. Given the colossal sums now being raised, even some of the leading figures in the industry are warning of severe short-term conditions if economic growth slows and global interest rates carry on climbing.

Structured products
Investors are increasingly looking at isolating particular characteristics from an asset class via structured products.

These vehicles come with a wide variety of pay-offs, including guarantees of capital preservation, dynamic leverage, distribution of income or changes to regulatory or tax treatment. It is clear that the use of such products is on the increase. For example, the move from active to passive fund management has allowed investors to separate out the two components of return and substantially reduce the overall cost of their return.

Real estate
Real Estate Investment Trusts (REITs) are one of the hot topics in real estate, and have allowed a much wider access to property markets. While the allocation in many funds and portfolios to property declined during the 1970–80s as equity returns far outstripped all other asset classes, the argument for re-allocating back into real estate is strong.

This is especially true given that its diversification benefits and lack of volatility have seen institutional investors increasingly returning.

Activist funds
While hedge funds are increasingly now part of the "mainstream", many investors have become familiar with activist funds. In the last few years, a number of high profile funds have taken positions in quoted companies and agitated for change. These changes are often centred on hedge funds voting for the removal of individuals, or whole company boards being replaced with supporters of the particular hedge fund.

Activist funds are not all aggressive corporate raiders as the media would sometimes have us believe. There are a growing number of friendly activist managers who work closely with management boards to improve company performance and which both the hedge fund and company management hope is reflected in the share price of the company.

This general style of investing has much in common with private equity. It is also, perhaps, the point at which the two asset classes start to morph into one another. What has become apparent in recent years is that hedge funds are trying to mimic many of the areas, which have up until now been the preserve of the private equity investor.

Another strategy that is growing in popularity is asset-backed lending. This strategy includes the sub-set of mortgage back securities, factoring funds, trade finance funds and leveraged loans.

The provision of finance to fund trade or corporate activity is no longer the sole remit of well known banks; hedge funds are increasingly becoming involved and as a result, investors can gain access to yet another asset class that offers very different risk reward characteristics to conventional equities and bonds.

Extensive choice
The downside to all these strategies is that it is often difficult to assess the risks and, since they are relatively new strategies, there is no real evidence of how they might cope in times of market turbulence.

One thing investors can be sure of in the future: choice in the alternative investment world will be extensive and will allow substantial diversification benefits for investors who don't want to keep all their eggs in one basket.

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