David Griffith looks at the myths surround alternative investments, and argues they have multiple uses in a range of investor portfolios.
Alternatives are often misunderstood. Some investors think of them as high-risk, exotic funds reserved for ultra-high-net-worth individuals and sophisticated institutions.
But the reality is that alternatives are widely accessible and can be used across many different investor portfolios.
Here we address 10 common myths about alternative investing:
Myth 1: Alternative investments are their own unique asset class
Reality: Alternatives represent different approaches to investing across a variety of markets and asset classes.
Many consider investments such as hedge funds and private equity as stand-alone asset classes that have little to do with more traditional asset classes such as stocks or bonds.
However, alternatives actually represent different approaches to investing across a variety of markets and asset classes.
Certain investments, such as currency and real estate investments, are truly alternative assets in that they have little relation to the performance of traditional stock or bond investments.
Then there are alternative strategies — those that trade in predominantly the same markets as traditional investments, but approach the markets in a unique way, using, for instance, long/short strategies.
In Australia, a broad spectrum of investors can access these strategies via retail funds, wholesale funds, and offshore unregistered funds — all of which are structured differently for a variety of management, liquidity, legal or regulatory reasons.
These vehicles may include similar investments, but can encompass many styles and methods of investing across different markets.
Myth 2: Only institutional investors and ultra-high-net-worth individuals can access alternative investments.
Reality: Individual investors have greater access to alternatives than ever before due to recent innovations in product structures.
While institutional investors do tend to be frequent users of alternatives, many individuals have also long relied on alternatives for their diversification benefits.
In the past, available options were limited and diversification could be costly.
In recent times a variety of alternatives is increasingly becoming an option for investors, particularly with the advent of comprehensive strategies that combine numerous investments in a single portfolio and because of the increased availability of retail hedge funds focused on alternative investing.
For some investors, a single-portfolio solution will be the only allocation they need.
For others, more tailored solutions that build around existing portfolio assets with a specific objective in mind, may help to provide the appropriate mix of risk exposures in individual portfolios.
Myth 3: Alternative investments are more volatile than stocks and bonds.
Reality: When used as portfolio diversifiers, alternatives have the potential to reduce overall volatility.
Some alternative investments can experience higher levels of volatility than traditional stocks and bonds but as a group, they are no more volatile than any other investment, and in many cases may be even less volatile than traditional assets.
Additionally, because alternatives approach financial markets differently than traditional investments, they can provide returns that exhibit low correlations with more traditional approaches.
As such, adding alternatives to a diversified portfolio has the potential to provide lower volatility than a portfolio composed exclusively of traditional stocks and bonds.
Myth 4: Alternatives invest in derivatives, which in turn, increases their risk.
Reality: Derivatives are commonly used investment tools designed to manage or hedge out risks.
Many investments, not just alternatives, invest in derivatives as a way of gaining access to, or hedging out, very specific risks.
Certain types of derivatives, such as futures contracts, can be more efficient and cost effective than purchasing assets such as equities or commodities directly.
By themselves, derivatives do not necessarily increase the return volatility of a portfolio, although it is true that derivatives are often associated with increased leverage and counterparty risk.
Myth 5: Investors do not have access to their capital if they invest in alternatives.
Reality: Liquidity levels vary among alternatives and are specific to each investment type.
Many alternatives are less liquid than traditional investments, but the level of liquidity is very specific to the investment itself.
When investing in less liquid assets, investors should expect to be compensated for that illiquidity (defined as an illiquidity premium) through improved risk- adjusted returns.
Some alternative investment vehicles are designed to provide more liquidity and greater regulatory oversight. However this approach can often mean that the investable universe, or the types of strategies implemented, is more limited.
In assessing any investment, investors need to consider such factors as the quality of the management team, their investment process, the current and potential investment opportunity set and features that might differentiate or set apart similar products.
Additionally, investors can look for alternative funds that are designed to manage less liquid investments directly alongside strategies that have some higher degree of liquidity.
Myth 6: Alternatives will always outperform stocks.
Reality: Just like traditional assets, alternatives are subject to inherent risks and will outperform (or underperform) at different periods in time.
While alternatives are often thought of as higher-risk/higher-return investments, that is not necessarily the case.
A well-constructed portfolio comprised of a diversified basket of alternative strategies may achieve returns similar to that of equity markets over time, often with the benefit of substantially lower levels of volatility.
The tradeoff, however, is that when equity markets are particularly strong alternatives may, and often do, temporarily underperform.
Conversely, when equity markets are underperforming, alternatives may do much better on a relative basis because of their tendency to assume less equity market risk, typically resulting in lower volatility.
These sorts of performance differences can be particularly pronounced during times of economic stress. As such, it can be a prudent strategy to incorporate both alternative and traditional investments into a well-rounded portfolio.
Myth 7: It is easy to pick the right alternative — all I need to do is look at historical performance.
Reality: Investors need to consider a wide array of factors beyond performance when selecting which alternatives are best suited for them.
Past performance may not be repeatable for a variety of reasons including size, opportunity set, concentration, and one-off events.
In assessing any investment, investors need to consider such factors as the quality of the management team, their investment process, the current and potential investment opportunity set and features that might differentiate or set apart similar products.
Many times, alternative funds that struggle to perform do so because of structural issues within their business models. For that reason, when considering alternatives, investors also should weigh the strength of the fund’s operational abilities and the liquidity considerations discussed earlier.
Myth 8: Investing in one type of hedge fund or private equity fund will diversify my portfolio.
Reality: Multi strategy alternative funds may alleviate concentration risks.
Investing in a single strategy alternative fund may provide some diversification benefits, but can also concentrate risk exposures.
Multi strategy alternative funds, as the name suggests, invest across a range of alternative strategies and may help to alleviate concentration risks.
Myth 9: Alternatives failed to protect investors during the financial crisis.
Reality: In general, investors with exposure to alternatives fared better during the financial crisis than those with traditional portfolios.
It is true that correlations across nearly all investments converged during the financial crisis.
Even during crisis periods, however, history shows that alternatives have not typically fallen as far as equities, providing an important cushion for those investors who maintained a position in alternatives.
The reality is that during the 2008 financial crisis, an investor who had exposure to a broad range of alternatives would have been better off than an investor who was restricted to traditional long-only equity and fixed income investments.
This reaffirms our view that investors should consider adding a strategic allocation to alternatives in their core portfolios.
Myth 10: Alternatives are too expensive.
Reality: Although fees for alternatives are typically higher than they are for traditional investments, the fees may be justified if they provide access to return streams that offer a benefit over traditional assets and are intended to align manager and investor interests.
Depending on the particular investment vehicle, alternative investments can carry different/higher fees than traditional investments.
Higher fee rates are typically charged for alternative strategies as they offer return streams that offer a benefit over traditional assets.
For example, hedge funds often seek a high level of absolute returns that require a greater degree of manager skill than traditional portfolios.
In addition, the return streams may have different or enhanced risk characteristics when compared with traditional portfolios, whereby meaningful returns can be achieved with a lower level of risk, or the return stream offered may help diversify a portfolio of traditional assets by bringing down overall portfolio risk.
Many alternative investment funds split fees into a management fee and a performance or incentive fee whereby a manager is rewarded according to the performance of the fund.
Importantly these performance fees (which typically represent the majority of fees paid) are only earned when the fund, and therefore the investor, has positive performance over a certain hurdle rate.
Also, many alternative product fee structures have high water mark mechanisms that require a manager to earn back any performance losses before any new performance fees are charged.
The bottom line is that for most alternative investments, fees and performance are closely aligned and managers are only fully compensated for delivering positive returns to investors.
Investors need to carefully consider fees and how they may impact long-term returns.
David Griffith is the director and senior investment strategist at BlackRock Multi-Asset Strategies Group.