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Credit crisis transforms alternative investments world

08 October 2008 John Mauldin, President of Millennium Wave Advisors

Turmoil in financial markets stemming chiefly from the credit crisis is rapidly transforming the world of alternative investments, giving prominence to a wider range of investment options.

“As the crisis plays out, an entire financial structure is crumbling and a revised investment system will need to be considered and built up in its place,” says John Mauldin, one of the US’s top investment advisors and a partner with SA’s Plexus group. “This process of change, as well as expected future returns from the various asset classes, will have a significant effect on traditional as well as alternative investments.”

Since the first signs of the subprime crisis emerged over a year ago, some of the highest-profile upsets occurred within the hedge fund industry, says Mauldin. As banks around the world tightened access to money on concern that borrowers' collateral was impaired by exposure to subprime loans, hedge fund managers have scrambled to raise cash and dump tradable assets.

According to Mauldin, it was too late for some. Since June 2007, some of the world’s high-flying hedge funds have reported double-digit losses, implosions and bankruptcies, including those managed by US investment banker Bear Stearns, Goldman Sachs and Sowood Capital Management.

“The crunch raises questions about the viability of some hedge fund strategies in the absence of easily available money, which, until last year, encouraged fund managers to take on increasing levels of leverage and risk,” says Mauldin. “It questions the extent to which leverage is used, a strategy which has assisted some hedge funds to post annual returns of 30 to 40 percent. It also highlights other issues, including choice of underlying securities and the use of borrowed money.”

“Quite simply, hedge fund managers will need to rethink how they are going to generate returns going forward, as well as at what level of risk. With liquidity and traditional fixed income securities – until now a popular source for generating investment return – likely to disappear, hedge funds need to revert to other strategies to add value. Already, the number of quantitative hedge funds has shrunk,” says Mauldin.

How else will the alternative investments landscape differ? According to Mauldin, asset backed lending (ABL) funds will increasingly appeal to investors. As access to capital becomes scarcer, future equity returns decrease to one-digit numbers and investors show aversion to excess leverage, they will seek an investment vehicle that provide solid returns at low risk.

ABL funds are not hedge funds, as they do not invest in equities, bonds or commodities, and selling short is unknown to them. Most ABL funds also use no leverage.

Rather, ABL funds are almost like small banks, lending capital to companies and individuals against collateralised assets. Returns are generally relatively stable and fairly consistent. The largest risk is that borrowers default on the loan, however, that risk is mitigated through the collateralised assets that secure the loans.

With increasing capital scarcity, ABL funds will be able to charge higher interest rates and also improve the quality of their loan book as they attract higher quality borrowers. Historically, they have produced attractive returns in adverse economic conditions where there is low liquidity in markets.

“Investors are also likely to see the creation of a series of absolute-return funds that can be though of as private credit funds,” says Mauldin. “These funds will look like banks. When they loan money, they will expect it to come back with a level of risk return commensurate with the manager’s level of risk.”

He says private credit fund managers will approach investors requesting a capital sum, and quote an investment return upfront. Their returns will be steady and bond-like. These private credit funds will look like private equity in that they will have long lock-up periods, so that the duration of the investment matches the duration of the loan.

“As the alternative investments landscape evolves, it is clear that alternative investments will play a far more prominent role in future,” says Johan Pyper, Plexus group head of research. “With investors chasing the best returns they are likely to look wider than the traditional investment range and consider diversifying across alternate options.”

Pyper continues, “From our point of view, we will certainly consider including alternative investments in our portfolios where we believe investment value can be added.”

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