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Watch that risk

02 November 2004 Angelo Coppola

What do the world’s wealthiest investors know that many investors don’t? Could it be the use of alternative assets such as hedge funds to lower the asset class risk of their portfolio?

In recent years wealthy investors and their financial advisors have poured money into global hedge funds. Today, the global industry is worth nearly $900bn and there are 8 350 funds on offer, and hedge funds are the fastest growing asset class, growing at 20% a year.

“Any portfolio carries both currency risk and asset class risk. Currency risk is largely out of the investor’s control, but the investor can control asset class risk by adding hedge funds to their portfolio,” says Robbie Alexander, chief executive of Octane, the international alternative investment specialist in the Sanlam group.

Individual investors should follow the lead of institutional investors and take a more scientific approach to risk, says Alexander.

“Individual investors must understand the impact of the risk of the various asset classes, as measured by volatility and the Sharpe ratio, on their portfolio,” says Alexander.

Asset classes should be ranked on a risk-adjusted return basis, which gives investors a better insight into the risk they are taking. “Risk is not a bad thing, but investors must be compensated for it.

Equity investments, especially in the current markets, aren’t adequately compensating investors,” says Alexander.

The rise in popularity of hedge funds among wealthy individual investors can be attributed to the fact that on a risk-adjusted return basis they have proven their worth.

A comparison over the past 15 years shows that global hedge funds (the benchmark Hedge Fund Research Index) rendered a risk-adjusted return superior to both global equities and global bonds.

Individual investors, however, should be circumspect about choosing the offshore hedge funds they invest in. Expert advice is preferable as there are a wide range of investment strategies to choose from and an equally wide range of investment styles.

A fund-of-hedge-funds can be the most appropriate choice for an individual investor, says Alexander. “Not all international hedge funds are equal. The most important factors to consider before investing are the fund’s leverage and its transparency.”

Excessive leverage greatly increases the risk of the fund, and the fund must be transparent in terms of its fee and the assets in its portfolio.

“When alternative investments are added to traditional investments it can reduce the investment portfolio’s volatility, improve diversification and enhance returns,” concludes Alexander.

Health warning: This article should not be construed to be offering advice. Each client and investor has unique circumstances and a thorough needs analysis should be the first point of departure.

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