Looking for alternatives

With the current volatility in investment markets, investors are seeking innovative, non-traditional asset classes to increase the portfolio's performance. FAnews spoke to a few experts to uncover some of the issues surround alternative investments.

Alternative assets offer investors increased opportunities to extract additional returns by investing in markets and instruments not easily accessible via conventional investment management, says Glen Copans of Momentum Wealth. "They are increasingly utilised as an essential component of a funds strategic asset allocation, specifically those with targeted return mandates.

"Alternative assets tend to have low or negative correlation with other asset classes and their performance is therefore impacted differently by political and economic events. This allows investors to counterbalance the risk related to potential underperformance in the equity or bond markets."

Drawbacks

A shortcoming of these investments is that they are often highly illiquid and costly, says Copans. "In addition, the current regulatory framework does not offer sufficient protection for investors. As a result, they require a large level of professional expertise and due diligence in selecting the appropriate fund."

Preferred options

"Globally, alternative assets have evolved into specialist areas for e.g. forestry, commodities and infrastructure. Domestically, the opportunity set is far more limited with Hedge Funds, Private Equity, Socially Responsible Investments (SRI) and Structured Products being the most preferred," explains Copans.

Hedge Funds

Carl Liebenberg of the Clade Group, adds that hedge funds are increasingly the choice of mainstream investors, who want to reduce their risk by diversifying into other asset classes. "However, investing in a single hedge fund can be quite risky and is generally left to professional investors. With the explosion in popularity of hedge funds has come an increased desire to manage the risk of investing in this asset class. Consequently a natural evolution has been the emergence of products that seek to diversify the risk by holding a large number of different hedge funds.
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Liebenberg explains that these fall into two main categories - Funds of funds (FOFs) and hedge fund index products.

FOFs

"These are actively managed portfolios of hedge funds where managers pick a select group of hedge fund managers to reduce risk and deliver consistent returns," says Liebenberg. "However, evidence suggests it is quite difficult to deliver consistently better-than-average performance in a FOF and that most fund-of-fund managers have been unable to consistently assemble a group of hedge funds that outperform the market."

Hedge fund indexes

These products are passively managed collections of hedge funds seeking to provide the investor with exposure representative of one or more strategies within the industry, explains Liebenberg.

"Hedge fund indices typically provide greater diversification than funds of funds. Whereas a FOF in SA may use around 10 hedge funds chosen by its management team, the SA Hedge Fund Index has 26, which are chosen according to size or other objective criteria. The SA Hedge Fund Index fees also tends to be lower (1% p.a.), and charges no performance fee. This difference results in the SA Hedge Fund Index costing investors about 4% less per annum.

"The unique characteristics of hedge fund indices make them well suited to the alternative investment needs of most investors because indices offer low fees and diversification benefits while delivering comparable performance to FOFs."

Steering clear of the landmines

Lizelle Steyn, Manager Alternative Products of Nedgroup Investments, says that investors need to implement some strategies to avoid hedge fund landmines.

"Steer clear from portfolios taking on large concentration risk – diversification remains a prudent investment principle. At the very least an independent administrator or risk manager should report to the investor on the number of long and short positions respectively, as well as the extent of the largest long and short position – as an indication of concentration risk.

"Should the investor not have the time or expertise required to identify and constantly monitor an appropriate hedge fund investment, he or she might rather want to opt for a fund of hedge funds, which is usually highly diversified across different strategies that display little correlation to one another, which dramatically decreases the volatility of the investment."

Steyn suggests that investors make sure they are comfortable with the level of leverage of the portfolio. "However, levels of leverage should never be used as a risk measure in isolation, but always in conjunction with Value-at-Risk and net exposure levels. Remember, too, that hedging out market risk with short positions is no guarantee of consistent positive returns, as the stock could appreciate contrary to the predictions of the manager.

"Because short positions can, in theory, lead to an investor losing more than his capital, it is essential to invest via a vehicle or structure that limits the liability of the investor to the capital invested. A standard broker account or segregated portfolio does not provide such comfort.

"To minimise the risk of misrepresentation, ensure that the hedge fund has an independent prime broker, fund administrator, client administrator and auditor before investing. Request monthly valuation statements and risk reports directly from the independent service providers, where possible.However, unlike traditional portfolios, hedge funds have the tools (the shorting mechanism) to benefit from stock devaluations, a unique advantage," says Steyn.

Other alternatives

Igna Breytenbach, Chief Investment Officer of Keymax Investments, says that a relatively new alternative in SA is Contracts for Difference (CFDs). "Initially, CFD's were the exclusive domain of institutional investors, now it's a valid and respected private investment form as well.

"CFD's mirrors the price movement and development of an equity, commodity, Indices or currency on all markets. As a mechanism for leveraged speculation and hedging of portfolios, CFD's benefit the investor without incurring the cost of actually owning the asset outright, allowing long and short trading on individual positions short-term, whilst responding to market timing and key news releases."

A long CFD position earns a profit when the stock rises in value, explains Breytenbach, while a short CFD position results in a profit when the stock falls in value. "Traded on margin, CFD's allows for more market exposure and for investors to really profit substantially when used correctly."

Another alternative, says Breytenbach is Currency or Foreign Exchange (FX). "Currency (FX) trading has also experienced a steady growth over the last decade. At present, currency trades are estimated to exceed R16.5 trillion during any 24-hour period. The potential for profit exists because there is always movement in the exchange rates (prices) and all CFD and FX trading platforms offer technical analysis software and trading signals free of charge, making expensive so called 'share tracking and training' packages redundant."

Assessment crucial

The decision to invest in alternatives should only be made after a comprehensive assessment of the risks, requirements and circumstances, says Momentum Wealth's Copans. "The asset should only be selected if deemed appropriate, as part of the overall investment strategy and the allocation thereto will provide additional return and diversification benefits to the existing portfolio. Investors need to be aware of the risk elements associated with each underlying strategy and seek professional advice before investing in alternative assets."