Beyond the realm of stocks & bonds

Alternative investments like private equity, hedge funds and real estate are now significant portfolio components, writes SALMAN HAIDER

ALTERNATIVE investments, particularly hedge funds, are attracting growing interest from global institutional funds to high net worth and retail investors. Considering the volatility investors have seen this year, it is little wonder they are seeking alternative investments - not only for new avenues of return opportunities, but also as a way of controlling risk. The promise of positive returns certainly plays a part. Ever-rising gold and property prices come to mind as well as the increasing resilience to risk as investors invest heavily into emerging markets. Increasingly, however, astute investors are also realising that allocating across stock and bond markets alone may not be the most effective way to manage their portfolios.

In fact, private equity, hedge funds and real estate are evolving to become significant components of many investors' portfolios. A recent Asia-Pacific Wealth Report published by Capgemini and Merrill Lynch found that Singapore's high net worth individuals had the highest allocation to alternative investments in the region, at 37 per cent. No longer confined to the universe of traditional long-only investments, investors today are bravely exploring the 'alternative' space beyond. Simply put, alternative investments include strategies other than just buying stocks and bonds. Though limited only by the creativity of the investment managers themselves, common examples of alternative investments include hedge funds, which can take both long and short positions); commodities and real estate (the 'traditional' alternatives), and private equity funds, which can also invest in non-public companies (see table).

The universe of alternative investments is greater for high net worth investors, but even retail investors are spoilt for choice these days. What is interesting from a portfolio perspective is that alternative investments have historically shown low-to-moderate correlation to traditional assets and to each other. In other words, they do not always move up or down in lockstep. While this may not seem particularly exciting when markets are moving in one direction (ie, up), diversification becomes highly valued in times of volatility, and over longer time horizons as market leadership shifts from one asset class/market to another.

Of course, these benefits cannot be guaranteed and investing in alternatives carries varying degrees of risk. But for a typical investor, incorporating some alternative investments to a portfolio of stocks and bonds could help improve the portfolio's return for each level of risk (see chart). This helps to reduce overall volatility which, in turn, leads to faster compounding of returns over time.

At the same time, alternative investments provide qualified investors with exposure to less efficient private and public markets and investment strategies that cannot be accessed through traditional fixed income and equity markets, for example, having sufficient ownership through a private equity fund, to influence the management of a company. It is important to realise that the world of alternatives is diverse, comprising a wide range of options with different risk-return characteristics. At Citibank, our model portfolios factor in some allocation to alternative investments, depending on a client's risk profile and suitability. But as with all investments, there are key areas and risks that investors need to consider before deciding to invest.

Besides the usual risks that apply to traditional assets - such as market risk, where the value of securities, commodities and currencies may fluctuate reflecting a variety of factors, including changes in outlook, and political and economic environments - there may be other specific risks that apply to alternative investments.

It may not be feasible to observe market prices for investments such as private equity or private real estate. This challenge makes it difficult to compare the risk-return profiles. Moreover, some managers may receive additional performance compensation for the value of their expertise and exclusive access to markets or other managers. Despite the rising popularity of alternative investments in recent years, investors should first look at their own overall risk appetite and suitability, time horizon and liquidity needs before investing. Speak to your financial adviser about how the investment would fit into your investment objectives and existing portfolio.

Although alternatives may reduce overall portfolio volatility, some have risks other than those associated with traditional stocks and bonds, including:

Lack of liquidity: Alternative investments are generally not readily marketable, sometimes not redeemable and are transferable only in limited circumstances.

Specialised trading: Special investment techniques such as leveraging, short selling and investing in derivatives may result in significant losses, including the loss of principal.

Strategy risk: Investment strategies may at times be out of market favour for considerable periods, with adverse effects on the investment. Because of these risks, and the largely unregulated nature of the alternative investment industry, laws restrict those eligible to invest in alternatives. Criteria generally include income and net worth thresholds, as well as investment expertise and the ability to understand and tolerate risk.

Valuation: Valuation procedures may be subjective in nature, may not conform to any industry standard or reflect the values that are ultimately realised. However, the valuations of these positions may affect asset-based management fees and performance-based fees.

Salman Haider is head of investments, Citibank Singapore Ltd

Source: Business Times Online