Patrick Armstrong, director of fund and manager selection, and Dr Ana Cukic-Munro, director of portfolio strategy and construction, explore the world of alternative asset classes in a portfolio context for retail investors
There has been much discussion and debate on the benefits and risks of alternative asset classes such as commercial property and hedge funds.
Retail investors are therefore quite right to ask if these asset classes have a place in their portfolios, and if so, what types and how much should they include? Patrick and Ana explore these questions.
Of course, institutional investors, including pension funds, endowment funds and high net worth individuals have already been making use of such alternative investments as an asset class in their portfolios for many years. We believe there are compelling benefits to retail investors in adding alternative assets to the traditional mix of equities and bonds.
Portfolio diversification: The most compelling argument for investing in non-traditional asset classes, such as hedge funds and commercial property, is portfolio diversification. This means reducing the expected volatility of the portfolio without diminishing the expected returns. Adding asset classes with expected returns that have a low correlation with traditional asset classes further increases the efficiency of the investor's portfolio.
This can be clearly demonstrated by running an efficient frontier (EF) analysis. The EF shows the maximum level of expected return that can be achieved for a given level of risk. The chart below shows the EF for a portfolio that can invest in UK bonds, and/or UK equities. Underneath the efficient frontier are the various IMA sectors which generally underperform the EF by an amount representing their fees.
Historic returns of asset classes are of little to no use in forecasting future asset class returns, particularly when using periods as short as 10 years. We have established risk premiums for the various asset classes to forecast future returns, and used the historic volatility and covariance matrix for the risk measures.
Historic risk and covariance is a statistically significant predictor of future risk and correlation across asset classes. Had we used historic returns hedge funds would have been the dominant asset class, because they delivered the highest historic return.
We think hedge fund index returns overstate performance because of a survivorship bias where failed hedge funds do not appear in the index, and returns may be overstated where estimated pricing is used for illiquid securities. In our analysis we have discounted historic hedge fund outperformance by 25% to account for these biases.
The chart shows the traditional hook shaped efficient frontier produced when varying the exposures to UK equity funds and bond funds, with a 100% allocation to equity funds providing the highest expected return, but also the highest forecast risk.
The effects of including different asset classes in a diversified portfolio: As alternative asset classes are added to a portfolio, the EF shifts upwards and to the left, ie giving more expected return for the same level of risk. Whenever non-correlated asset classes are included in a portfolio, the risk of that portfolio can be reduced. For example, by introducing the IPD UK Property sector into the portfolio the EF moves out to the blue line on the graph. The same effect happens when hedge funds are introduced, even with conservative assumptions, the EF is further shifted up, and to the left.
The benefits of including alternative asset classes are readily apparent from a risk/reward perspective: The hedge fund industry has undergone exponential growth. Currently, around $1 trillion is invested in around 8,000 hedge funds. We believe the rapid expansion of the hedge fund industry does not represent an asset class bubble, due to two industry trends: focus on capital preservation and hedging.
These increase the possibility that hedge funds perform better than mutual funds in falling markets. In addition, capacity constraints leading to the closure of funds to new investors, fees and even innovative contrarian strategies are acting as strong self-regulatory mechanisms for the hedge fund industry.
In principle, hedge funds are investment funds that operate in traditional markets using alternative investment strategies. Most often they can be viewed as ordinary funds with the additional flexibility of borrowing securities and obtaining finance. The prime brokers (most investment banks) are effectively lenders (bankers) of securities and capital to hedge funds.
By virtue of regulation, mutual funds are not allowed to borrow securities, ie sell short. This constraint implies their portfolios are less efficient. Assuming no manager has the competitive advantage of acquiring information, only a limited number of managers that invest both long and short can act upon it by selling short. Thus, the pessimism of investors may not be fully reflected in the price of assets and the market could be overpricing securities.
Long-short funds would, therefore, earn extra return due to their investment flexibility, rather than just their skill. Consequently, a higher proportion of the hedge fund manager's capital is invested in positions about which the manager has convictions. Hedge fund managers carry less dead weight than long only managers, who often carry positions in large index weights regardless of their view on that stock.
Additional long-short manager skills include managing both sides of a fund's capital base. The common misconception is that the leverage of all hedge funds is very high. While this is certainly true for a certain number of hedge fund strategies employing only futures or fixed income arbitrage (famously in the case of Long Term Capital Management (LTCM), prime brokers now operate constrained financing and margining programmes that effectively limit leverage to more conservative levels.
Investments in commercial property, and hedge funds often carry significant liquidity risks: Mutual funds today represent a significant portion of the strategic asset allocation of most investment portfolios. Higher transparency, strict investment processes and regulation have resulted in higher investor confidence in holding mutual funds. In addition, traditional asset class mutual funds will outperform alternative asset classes at various stages of a market cycle.
The majority of equity, bond and property fund returns will derive from how their respective asset class performs. This has both advantages and disadvantages for investors. Traditional asset classes have risk premiums that work for long-term investors, meaning their expected return is greater than cash. The fact that the majority of their returns come from the beta of funds to their relative asset class, means the valuation and growth potential of that asset class will need to be reassessed by investors who tactically allocate to different asset classes, since it is the asset class movement that drives returns.
How do retail investors actually feel about these types of alternatives? From an investment perspective there are many reasons to consider portfolios that contain alternatives to bond and equity funds. Feedback from our investors indicates they welcome alternative asset classes to their portfolios, rather than fearing new exposures.
Many retail clients think more often in terms of "have I made money?" or "have I lost money", rather than how their fund has done versus a benchmark or sector. Including alternative asset classes in a portfolio would allow portfolio managers to reduce risk and focus on making money rather than beating a benchmark. We expect that this will appeal to many investors.
The new paradigm of absolute return funds, and risk management's role in controlling value at risk, volatility and downside deviation: These may be scary terms, but they actually do capture what investors are concerned about. While the main risk characteristics of mutual funds are often tracking error, beta and sometimes standard deviation, which are effective risk measures to consider in managing portfolios with defined strategic allocations in line with clients risk profiles, they do not actually address the risk investors care most about - which is their investment losing value.
The FSA has now approved vehicles that can combine these alternative asset classes in retail portfolios, and now retail investors will be able to take advantage of the benefits that institutional investors have enjoyed for years.
