Weighing up pros and cons of alternative investments
Alternative investments have delivered very attractive returns over the past 20 years - not only on a stand-alone basis, but also on a risk-adjusted basis.
Since 1994 the HFRI Composite Index (a broad index of hedge fund managers) has returned 9.01% on an annualised basis with a standard deviation of 7.01% versus a return of 6.99% and a volatility of 15.29% for the MSCI World Index.
These funds have typically also exhibited low correlation with traditional asset classes making it a very attractive option for inclusion in a multi-asset portfolio from a diversification point of view. This correlation profile tends to be specifically beneficial during times of market stress as the correlation between traditional asset classes tends to move to 1. During the 2008 financial crisis for example the correlation between equities and hedge funds only increased to 0.67.
One of the main reasons for this enhanced return profile is the fact that these mandates tend to be more flexible (and less constrained), allowing the managers to access additional sources of return. This flexibility not only allows access to additional markets but also the use of instruments not available to long-only managers, to either extract value or hedge the portfolios. One of the main reasons why these strategies have outperformed traditional markets over the recent past is because of the manager's ability to use derivatives to hedge their downside risk.
High costs
Alternative investments do however have their drawbacks, especially to less professional investors. The cost that an investor pays for these investments is typically quite high with the most common fee across the industry being a 2% annual management fee, with a 20% performance fee for performance above a predefined benchmark. The one benefit of these cost structures is the fact that the investors' interest is completely aligned with that of the manager.
The strategies that some managers employ to generate alpha tends to be quite complex causing less sophisticated investors to shy away from the asset class. Not only can certain strategies be complex but because of the multitude of strategies employed by managers, making an informed decision as to which strategies to access could be problematic for investors. Even once an investor has decided on a strategy to access, the wide dispersion in returns of the universe of managers means that a lot of additional work is required on manager research.
Alternative investments are also typically only accessible by high net worth or institutional investors as the minimum investments required can be substantial. Another drawback that pertains specifically to less wealthy investors is the liquidity terms of these funds. Typically investors can only access their capital on a monthly basis, even yearly in some cases, with additional notice periods also prevalent in most funds.
Based on the enhanced risk/return profile, and hence the clear diversification benefit, that these funds exhibit we have a fairly large allocation to certain alternative strategies in our multi-asset portfolios.
