Although it is quite common for industry practitioners to refer to alternatives as one, monolithic group of asset classes, this expression is just a shortcut to address a very diverse group of investment opportunities, ranging from hedge funds, private equity and real estate to infrastructure and structured notes; these are considered an alternative option to the traditional investment vehicles for most investors: equities and bonds.
Lack of correlation or low correlation with equity markets is a necessary condition for a product to be defined alternative, says Ravi Bulchandani, head of alternatives at Barclays Wealth. And this attribute is strictly associated with the absolute return concept, even to the extent of being identified with it.
Barclays Wealth has recently developed a “different” approach to wealth management which makes the decision between traditional or market returns on one hand, and absolute returns or alternative investments on the other, much more rigorous, says Mr Bulchandani. The new investment philosophy considers risk as a multi-dimensional factor; investors’ attitudes and financial personality are identified through a thorough profiling process and matched with a range of investment styles to create an individual investment strategy which delivers performance that really suits the investor.
For example, an investor with strong preference for stable returns and no great regret if his portfolio is not returning as much as the market in positive cycles, is a candidate for a significant proportion of absolute return or alternative investments, he says.
“For our absolute return portfolios, we use funds of hedge funds, but we also supplement them with some liquid traded arbitrage strategies, such as funds that trade in the currency market or in the fixed income market,” says Mr Bulchandani.
But investing in alternatives also means adding value in investors’ portfolios by getting access to different sources of returns. For example, by investing in private equity the investor gains access to the ability of a skilled management team that affects changes at the corporate level, which might have not been possible in the full glare of the public market, explains Mr Bulchandani. Unlike algorithmic trading strategies or hedge funds, private equity and real estate are not as easily “modellable”, he says. Therefore they are not included in pre-constructed discretionary portfolios, but tend to be recommended to clients on a one-time basis.
The lines between traditional and alternatives are getting blurred because traditional investments are now using some of the freedom that alternative managers have, such as derivative leverage.
“On the other hand, there are funds that describe themselves as alternative investments, but in fact are just leveraged plays on the equity market. For example, in emerging markets certain funds that describe themselves as hedge funds, because of the difficulty of going short, are actually just leveraged longs on the market,” he says.
Core versus satellite
Alternatives used to be considered as the satellite, riskier and alpha generating part of a portfolio, but things are changing in that respect too. “Alternative investments are becoming more of a core investment” says Paul Wharton, investment director at Deutsche Bank, the German heavyweight that strengthened its presence in the UK private wealth management market by acquiring independent private bank Tilney at the end of 2006. “A combination of commodities, hedge funds and structured notes are now becoming more and more regarded as mainstream investments, in the sense that they give portfolio managers more flexibility to manage risk and opportunity on behalf of their clients,” he says.
Beyond any semantic discussions on the definition of alternatives, Mr Wharton says the point is that all these instruments increase the level of asymmetry, aiming to maximise upside potential and at the same time minimising risk downside, so that portfolios exhibit a low level of correlation to the underlying markets. “We look to allocate between 25 and 30 per cent of clients’ portfolios to alternatives, which include commodities, structures and hedge funds,” he says. But, as structured notes can be in any part of the portfolio, alternative exposure could comprise nearly 40-45 per cent of the portfolio, adds Mr Wharton.
Alternatives in general have benefited from the change in clients’ asset allocation made as a consequence of market turbulence. At Deutsche, “for a reasonably stable long term portfolio with a key to control the volatility on an annualised basis” this has lead to double the exposure of commodities to 10 per cent, in addition to increasing cash and reducing exposure to long-only equities. Given the long-term supply squeezing developments, commodities look attractive for potential profits but also to hedge inflation problems, according to Mr Wharton. And the wider range of instruments available today has eased the investment process.
