07 Aug Fund Manager Focus – Alternatives
Our Fund Manager Focus Newsletters focus on a fund manager within our investment portfolio and provide information to help our clients understand their investment philosophy and outcomes.
This newsletter focuses on Alternatives.
Introduction
We have not provided you with this newsletter for some time. Most recently, we provided a commentary on our investment process in place of this newsletter. Again we will diverge from our regular format to talk more about an asset class rather than a specific fund. This sector is generically known as ‘Alternatives’.
Basically, ‘Alternatives’ cover assets that do not conform to the standard asset classes i.e. equities, property, fixed interest etc. The asset class is most often identified with ‘Hedge Funds’, itself another catch all for non-standard investment classes.
The theory of using ‘Alternatives’ in your portfolio is to provide returns that are less correlated with standard assets. Correlation is the measure by which different assets move in a similar manner i.e. Australian Equities and Global Equities markets will broadly move in the same direction, whereas equities and fixed interest markets will generally move in different directions, for a given policy or economic event. Currently you will find at least some exposure to Alternatives in most pre-set superannuation investment options. The managers of these funds are trying to reduce the capital volatility of your benefits, and academically the data would support this approach.
As yet, we have not introduced this option to our tailored portfolios. We have been researching Alternatives and the various product providers for over two years. In some regards, we have been lucky that this has had no impact on these portfolios. In fact given the performance of traditional assets classes, an early foray into Alternatives would have detracted from portfolio returns over the recent past. This is because low correlation works both ways – if traditional asset classes are down, alternatives can provide relief by producing positive returns; if traditional asset classes are strong, alternatives will tend to provide less attractive returns. The following table illustrates:
To be fair, the performance of equity markets has been exceptional over the past 5 years. Moreover these returns include the rebound from the GFC. Nevertheless, this illustrates the point about lowly correlated returns – it just happens that during this period. it would not have worked in your favour.
Our research into product providers in this sector has resulted in the production of a short list of potential candidates that we may, in time, recommend for inclusion in your portfolio. As there are many sub-sectors within the alternative space. we have sought managers that can provide exposure to a range of strategies and who can rotate through these strategies as their analysis dictates. This removes the need to select specialists in specific strategies, potentially adding several funds to your portfolio. Other key considerations include liquidity; some managers only provide monthly investments/redemptions, and cost. In so far as liquidity is concerned. we prefer full liquid daily investment/redemption providers. However, this narrows the opportunity set. In regards to cost, this has been a real issue in the past. Even today, a number of products charge 2% of assets plus 20% of gains. In our view, this is not an attractive value proposition.
The other major consideration is transparency. Prior to the GFC, the approach seemed to be ‘trust me’. That did not work out so well. Incidentally, during that period a number of alternative funds saw their return correlations converge with traditional assets classes, just when low correlation was required. Given a low level of transparency, it was difficult to determine the underlying drivers of this convergence. Like any of the fund managers we use, we prefer to be able to look through a product with the manager to understand the underlying exposures and risks within a fund. This too has narrowed the opportunity set we are considering.
The following is a typical range of subsectors in which an alternatives manager can operate:
We are also aware of new alternative investment strategies that may be of interest in due course (alternative alternatives?). Amongst the most interesting of these is a fund that provides exposure to volatility indices. As you may be aware, the major index of market volatility is the VIX. This is an index of implied market volatility based on options pricing – it is also known as the fear index. In simple terms, as market volatility rises, the index rises. There is a widely traded and very liquid derivative offered by the Chicago Board Options Exchange (CBOE) that enables investors to buy and sell this index.
As this index is generally negatively correlated with movements in share markets (it goes up when shares go down), the potential to hedge equity risk is attractive. You should note that our research in regards to products in this sphere is still developing. Nevertheless, it is illustrative of the range of options becoming available within the ‘Alternatives’ sector.
We expect that at some time in the future, we will recommend an exposure to ‘Alternatives’. However we have yet to decide on the best approach to this sector. As you know, we are committed to ensuring your portfolio provides the optimal opportunity to meet your personal financial outcomes. You will also know that we are sceptical of the fashion and fads that permeate the investment sector. We see no point in adding to a new sector unless it can;
a) improve risk-adjusted returns
b) provide adequate liquidity
c) provide value for money
In the meantime, we will continue to work with you to ensure your portfolio is optimised to meet your long term personal objectives.
Please contact this office if you require further information in this regard or have any other queries in respect of our investment approach.
David Graham CFP® SSA
7th August 2014.