Alternative Investments: Your questions answered
We’ve recently seen an increase in interest amongst our investors around alternative investment, particularly around what they are and why we use them. So we’ve put together this handy guide to help answer the most common questions.
What are they?
An ‘alternative’ is basically any fund that doesn’t fit neatly
into the traditional asset classes of:
Equities;
Bonds / Cash; or
Property / Infrastructure.
In other words, an ‘alternative’ is in anything that falls outside
of the usual fund / asset class classification process we undertake in
markets.
For example, a fund could be classified as ‘alternative’ thanks to
the instruments it trades such as oil, derivatives, bitcoin etc or its strategy
(the way it trades) The latter can sometimes cause confusion arises as
some funds such as Bennelong or L1 actually trade equities but because they are
long / short (profiting from falling prices of shares or other investments)
they are classified as an ‘alternative’.
What do they do?
The key feature of alternatives is that they don’t typically move
in sync with equities.This makes alternatives a very useful tool from a
portfolio construction standpoint as most growth-orientated portfolios have
60-70% of their holdings in traditional ‘long only’ equity strategies. That
means the performance of these portfolios tends to rise and fall according
to general equity market movements. Put simply, adding alternatives to a
portfolio helps cushion the falls, whilst taking some cream off the top during
the upswings).
How do DMDGP use alternatives?
We use them as a defensive mechanism to help protect against
the losses within the DMGDP when equity markets record sizable falls.
This won’t happen in every instance - occasionally alternatives can have bad months
at the same time as the equity markets record bad months. But on average the alternatives we invest in have a tendency to rise when equity markets record sizeable falls and therefore help mitigate the losses within the DMGDP.
But don’t they have a bad reputation?
There are plenty of scare stories out there that portray
alternatives negatively and there have been a couple of instances where
investors have lost large sums of money by investing in alternatives.
Ironically, very few alternative funds have performed as poorly as many
mainstream equities such as AMP, Myer or Telstra but alternatives do still tend
to carry a stigma.
Part of the reason for this reputation is that the alternative
strategies themselves tend to be complex. This creates the benefit of moving in
a different direction or at a different pace to equity holdings but also
provides an opportunity for scare mongering.
One perception that people seem to associate with the alternatives
is ‘leverage’. They therefore view them merely as a vehicle to ramp up return
(and subsequently, to magnify losses as well). What this argument doesn’t take
into account is the correlation benefits of alternatives in portfolio
construction – and therefore their defensive attributes within a wider
portfolio. Also, not all alternatives use leverage.
Another perception of ‘alternatives’ is that they are expensive.
This again is misleading as many of the alternatives we invest in carry the
same fee or are even cheaper than ‘long only’ managers. For example, we just redeemed
from ‘long only’ global equities manager Magellan. It was more expensive than
Munro, the ‘alternatives’ manager we invested in (who also operates in the
global equities area but because of the complexity of its strategy and its
ability to sell short is classified as an ‘alternative’). Similarly, AQR
Managed Futures is one of the cheapest funds we have in the portfolio even
though it’s classified as an ‘alternative’.
So why use them now?
For starters, we’re very late in the investment cycle and at some
point in the not-to-distant future equity markets will experience a sizable
drawdown. Subsequently, we need an allocation to alternatives to help cushion
any falls.
Why not use bonds (the traditional asset class ‘non-correlated’
with equities)?
We do have some allocation to bonds through T Rowe Price and
Smarter Money. But these vehicles may not be as good a diversifier as they were
in the past, given the degree of unprecedented central bank intervention in
bond markets since the GFC. Unwinding all this central bank purchasing (known
as ‘tapering’) at the same time that equity markets go through a sizable
drawdown is creating uncertainties in the perceived diversification benefits of
bond holdings (fixed income). So, while having some form of fixed income
exposure is worthwhile within the DMGDP, to be doubly sure of our downside
protection we need alternatives to ensure we have enough defensives in place
should the worst happen.
What about simply lowering our exposure to equities when equity
markets fall?
We are an active Investment Committee and yes, we do aim to lower
our market exposure before and after turning points in financial markets. That
said, we still need alternatives as they will help us to generate positive
returns even if a bear market takes hold post a crash and equity markets record
annual losses for 2 – 3 years.
Given we are a real return fund (ie, we’re benchmarked against a
cash plus 4% objective rather than simply just outperforming the equity
market), we need something other than cash to achieve the ‘plus 4%’ portion of
our objective when equity markets are in a negative phase. Alternatives will
help us to achieve this aim.