Time to reconsider alternatives?
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Nick Ryder is an investment strategist with NAB Private Wealth, the wealth management division of National Australia Bank.
We know that many investors have had a less than satisfactory experience with alternative assets over the last five years.
Many investors were surprised by low liquidity strategies becoming completely illiquid. They were also surprised by products that were presented as well-diversified strategies, suddenly appearing heavily reliant of on a single theme.
We appreciate many investors will be reluctant to reinvest in alternatives for some time to come. We are not suggesting investors rush heavily back into alternative assets, but we do believe there are strategies that can add value.
Whether you are prepared to invest in alternatives today or not, it is worth keeping up to date with the strategies available and watching how they progress, to hopefully build up your confidence for investing in alternative strategies in the future.
We believe that over the past five years product designers, fund managers, researchers, advisers and investors have learnt several important lessons.
Firstly, liquidity. It has always been important, but even more so today. Our preference is to focus on those strategies offering daily liquidity. But this doesn't mean you exclude all other investments offering less frequent liquidity terms - there are some strategies that may add value.
However, when incorporating those less liquid investments you need to balance the liquidity needs across your entire portfolio. The critical issue is that the liquidity of the product needs to be consistent with the liquidity of the underlying investments.
This wasn't the case for several fund-of-hedge funds in the past where the core fund offered monthly liquidity, but many of the underlying strategies only offered quarterly redemptions. As we saw in the global financial crisis (GFC), this issue, along with cash-flow requirements associated with currency hedging strategies, led to the closure of several funds.
The next lesson learnt is to tread carefully with complex strategies. It is important to select investments with a clear investment strategy. A reasonable rule of thumb is to say that if after a five-minute conversation about a strategy you don't understand how it makes money, then it is probably worth avoiding.
In order to fully understand a strategy it may take several conversations with your adviser, along with reading through material. But generally, if you are still completely confused by a strategy after five minutes, it is likely to be far too complex for your portfolio.
That isn't to stay the strategy won't be successful. But as we have seen in the past, the more complex an investment is, the more likely there are unknown risks that may impact returns. It is important that you understand the role that every investment in your portfolio plays and the risks associated with each investment.
The stress related with investing in poorly understood strategies is likely to outweigh any benefits from returns.
It is also important to invest in strategies with a low correlation to the traditional asset classes of equities and bonds. We suspect some investors are sceptical of the benefits of low correlations. This has more to do with a breakdown of low correlations for some alternative assets over the last five years, rather than the non existence of any benefits.
This breakdown was particularly relevant during the GFC, when many hedge funds (particularly long-short equities) generated significant negative returns, at the same time equities in general were very weak. It appeared that many of the strategies that claimed to generate uncorrelated returns were very much dependent on equity markets.