The alternative way to diversify your portfolio

Australian Financial Review, Australia
28 Jan 2015, by James Dunn
Smart Investor, page 19 - 1,097.00 cm²
National - circulation 62,455 (MTWTFS)
Copyright Agency licensed copy
ID 365894775
PAGE 1 of 4
The alternative wayto
diversify your portfolio
Investment Thinking
outside the box can
protect you from
market-related shocks.
James Dunn
It happens in art, fashion, music,
literature, so why not investment?
Eventually, the "alternative" becomes
Alternative investments are those
that are not the traditional building
blocks of a portfolio, being shares, cash,
bonds and property. As they have
different returns streams from mainstream investments, such as equities
and bonds, where payments in the form
of coupons or dividends can generally
be expected every six months, alternatives can diversify a portfolio.
They can also have a low - or even
negative - correlation to the traditional
investments, so at times when all the
traditional markets appear to tear
downwards at once, allocations to
alternatives may move to a much lesser
extent (low correlation) or move in the
opposite direction (negative correlation). This ability to absorb shocks can
take the risk out of portfolios. But
alternatives are not without risk.
The term alternative investments is
usually taken to include:
• Hedge funds, which are managed
funds that can invest across many
different markets and strategies, with
maximum flexibility, so they can make
money regardless of what the share and
bond markets are doing. They can lose
money, too.
• Managed futures/commodity
trading adviser (CTAs) strategies.
• Absolute-return equity-based
funds, such as long-short funds, which
will simultaneously go long (buy)
under-valued stocks and short (sell)
over-valued securities, and "marketneutral" funds, which try to deliver
above-market returns with lower risk
by hedging out market risk, looking to
negate the impact and risk of general
market movements, trying to isolate
the pure returns of individual stocks.
• Private equity, being capital
invested in a private company which is
not yet listed on the sharemarket This
is also known as "venture capital",
which is really a private equity investment made at a very early stage.
• Infrastructure assets, where
income streams can be generous but
not without risk.
• High-yield assets, for example,
funds that invest in distressed debt,
junk bonds and mezzanine debt
• Commodities, such as precious and
base metals, oil and energy and soft
(agricultural) commodities.
• Agribusiness, such as investment
in forestry, farming or horticultural
• Art and other collectible items,
such as coins and wine.
More recently, the range of alternative assets available has been widened
to include investment in insurancelinked securities (the value of which is
driven by insurance events); water
entitlements (traded in the Australian
water market); social impact
investments, where the investment
both earns a financial return and
generates a targeted positive social
outcome; shipping funds; aircraft
and other equipment leasing; weatherrelated derivatives; volatility derivatives, and; carbon trading.
"Broadly speaking, you can really
consider 'alternatives' to be an investment that produces a return stream
that is very differentto that produced by
equities or bonds," says Craig Stanford,
head of alternative investments at
Ibbotson Associates. "We look for
assets with low correlation, but
correlation isn't the only important
thing - beta to the sharemarket is quite
important as well. At times you may
want a bit of sensitivity to stock market
moves. The problem with having an
investment that is negatively correlated
to the stock market all the time is that
you lose money when the stock market
rises consistently."
Inspired by endowment funds
The move to alternative investments
was pioneered by the big US endowment funds, which manage money on
behalf of institutions such as Harvard,
Yale and Stanford universities. Over the
past 25 years these funds have diversified into large holdings in hedge funds,
private equity and "real assets" (real
estate and managed timberland), in a
bid to insulate the funds from sharemarket moves by picking up diverse
"illiquidity" premiums.
Australian super funds began
moving into the alternative investment space in the mid-1990s, looking
for portfolio diversification and
non-correlated returns.
Alex Dunnin, executive director of
research and compliance at research
firm Rainmaker, says die proportion of
Australian managed funds held in
alternatives has risen from 10 per cent
in September 2004 to 18 per cent in
September 2014, led by the non-profit
(industry fund) superannuation sector,
which has lifted its allocation from 6 per
cent to 17 per cent over that time. In
contrast, the retail super funds have
lagged behind, with 1 per cent in 2004
rising to 11 per cent in September 2014.
"The retail funds have finally come
on board," Dunnin says. "An interesting
aspect here, though, is that when the
non-profit funds get into alternatives
they tend to do so through private
equity and infrastructure, while retail
funds tend to use hedge funds and
commodities-presumably because the
non-profit funds are happy having
alternative 'real' assets, even if they
aren't as liquid as they would like, while
the retail funds are very reluctant to
sacrifice liquidity."
But despite the rise in the alternatives allocation, super funds are "still
Australian Financial Review, Australia
28 Jan 2015, by James Dunn
Smart Investor, page 19 - 1,097.00 cm²
National - circulation 62,455 (MTWTFS)
Copyright Agency licensed copy
ID 365894775
as hog-tied to equity risk as ever",
Dunnin says.
"Sharemarket and super fund
returns are still 90 per cent correlated,
suggesting that the alternative assets
[that] funds are buying are very closely
linked to equity markets."
That may mean the equity market is
just the lead indicator for the economy
more broadly, Dunnin suggests, and
that it is not possible to diversify away
equity risk. "But with only about onethird of funds' asset-class investments
beating their asset class benchmarks,
the funds that want to beat the market
are going to have to rethink what they
invest in, and how," he says.
Daniel Liptak, chief executive at
specialist alternatives investment
consultancy ZG Advisors, says it is this
high sharemarket correlation that is
"baked in" to Australian portfolios that
makes "some form of non-correlated
return" necessary.
"In Australia, there are really only
10 equity managed funds that do 80 per
cent to 90 per cent of the daily volume
on the Australian Securities Exchange,
and really only the top 20 companies
in Australia that are of interest to
offshore investors, because they are
large enough to invest in," Liptak says.
"As we know, one of the best free
kicks anyone can have is a well diversified portfolio, but you're not diversified
if you don't have something that's not
correlated to the market's returns because those returns are at the whims
of the largest investors."
Liptak advocates using some of the
Australian equity market-neutral
funds, and some of the managed
futures/CTA offerings. "The best market-neutral managers have an excellent
record, going back 14 to 15 years, of considerably outperforming the ASX200
Accumulation Index, and they are completely non-correlated to the market.
They also have very low correlation to
each other, such that it is actually possible to build a more diversified portfolio
by investing in several of them."
Considering the CTAs
The other place to look at would be the
CTAs/managed futures. The best of
them clearly and demonstrably have
low correlation to the market, and
they've consistently worked in the past
"They follow trends, so last year they
were short commodities - they made
PAGE 2 of 4
lots of money on the commodities fall.
They tend to be on the other side of an
equity fall - they tend to make money
when shares start falling," he says.
Liptak is also interested in newer
alternative exposures such as water,
social impact investing and shipping
funds. "Water makes a lot of sense, it's
completely uncorrelated returns, and
it's a fairly unique opportunity for
Australian investors, because we have
such a large and sophisticated
water trading market. Social impact
investing is also very interesting;
again, it is uncorrelated returns, but
there just haven't been that many done
yet, and it's still at the super fund/highContinued next page
Sharemarket and
super fund returns
are still 90 per cent
correlated, suggesting
the alternative assets
funds are buying are
very closely linked to
equity markets.
Alex Dunnin, Rainmaker
Australian Financial Review, Australia
28 Jan 2015, by James Dunn
Smart Investor, page 19 - 1,097.00 cm²
National - circulation 62,455 (MTWTFS)
Copyright Agency licensed copy
ID 365894775
PAGE 3 of 4
Manv routes to riches
Australian alternative investment funds,
12 months to Dec 31 (%)
Water makes a lot of sense
for its completely
uncorrelated returns and it's
a fairly unique opportunity
for Australian investors
because we have such a large
and sophisticated water
ling market
Fund of
alternative funds
A5X total
From previous page
The alternative path
to a diverse portfolio
net-worth/family office investor level."
Another spot to get uhcorrelated
returns is in shipping funds, he says, but
again, it's hard for retail investors to get
into that area.
Liptak also likes the concept of
insurance-linked securities, and volatility exposure, as a "nice spot to make
uncorrelated returns, as well". But he
adds, "your manager needs to be good".
Gary Brader, chief investment
officer of QBE, is looking to place up to
$100 million of his $31 billion QBE
investment portfolio in social impact
bonds, to help diversify its assets.
"Intuitively it is highly likely that the
performance of these sorts of assets will
not be correlated to anything else we
own, so fundamentally and technically
there is a compelling argument for this
kind of investment" he says.
Alexander McNab, director of Blue
Sky Alternative Investments, says that
for retail investors, alternative investments can be both a shock absorber
and a return generator. "The traditional
Australian Financial Review, Australia
28 Jan 2015, by James Dunn
Smart Investor, page 19 - 1,097.00 cm²
National - circulation 62,455 (MTWTFS)
Copyright Agency licensed copy
ID 365894775
approach to managing risk is dialling
up or down your allocation to government bonds. Increasing that reduces
the overall portfolio risk, but because
government bonds have a low expected
return; you lower the overall expected
return of the portfolio," he says.
The problem with the full menu of
alternative exposures, he says, is access
and liquidity. "The challenge for retail
investors up until now has been that if
you wanted to allocate to alternatives,
how would you do it? If you look across
private equity, infrastructure, the vast
majority of managers have focused on
institutional funds, rather than vehicles
for retail investors. Plus there are issues
with liquidity. "The business model for
a financial planner revolves around
platforms. Platforms demand liquidity
and daily pricing and so on. But you're
beginning to see the emergence of
alternatives vehicles aimed at retail
investors; for example, listed investment companies [LJCs] and exchangetraded products tETPs]."
Last year, Blue Sky launched Blue
Sky Alternative Access Fund Limited
(ASX code: BAF), an LIC giving
investors access to a range of
alternative asset classes, including
private equity, venture capital, water
entitlements and infrastructure, hedge
funds and real estate.
"We wanted to offer retail investors
and SMSFs exposure to alternatives,
but through a liquid vehicle,"
McNab says.
Likewise, ETPs have given investors
a simple, cheap and transparent means
of gaining exposure to commodities,
through a single stock. Some are
physical ETPs - backed by a holding of
the commodity - while more recent
offerings are synthetic ETPs, which use
derivatives - for example, indices over
futures contracts or swaps -to generate
returns from a much wider range of
major commodities, for example the
agricultural commodities, the
industrial metals and the energy
commodities, which cannot be owned
physically by retail investors.
Andrew Spence, senior investment
adviser at Hillross CBD in Sydney, uses
commodity ETPs as a portfolio diversifier and inflation hedge for SMSF and
wealthy investor clients. "The story
for us in commodities is one of low-tonegative correlation, and protection
from inflation. We wanted an alternatives allocation that will hold the portfo-
PAGE 4 of 4
lio together, and make it more robust in
a downturn or a left-field event like the
[global financial crisis]," he says.
Blue Sky's Alex McNab: alternatives can be a shock absorber, PHOTO: BEN RUSHTON