What Role Can Alternatives Play in Your Portfolio?

After the disastrous performance of illiquid hedge funds in 2008 and the subsequent failure of many UK Absolute Return funds, it is easy understand why investors are wary of Alternatives

Psigma Investment Management 20 November, 2014 | 3:55PM
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Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Tom Becket, Chief Investment Officer for Psigma, discusses how investors can incorporate alternatives into their portfolio.

One of the more emotive subjects we face in our working lives is Alternative investments. After the disastrous performance of illiquid hedge funds in 2008 and the subsequent failures of many natural Alternative strategies, chief amongst them UK Absolute Return funds, this is easily understandable. There have been long periods where a number of Alternative investments in the market-place just haven’t justified their existence and often high fees.

We place a great deal of value on Alternative strategies and have found that they can be very useful in helping us to achieve our long term aims on behalf of our clients. However, our greater admiration for Alternatives can perhaps be best explained by our definition of an Alternative and how we use them within portfolios.

Following the welcome developments of the asset management industry over the last decade, there are now a number of interesting investment opportunities that cannot easily be classified as one of the 10 core asset classes so we break down our client portfolios in to 11 different core asset classes in an attempt to provide clear and efficient information on asset allocation. Alternatives is our 11th asset class.

One such example would be the holding we have in short duration Asian bonds, which have been left in their local currencies. Because of the nature of this investment and the volatility of the Asian currencies we feel it would be inappropriate to classify this fund as Sovereign Debt (Aberdeen Global Asian Local Currency Short Duration Bond). Therefore we consider it be an Alternative. As a dollar and Asian currency play this fund has had a good year.

There are some funds that are obviously Alternatives, particularly as their correlation to the other 10 asset classes is negligible. It is due to the lack of obvious correlation to other asset classes that we like Alternatives and they have proved very useful in our portfolios when equity markets are falling, such as in 2011. One fund that fits this bill is a credit long/short strategy we have held since 2011 (Legg Mason Western Asset Global Credit Absolute Return). The managers of this mainstay holding within our portfolios have eked out minor positive returns every year that we have owned it, with volatility similar to that of the Dodo. Positive returns throughout the investment cycle with low volatility makes this fund an excellent Alternative.

Not all Alternatives will exhibit low volatility – which we always try to remind everyone is just one form of risk – and some of our Alternative selections have been specifically selected to generate high returns, while taking aggressive investment stances.

Our two riskier Alternatives are presently a European distressed debt fund (City Financial High Yield Opportunities), which has had a tough year, falling 10%, but is probably our most exciting future investment opportunity, and a global macro fund (Odey Odyssey) , where the manager takes large positions in different global markets. This has meant that his fund has been the most volatile investment we own, but he has achieved over 13% per annum returns over the three years we have held the fund. Mostly that return has come from his equity investments, but because he takes both long and short positions, as well as investing in other asset classes, it is hard to define this fund as an equity investment.

It is almost impossible to do so, but if we had to define the perfect Alternative it would be an investment where there are consistently positive returns, with low volatility and low correlation over an investment cycle. A key holding in our portfolios fits this bill; the fund invests in high quality UK equities, with a covered call overlay helping to achieve an annual yield of 7% and always holds a high level in cash as protection (RWC Enhanced Income). Despite a tough year for UK equities, this fund has performed well and is on course to achieve its objectives. Sadly we had to wave goodbye earlier this year to another “perfect” Alternative, which invested in Catastrophe Bonds.

Why did we say arrivederci to this fund? We had become concerned about how excited other investors had become in this niche market, having been an undiscovered gem when we first took a position, as evidenced by yields falling from 8% at purchase to just above 5% when we sold. We believed that there could also be liquidity impairments in the future, which meant that the red flag came out and healthy profits were taken.  As you all know, we hate illiquidity and hold this risk as a preeminent driver behind all investment decisions; daily dealing and highly liquid is always our preference when investing.

What Next for Our Alternatives Allocation?

One of the major difficulties that we currently find is that outside of certain equity and credit markets and you have to be very selective, sourcing attractive potential returns, particularly with low volatility and reduced correlation to other asset classes, is practically impossible. We are currently running the rule over convertible bonds, specialist emerging market debt and a manager who can genuinely point towards an ability to short equity investments through an Absolute Return strategy. We hope to be able to diversify our Alternatives allocation further and replace the departed position in Catastrophe Bonds. For now we are comfortable with our allocations in Alternatives, look forward to them achieving their potential and will continue to field the tough questions.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Odey Odyssey I GBP Inc  
RWC Enhanced Income Fund A GBP Acc150.75 GBP1.00Rating

About Author

Psigma Investment Management  Psigma are part of the Punter Southall Group, a diverse financial services organisation offering a unique combination of actuarial, pensions consultancy, administration and investment services.