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Are Alternative Funds Living Up to Investor Expectation?

The rise of alternatives continues despite some disappointing performance numbers. We unearth the ‘alternative UCITS’ universe

Dan Kemp 5 July, 2017 | 1:42PM

For many retail investors, the world of “alternative investments” was off-limits until the launch of the more liquid hedge fund strategies in “UCITS” form several years ago. Their rapid growth in assets under management is evidence of their rising popularity; spurred by professed diversification benefits, lower returns from bonds and fresh memories of equity market losses in 2008 and 2011.

To make the most of these funds, investors need to understand how they differ from the long-standing alternatives such as private equity and traditional hedge funds. Investors also need to understand the role they can play to potentially improve outcomes in a portfolio. 

UCITS Funds vs Conventional Alternative Funds

You can think of the “UCITS” structure as offering a more regulated subset of the alternative fund universe. It has the aim of making these alternatives more suitable for individual retail investors, introducing limitations and protections not present in standard hedge fund and private equity fund structures. Constraints include limiting the use of leverage, concentration and keeping exposure to illiquid investments low, as well as preventing outright shorting.

The popularity of alternatives as an asset class is alarming

The result is that alternative UCITS offer exposure to a very small slice of the full range of alternatives strategies. While many deem this to be a positive development, there is downside as the regulation limits a manager’s capacity to generate returns as well as manage risk and diversify traditional portfolios.

What are the Key Issues to Consider? 

It’s worth noting that the range of strategies and the fund managers on offer are generally less well known than with conventional equity or fixed income. It is therefore very important to understand what you are getting and its total portfolio impact. The three key things to consider are:

  1. Is the Investment Strategy Clear?
  2. Is it bringing something different to the portfolio that will be diversifying in a crisis?
  3. How much can it add to total portfolio returns given the fees?

These holistic considerations are worth elaborating on as they are imperative in a total portfolio context. The key inference is that an ‘alternative’ fund is only truly alternative if it brings something to the table that traditional assets can’t. The investor must also get their fair share of any returns to make it worth their while.

Investment Strategy

In essence, alternative UCITS can own traditional securities as well as derivatives such as futures or options. Currency exposures are also typically actively managed. To navigate your way around the strategies on offer, you can use the Morningstar categories of liquid alternative strategies:

  • Long short equity  
  • Long short credit 
  • Managed futures 
  • Market neutral
  • Multi alternative
  • Option writing
  • Multi currency
  • Bear market

Given the broad opportunity set these mandates offer, close monitoring is needed given the more frequent changes and greater discretion when compared to conventional funds. As with any investment, it is essential to understand the risks associated with the strategy and the range of potential outcomes.

Diversification Impact

One of the primary motivations for alternative UCITS exposure is to look for strategies that offer something different from the equity and fixed income exposures one may already have. Choosing strategies that complement rather than replicate what your active equity and fixed income managers are doing is therefore very important. 

For example, check that your macro hedge fund is not simply taking the same exposures as your active global fixed income managers, since both will typically use economic insights to choose between currencies, different durations and different amounts of credit risk.

Most important of all, total portfolio diversification is most needed when equities sell off heavily, so understanding how the strategy will perform in this environment is crucial.

Return Impact

Alternative UCITS are not risk-free investments so returns need to be above those of cash to reward investors for this extra risk. The three drivers of the return investors get are (1) market returns that come from the market exposures or beta of the fund; (2) excess returns that come from the manager’s active decisions vs the market exposures; and (3) total fees and expenses.

For example, the market exposure of ‘equity long/short funds’ are typically “net long”, meaning the exposure adds to returns when equity markets rally and detracts when they fall. The largest market exposure for ‘market neutral’ funds tends to be cash. Therefore, one should make sure they don’t end up with either “expensive beta” propositions that act like traditional assets under stress or “cash proxies” that deliver a low return and charge high fees for the privilege. These expenses are a distinguishing feature as they are often higher than those of traditional managers and can include performance-related fees.

How Does this Work in Practice?

The overwhelming theme when considering alternative UCITS is to be disciplined and selective. Alternative UCITS can provide exposure to diversifying strategies with the potential to enhance total portfolio returns – however it is not always safe to assume this is going to be the case. The constraints imposed on alternative UCITS mean that only a fraction of the full gamut of alternative strategies is available. By extension, the constraints also limit the scope for generating returns and managing risk.

In our experience, better outcomes are likely if you are highly selective in this space. One should allocate and size these positions appropriately and always keep in mind what they offer relative to equities, bonds and cash.

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.

About Author

Dan Kemp

Dan Kemp  is Chief Investment Officer, Morningstar Investment Management EMEA

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