Funds: Discovering the alternatives

Anyone who has been following the fortunes of the hitherto little known GameStop of late will have become familiar with the concept of short selling.

This is where an investor bets that a stock will fall in price. They borrow a stock, sell it at the current market price, and then buy it back at a lower price to return it to the lender, having earned a tidy profit along the way.

That’s the theory anyway, but they can lose their shirts if the price goes in the other direction.

This is one of the many different types of investment strategy used by alternative investment funds (AIFs). They are inherently riskier than the standard UCITS (Undertakings for Collective Investment in Transferable Securities) funds offered to retail investors but can also offer the potential of higher returns. More importantly for the investors concerned, they can offer the prospect of growth at a time when equity and other investment markets are going in the opposite direction.

According to Martina Kelly, director of funds at IOB, under European law all funds, whether regulated or not, are classified as UCITS or AIFs.

“In essence, an AIF is any fund which is not a UCITS,” she says. “UCITS are tightly regulated and subject to detailed rules in relation to their managers, depositaries and their investment policies. They are authorised on the basis that they are available for sale to retail investors.”

But AIFs are not subject to product rules at European level. “The EU regulatory regime which applies to them – the Alternative Investment Fund Management Directive, which must be implemented by member states, focuses on the regulation of their managers.”

“Alternative investments have grown steadily over the years,” says Vanora Madigan, director of DMS Investment Management Services. “They are typically for well-informed professional investors, people who know what they are getting into. The principal attraction is the broad range of assets they can invest in. These include private equity, infrastructure, and property. These are typically not found in a UCITS fund. They are also quite flexible and have no real investment restrictions. From an Irish perspective, AIFs can be sold throughout the EU from here.”

Flexibility

That flexibility applies particularly to what are known as Qualifying Investor AIFs, which are reserved for professional investors. According to Kelly, these funds are not subject to detailed investment rules by the Central Bank and are generally permitted to have high levels of leverage through the use of borrowing or derivatives.

“These types of funds are often referred to as hedge funds and can follow a broad range of very diverse strategies including investment in private equity, or highly leveraged derivative-based strategies.”

Despite their apparently novel approach, they’ve been around for quite a long time. “They are not new,” says Tara Doyle who heads up the Asset Management and Investment Funds department at Matheson.

“The world’s first hedge fund was set up in 1949. An AIF is really just a way of describing a fund that don’t invest in the traditional long only way of investing in stocks and bond markets. Anything else is alternative.”

But there can be challenges around the valuation of some of the assets in the funds. “You need specific expertise for that,” says Doyle. “There can also be challenges around liquidity with assets like private equity and property. And investors definitely need more expertise where derivatives are involved.”

In other words, it can be hard to tell what your investment is worth until you try to cash in, and cashing in can be a drawn-out process if it involves having to sell properties or stakes in unlisted companies.

That said, AIF growth is likely to continue in the current low interest rate environment where investors are seeking superior returns. Another growth area for the funds is the credit markets.

“When you look at what’s coming down the tracks, government deficits and infrastructure spending will need to be funded,” says Patricia Johnston who leads PwC’s Asset and Wealth Management practice in Ireland. “Not all of this will come through traditional banking and we will see more of it coming from the investment markets as is already the case in the US.”