Investments: Taking the alternative option

Many investment portfolios now include alternatives such as private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, derivatives contracts, and even cryptocurrency holdings. Many of these are potentially very risky but they can still form an important, albeit small, part of a balanced and diversified investment portfolio.

“Most investors are familiar with the concept of building a portfolio from listed equities and bonds along with cash,” says Davy head of investment selection Michael MacGrath. “Alternative investments are anything that sits outside of those categories. It’s therefore an exceptionally broad universe of investment opportunities, covering everything from familiar assets like property and gold to more esoteric ones like hedge funds and ownership of private companies.”

Davy includes alternatives in client portfolios because they have the ability to generate returns and because they tend to be uncorrelated with stocks and bonds. “Because alternatives can generate performance when traditional asset classes are challenged, they can help diversify the overall portfolio, improving its risk-return characteristics and smoothing the investment journey.”

According to Kevin Quinn, chief investment strategist at Bank of Ireland, the more mainstream alternatives investors may be familiar with are private equity and hedge funds. But these tend to be mainly for institutional investors and are not easy to access for private investors.

They can also offer a bumpy ride. “Private equity is a long-term investment,” says Quinn. “Returns tend to follow a J-curve where you can lose in the early years, with the biggest gains coming later. They can perform strongly in the long term but a lot of people find the prospect of early losses a bit challenging.”

Hedge funds are actively managed investment funds where the managers use a wide range of strategies and may include some very esoteric assets, including very complex derivatives. Many of them are also highly leveraged, meaning that they invest with borrowed money. This can amplify the return for the investors but can also lead to heavier losses. They are generally considered to be quite risky investment choices.

“Hedge funds haven’t had a good 10 years,” says Quinn. “The gloss has come off them somewhat but that has changed a bit in the last year when they have delivered a better performance than bonds.”

Covid crisis

Davy also allocates to hedge funds and liquid absolute return funds. “With flexible investment mandates and teams of talented professionals, these funds can take positions which are beyond the capabilities of a traditional portfolio,” MacGrath says.

“For example, we invest in a number of funds pursuing a global macro strategy – that is to say that they invest across bonds, equities, currencies and other market positions in line with a specific macroeconomic view of the world. This part of our portfolio held up particularly well through the Covid market crisis last year.

“We also hold a number of long/short equity specialists who seek to make returns not only from going long on strong companies, but by shorting underperformers. And we hold a number of systematic programmes which seek consistent exposure to particular market factors – we have seen some of our funds here perform very well year to date, including those seeking exposure to undervalued equities.”

Ian Quigley, head of investment strategy at Brewin Dolphin, advises people to be cautious when considering hedge funds and absolute return funds. “The experience for most Irish people has been underwhelming,” he says.

“Absolute return funds became quite popular in wake of the global financial crisis but lots of them underperformed. They were managing to volatility but not for return. In a very low-interest-rate environment that’s very challenging. They can also be quite complex when you get into them. There can be a bit of opacity to them.”

The nature of the investment is also a bit different to other, more mainstream asset classes. “The investment tends to be more in the ability of the investment manager to navigate different markets rather than the economic and financial fundamentals of the underlying assets,” says Quigley. “Like anything else, there are some good managers out there, but people should always seek advice before considering an investment. In a very low-interest-rate world, there is a risk that people could end up investing in something riskier than equities without realising it.”

Idiosyncratic options

MacGrath points out that the Davy alternatives programme allows the firm to access highly idiosyncratic opportunities that are well beyond the reach of a traditional stock-and-bond portfolio.

“For example, we have been investing in private equity for over 15 years, and we have found that this part of our investment programme has resonated particularly well with our clients,” he says.

“We partner with some of the world’s foremost deal makers, investing to transform established private companies for the next phase of their growth. For example, our clients participated in the take-private of Dell – one of the original names in desktop computing which has now re-entered the public markets as a full-service technology solutions provider. Elsewhere, we target the leaders of tomorrow. That approach has given us access to companies like Facebook and Spotify well before they were listed.”

There is somewhat less enthusiasm for structured products, however. These are pre-packaged investments that normally include assets linked to one or more derivatives. “Some have worked well, some not at all,” says Mercer private wealth leader Michael Lacey.

“We have seen geared property funds which have collapsed and other funds promising enormous returns which turned out to be Ponzi schemes. If it looks too good to be true, it probably is. There are some good ones out there, but they get marred by the bad. It is important to sit down with advisers to get details of the products and see if they stand up to scrutiny.”

They do have their place, according to Quinn. “They come with challenges, illiquidity being one of them. But you can get a structured product with part capital security. And some of them can pay off even if the market is flat.”

Cryptocurrencies are still viewed with a degree of scepticism. “Potentially in the future they will merit addition to an investor’s alternatives toolkit,” says McGrath. “But that’s probably as far as I would go for now. They are still very much an asset class in development, still subject to significant volatility, often due to swings in investor sentiment, and many of them still do not provide a reliable basis for valuation.”

“There has never been so much talk about cryptocurrencies,” says Lacey. “They are clearly a dark web sort of instrument. Without being regulated I can’t see them being a mature investment choice.”

Volatility is one of the chief problems, according to Quinn. “The returns can be breath-taking but look at the rollercoaster valuation of bitcoin over the past year. It’s still in early days and it’s not for the faint-hearted. We don’t advise on cryptocurrencies.”