LONDON, 16 May 2005 — There are two distinctive types of investments: Traditional and Alternative. Traditional investments include long positions in equity, fixed income, and cash commodity markets.
Alternative investments exist within this context of equity and fixed income markets but also include: Private equity, hedge funds, managed futures, and securitized products. These investments use strategies and techniques not available to traditional investment vehicles, e.g. mutual funds, in order to produce and enhance their returns.
These “unique” tools can also include futures, short selling, leveraging, options, arbitrage, and private markets. In today’s investment climate, the choices are not especially attractive. True, US stocks rallied in 2003 and 2004 after a three-year slump, and now trade at prices that no longer are cheap. Bonds aren’t much more exciting as interest rates on all kinds of fixed-income securities have come down a lot in recent years. Those bonds prices will be under pressure as the US Federal Reserve raises rates.
Given this discouraging environment, many investors are turning to alternative investments as defined earlier. Some of these investments have turned in great performances in the past few years, catching the eyes of investors. Consequently, it has become easier for smaller investors to move into them. But what are the main reasons for shifting into alternative investments?
First and foremost: Diversification. Too many investors felt the pain during the brutal bursting of the bubble (bear market of 2000-2002) when they had too much money in stocks and suffered as prices tumbled. Moreover, one would consider including bonds in a portfolio, but often bond prices also move in step with stocks. So far this year, for example, stocks have fallen even as bonds have lost ground.
Alternative investments move within their own “sphere”. Gold, for instance, tends to rise in periods of global tension, even as stocks tumble, in part because it is a safe haven.
The question then becomes: What is the right alternative investment right now? I believe the answer is hedge funds. In the US alone almost $1 trillion is invested in hedge funds.
These are private investment partnerships that aim to do well in both rising and falling markets. In hedge-fund parlance, they strive for “absolute returns”. In contrast with mutual funds which often try to beat the market averages.
Hedge funds generally speaking buy investments they think have upside, such as stocks and bonds, while betting against other investments they think will go down. In that way, they seek to “hedge” themselves and achieve positive returns in all kinds of markets. Because they can bet against overpriced stocks, or move to the sidelines when opportunities are scarce, hedge funds tend to be less volatile than mutual funds.
There are however some downsides: Hedge funds charge higher fees than mutual funds and other investments, usually around 1 percent or more annually of all assets as well as 20 percent of any gains. They are also lightly regulated, and some funds have exaggerated returns or taken on much more risk than they promised.
Finally, an investor would ask: How much of a portfolio should be in alternative investments? This is not easy to answer! At one time, most experts recommended a basic investment mix of 60 percent stocks and 40 percent bonds, with some adjustments based on an investor’s profile. But in recent years, more have begun to appreciate the advantages of having 5 percent to 15 percent of a portfolio in alternative investments. In part because some of these investments have done so well, especially real estate, where home prices as well as stocks in real estate investment trusts have climbed sharply.
One caveat worth mentioning about alternative investments: They tend to be less transparent. A stock price is just a mouse click away, but it is harder to get an accurate price for that rare stamp or piece of furniture, thus making some alternative investments a bit riskier.
(Habib F. Faris is vice president at Clariden Bank, London.)
(The information contained here in is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information.)
