Smart Investor, October 2010

Acid Test: Should you invest in alternative assets like hedge funds?

Alternative investment vehicles – hedge funds, private equity, timber, distressed credit – appear to have survived the financial crisis and are increasingly targeting Australian retail investors once again. Should you be tempted?

1. Are you overly concentrated in too few things? Yes/No

Many Australians have all their eggs in, if not one basket, then not many. The typical Australian allocation is: a great big chunk in Australian equities; maybe a bit in Aussie bonds; perhaps an investment property (in which case they’ve probably ditched the bonds). One of the attractions of alternatives is that they are supposed to be uncorrelated to mainstream asset classes, so when equities crash, they still do OK. One of the problems is this hasn’t always proven to be true.

2. Do you like the idea of profiting from something that’s losing value rather than just from things that are going up? Yes/No

The most well-known type of alternative fund is the hedge fund. Actually that term covers a multitude of different styles, but the most common one is the long-short: a fund that can take positions to make money from things that are going down as well as up. Some fund managers swear by this: they say going short is just the other side of the same coin as going long, and if you’re restricted to only investing in rising stocks, you’re depriving yourself of half the opportunities you see in your working day. The downside is that if you’re wrong about a short position, there’s no limit to how wrong you can be.

3. Do you trust little-known managers with clever but rather opaque styles? Yes/No

The allure of a hedge fund boutique is that you’re getting into a secret nobody else has figured out: aligning yourself with the brains of the operation with a technique that the big guys can’t emulate. The downside of this approach is at least as many boutiques have proven to be of modest ability as have managed to shoot the lights out. Not all alternative managers are small boutiques – big institutions like Man Investments are every bit as big as our local Aussie equities heavyweights – but those who are carry a large degree of key man risk and an uncertainty that people must become comfortable with.

4. Do you like the idea of being invested in timber, commodities or even livestock? Yes/No

People differ in their views of what constitutes an alternative asset, but it can put you into some curious asset classes. Many big institutions, including the Future Fund and a number of super funds, have taken big positions in assets like timber, finding their long-term nature and predictable income appealing.

5. Do you think the real opportunities come when markets and assets are in trouble? Yes/No

One of the classic alternative investment approaches is to invest in distressed assets – be it bonds, real estate or companies themselves. There’s no question that some of the very best returns are made by buying the bottom of the market and getting ready for the recovery. But this is treacherous territory and only for the professionals: there is plenty of dross out there that is distressed for a reason and never recovers.

6. Do you like the idea of investing in the next Microsoft before anyone has heard of it, and can you bear the risk of being wrong? Yes/No

This is the theory of private equity and venture capital, another alternative asset class. These funds exist to provide money to companies that either haven’t yet hit the stock markets, or perhaps have needed to be revamped before being put back in public view. Australia has been a hotbed of private equity over the years, both for multinationals like TPG and Carlyle, and homegrown names like Ironbridge. There are many products that invest in local and international private equity funds – but expect to wait years and years for your return. Expect, too, that some of the names that your funds have backed will never even make it to the starting line.

7. Are you comfortable with performance-based fees? Yes/No

Alternative funds that charge a flat fee are few and far between. Most alternative products have complicated fee structures involving a degree of performance reward. The positive view of this is that it aligns interests of investor and manager; the negative, that those fees can really mount up (but generally only if the investment is doing well).

8. Can you live with multiple layers in your investment? Yes/No

In order to keep things suitably diversified, many alternative funds – particularly hedge funds – will invest in other managers, in what is called a fund of funds structures. It is true that this alleviates the risk of having all your money with one manager who goes under. But you can find yourself paying two layers of fees – pre-crisis, some products even involved three.

VERDICT:

Mostly yes: You need some diversification, some spice in your life. You know there are risks and that a long-term view is required, but you’re ready for that.

Mostly no: Alternatives might sound exotic but they just don’t fit your risk profile. You prefer what you know and can understand, and you don’t need some new-fangled technique to get you the returns you want.