Don’t fear Ucits III strategies, but handle carefully

It was not that long ago that most ‘alternative’ investments were beyond the reach of the average investor – domiciled in exotic locations with high minimum investments, very little information available and a high level of illiquidity.

The move to offer increasing numbers and types of alternative investment in Ucits III vehicles has meant more and more investors are able to access these types of product, and their Ucits structure has offered a degree of perceived comfort around the operational and regulatory risk controls for these structures.

Researching alternatives, even in a Ucits structure, still requires a focus on portfolio specific risks such as leverage, type of instrument used and counterparty risk. Fees also need to be considered: alternatives are associated with higher fees, often including a performance fee. Typical fee structures of a one to two per cent fixed management fee and an incentive fee of 10 per cent to 20 per cent of profits over a certain hurdle (often cash) are not uncommon. Investors must be aware of the impact of fees on their net return – for example a fund with a 10 per cent after fees target return, a two per cent and 20 per cent fee structure, and a 0 per cent hurdle rate must earn a gross return of 14.5 per cent. With cash rates at near-zero levels, the impact of fees as a proportion of a manager’s total return has increased significantly.

Aside from the necessary due diligence and consideration of fees, however, investors need to think about what they wish to achieve when using alternatives – there is no purpose to adding something, particularly with potentially higher risks and higher fees, without any obvious benefit. There are two (possibly complementary) objectives – diversification for volatility reduction, and the potential of additional performance (that is, capital gains). Simple investment theory tells us we should diversify portfolios and the best way to do this is to access uncorrelated asset classes. What investors need to be aware of, though, is that while using different and more complex underlying instruments compared to traditional investments, alternatives may not actually achieve the diversification benefit that the asset class might at first glance be expected to offer. Just because something’s building blocks are different, does not guarantee low correlations.

Correlations are something of a complex topic, and investors looking at the broad array of alternatives need to think carefully and in detail about what this means for them. Put simply, two assets can appear to be correlated in terms of performance because they both deliver a positive return over a given time period: this is not a bad thing – indeed, if all of the assets in which we were invested seemed to be correlated because they were all delivering good positive returns we would have the near-ideal portfolio. What matters, though, is what drives these longer term correlations and hence the implications for the extent (or lack) of diversity in a portfolio. For example, the MSCI AC World index and the HFRI Fund of Funds Index (shown in the chart) have almost-equal returns over five years, but this does not make them (necessarily) correlated. Moving to individual managers, consider an equity long/short manager: even if the manager is market neutral, his or her returns could appear correlated to a long-only equity manager if equity markets were returning, say, 10 per cent a year. However an equity long/short manager with a long bias could actually be underperforming, but the beta in the portfolio could pull the strategy up to again appear correlated with long-only equities. Simply looking at correlations would suggest that both are positively correlated, but one, being market neutral, does effectively diversify portfolio risk, whereas the other, having a structural long bias, does not achieve this objective.