Why alternatives have come of age

This article is part of
Multi-Asset Investing - June 2016

Why alternatives have come of age

Most market commentators tend to agree the current lower growth environment is set to continue for the short to medium term. In the context of these market conditions, traditional asset classes are unlikely to offer returns that investors have become accustomed to.

This leaves investors and advisers in something of a quandary. Should you increase your risk tolerance to try to maintain returns, or instead accept lower growth prospects? The available options may not be as binary as they first appear, if we consider the possibility of including alternative investments within a diversified portfolio.

The range of alternatives has become more diverse over past decades, as many industries have sought to become more accessible to external investment. Some alternative investments are more niche than others, but their detachment from the peaks and troughs of market cycles is part of what makes them intriguing.

These financial innovations really began with the emergence of mortgage backed securities, which financed the construction of most of the US skyscrapers in the 1920s. We then saw the creation of hedge funds in the post-war period. Alfred Jones is considered the creator of the hedge fund concept. His fund avoided regulatory requirements by limiting itself to 99 investors. At the heart of his idea was to leverage short-selling to protect investors from downturns in the stockmarket. Mr Jones chose to charge no management fees and instead take 20 per cent of profits as compensation.

More recently, catastrophe bonds were first issued in the aftermath of Hurricane Andrew and the Northridge earthquake in America. This followed the need by insurance companies to alleviate some of the risks they would face if a major catastrophe occurred.

Key dates: An Alternatives Timeline

The decade/years when different types of alternative investments were introduced:

1920s - Mortgage backed securities

1949 - Hedge funds

1960s - Real estate investment trusts, or Reits

1968 - Private equity

1970s - Infrastructure

1990s - Catastrophe bonds

1991 - S&P GSCI index launched

Source: Architas

Perhaps the most talked about part of the alternative investment universe are absolute return funds or hedge funds. The past decade has seen many different terms used to fundamentally describe the same thing. After the lack of downside protection offered to investors during the global financial crisis, and a couple of subsequent high-profile frauds, the term hedge fund fell out of popularity in retail markets.

Absolute return became the common phrase for hedge fund strategies, although more recently investment banks have created “liquid alternatives” as the buzzword for referring to absolute return strategies in a daily dealing format. At the root, the same strategies are employed, but managers will align themselves to whatever the classification du jour is. When looking at these investment vehicles, it is important not to forget the vast range of different strategies on offer such as merger arbitrage and long/short equity.

Investors now also have greater options within specialist property funds, which can include health surgeries, warehouse distribution centres and student accommodation. These investments can provide inflation-linked returns as well as potential capital appreciation. Importantly, these types of alternatives often help to smooth returns in different parts of the business cycle and potentially offer more certainty in terms of future cashflow forecasts.