Alternative investments have an image problem. When the FSA decided to crack down on the promotion of alternative assets, like overseas property and bamboo plantations, to retail investors, it went some way to tarring all investments in this sector with the same brush.
Indeed, many unregulated collective investment schemes (Ucis) are considered inappropriate for the everyday investor because of their inherent risks, but there are many other so-called alternative assets that wealth managers consider as legitimate ways to diversify away from bonds and equities, such as vehicles involving infrastructure, private equity and hedge funds.
The alternative investment market is large and is more accessible to the everyday investor than ever before. The Towers Watson Global Alternatives Survey 2012, which analyses the alternative investment market, shows total assets under management among the companies it tracks at $4.87tn. The 100 largest investment managers control some $3.13tn of those assets, which, in order of the assets invested, consist of real estate, private equity, hedge funds, private equity funds of funds, funds of hedge funds, infrastructure and commodities.
Chart 1 shows Towers Watson’s breakdown of how the money invested in alternatives is distributed. It shows real estate as the single largest area of investment at 28 per cent, while private equity and hedge funds follow closely behind at 23 per cent and 21 per cent respectively. Infrastructure and commodities make up a small percentage of overall assets under management, at 5 per cent and 4 per cent, respectively.
Chart 2, meanwhile, shows where in the world fund managers are investing their money. North America and Europe dominate with 45 per cent and 36 per cent of the market, while Asia Pacific has a 13 per cent stake.
While many alternative investment funds have lacked strict regulation in the past, a big change is coming for hedge fund and private equity managers in the shape of the Alternative Investment Fund Managers Directive (AIFMD). This intends to bring private equity and hedge fund managers under the supervision of European Union regulators for the first time and could go some way to improving the sector’s image.
Ultimately, the investment chosen depends on a client’s attitude to risk and financial goals. But, even more than that, alternative investments to a large degree depend on a client’s interests and the amount of wealth they have, because, apart from a few dozen retail-focused funds investing in these assets, the alternatives market is one that can have high barriers to entry.
Alternative vs Everyday Asset
For many people, the moment the phrase ‘alternative asset’ is mentioned, it raises alarm bells. This, says James Maltin, investment director at Rathbone Investment Management, is partly due to the bad press alternatives received in the aftermath of the 2008 financial crash.
Because the likes of Ponzi schemer Bernard Madoff and hedge fund managers are associated with this sector, many investors have formed a negative opinion. Furthermore, more esoteric assets like fine wine and art are linked with instances of fraudulent deals, which has also done little to promote a positive view.
While some might argue alternative investments are the preserve of the very wealthy, Fred Hervey, managing director of Berenberg Private Bank in the UK, says that is simply no longer the case. “I don’t think commercial property, private equity and hedge funds should be determined any less suitable,” he says, adding that many investments have been marketed badly and others have been opaque.
Mr Maltin says alternatives can be used to counterbalance a portfolio. When it comes to the likes of gold, macro-trading hedge funds, property, targeted return strategies and infrastructure, he says, “To us they’re not alternatives, they are part of the asset allocation process and play an everyday role in a portfolio.”
When building a portfolio, Mr Maltin says a way to protect from the downside of equities is to use either a government bond or an alternative asset. In this case, he defines an alternative as something where its correlation to equities is less than 0.4, where 0.0 is not correlated at all and 1.0 is full correlation.
Meanwhile, John Greenwood, chief executive of Creechurch Capital, says about a fifth of his firm’s portfolio is in alternative assets to offset volatility in equity markets.
At the moment he says his firm favours alternative finance funds, which fill a void left by banks that are lending less, and property, which is currently affordable after asset values fell following the credit crunch.
“The image of alternatives has been tarnished by the likes of life settlement and carbon credits in the past 12 months, but, in reality, the asset class offers attractive and respectable opportunities including hedge funds, infrastructure, commodities and property,” he says.
With the explosion of Ucits funds in recent years, most of what previously were difficult assets to access now have relatively low minimum investment levels and, in the case of investment trusts, are traded on the stock exchange like company shares.
Graph 1 shows how the major alternative assets – commercial property, commodities, hedge funds, infrastructure and private equity – have performed in the past five years.
The graph shows a clear disparity between property and private equity on one side and infrastructure, commodities and hedge funds on the other.
Property and private equity suffered greatly as a result of the financial crisis and have yet to recoup their losses. Infrastructure, however, has managed to produce steady upward growth. Commodities have been more volatile but have managed to produce positive returns, while hedge funds have recorded flat performance in the past few years despite recovering from their losses in 2009.
Commercial property funds are perhaps the most mainstream of them all and, while some would argue this is not an alternative asset, the fact it has a low correlation to equities over the long term means it lies in this category. “The method that you [employ to] get access to alternatives is important,” Mr Hervey at Berenberg says, adding commercial property is the easiest. Currently it is possible to invest in open-ended funds that invest either in direct property or in company shares, while real estate investment trusts (Reits) also allow investment into direct or indirect holdings.
While the commercial property sector went through a slump following the market correction of 2007, many strategists see opportunities opening up. Figures from Investment Property Databank (IPD) show commercial property in the UK returned 2.6 per cent in the 12 months to the end of November 2012. While that is not a high return by any means, it is the yield property generates that is the big attraction.
Unfortunately, values fell by 3.9 per cent in 2012 while rents increased by 3.1 per cent in the City and West End of London, but fell by 4 per cent elsewhere. Nevertheless, the income return from property, IPD says, was 6.2 per cent in the first 11 months of 2012.
Private equity funds are also a favourite among wealth managers, but it is necessary to be selective here, says Mr Maltin at Rathbones. He says private equity can be a difficult sector to gauge and is therefore one market where it is necessary to invest on trust.
Private equity could represent good value as many funds are still trading at deep discounts to their net asset value (Nav). When the markets dropped in 2008, this sector was one of the most badly hit and discounts widened to as much as 60 per cent. While investor sentiment drifted away from listed private equity funds and share prices tumbled, the assets backing them have in many cases held their value and analysts see opportunities here. However, despite statements that these funds are undervalued, their discounts remain wide.
Managers of listed private equity funds have struggled to narrow their discounts and today it is common to see a discount of 50 per cent or more, although the average among all funds is closer to 30 per cent.
Rainer Ender, managing director of Adveq, the private equity manager, says one problem with the sector is it can be illiquid, which might turn off investors. However, he says this has its advantages. “Historically, private equity has proven to provide an illiquidity premium,” says Mr Ender. In the institutional market this amounts to 300 basis points on top of the return, he adds.
Meanwhile, listed hedge funds are a favourite of wealth managers, but selecting them can be tricky because some have performed badly. “Hedge funds had terrible press but some of the best managers have set up these funds,” Mr Maltin says. He points out that investors who were selective saw good performance.
Mr Maltin says one of the major complaints about hedge funds is the high fee structure, but adds, “Ultimately what matters is the net return on charges.”
Normally closed to the average investor, listed hedge funds allow retail investors access to this sector. While many of these trusts are simply feeder funds for the managers’ unlisted strategies, they come with a degree of liquidity and flexibility not often available in this sector.
Another option might be the Battle Against Cancer Investment Trust (Bacit), which launched at the end of 2012 and blends private equity and hedge funds in its portfolio. With a pledge to donate part of its Nav to charity and not charge a management fee, it is structured as a fund of funds that holds some of the biggest and most inaccessible hedge and private equity strategies.
“What was so interesting is some of the funds in there were some of the most expensive, but all the fees were waived,” Mr Maltin says of Bacit.
Infrastructure is another alternative that wealth managers use in clients’ portfolios. This is a sector where the success or failure of a fund relies heavily on government spending, but is largely seen to be stable and have a lower risk than traditional equities.
Giles Frost, director of Amber Infrastructure, the company that manages the International Public Partnerships infrastructure fund, says as an asset class it has many features similar to property but it performs in a different manner. Typically infrastructure has a low correlation to equities, or not at all, and often will move in a different direction to financial markets. “Infrastructure could provide a steady return to investors regardless of the market conditions of the time,” Mr Frost says.
One of the main objectives of these funds is to produce an income, although they come with capital growth benefits as well. While the sector’s average return in the 12 months to 1 December 2012 is just 1 per cent, this is largely due to a single fund’s share price dropping by more than 60 per cent in that period.
Infrastructure India lost 64 per cent, while its peers like International Public Partnerships returned 11 per cent and HICL Infrastructure Company returned 12.7 per cent.
As income vehicles, many infrastructure funds have a yield of 5 or 6 per cent, but a major downside of these funds is the fact that nearly all trade at a premium to Nav, such is their popularity.
This, Mr Maltin says, is because infrastructure funds are popular assets and the share prices are being pushed up as a result. “It’s at a premium because the yields are high and everyone is searching for yield,” he says.
Yet another area to explore is venture capital trusts (VCTs) and enterprise investment schemes (EISs). Puma Investments is a VCT manager owned by Shore Capital and offers limited life VCTs, which allow investors to gain immediate benefit of the structure’s tax reliefs. Eliot Kaye, director of Puma Investments, says the fund invests in debt and runs for a five-year period. He says the VCT structure, because of the 30 per cent tax break, makes it a viable alternative to traditional pensions for those with more wealth.
He says with maximum annual pension contributions continually being reduced, most recently from £50,000 to £40,000, there is an appetite for capital preservation through tax-efficient investments like VCTs. “I think that’s where the market is going to go,” Mr Kaye says. “More people are going to see these as a place to preserve capital.”
One advantage of the VCT structure is that it is regulated by the FSA and can therefore be recommended to retail clients. Mr Kaye says many of his investors come direct, but a large number also arrive via IFAs who have clients in need of an alternative asset.
Beyond the familiar range of alternative investments, it is possible to hold assets like timber funds, agricultural land, classic cars, fine wine, art, venture capital, film finance and more. But if hedge funds and private equity require sound financial advice, it gets even trickier when it comes to the more esoteric offerings on the market.
For starters, many of these assets – particularly wine and art funds – are not regulated and therefore cannot be promoted to retail investors. In fact, Mr Maltin at Rathbones says investments like fine wine, art, classic cars and others are beyond his remit. “We wouldn’t advise clients on those areas and might find a specialist and refer the client to them,” he says.
Mr Hervey at Berenberg shares this view, adding, “Things like art, cars and farmland don’t really fit into the investment process.” However, his firm has launched an art fund, although he says it does not fit into clients’ portfolios and instead suits clients who specifically want to invest in fine art.
If it is a physical asset rather than a collective fund, giving advice is more challenging. For example, Paxton Private Finance runs its Paxton Secured Income fund, which finances the company’s bridging loans business. Because it is an Ucis, it is considered high risk by the FSA and therefore cannot be marketed to retail investors.
However, David Kinane, partner at Paxton Private Finance, says the firm’s loans, which tend to go to property developers or investors, are backed entirely by the collateral. The highest loan-to-value the firm offers is 75 per cent but the average is slightly more than 53 per cent. Minimum investment in the fund is £25,000, which puts it at the higher end of the market.
For the more adventurous, there is film finance, but again this area is difficult, if not impossible, to advise on because of its unregulated status. However, Nick Hocart, chief executive of Chizu Media, a film finance company, says the prospect of making returns for investors is much greater than many people think. Rather than trying to fund a single, big-budget production, Mr Hocart’s company invests in a portfolio of films, the first of which contains eight productions, all around the £1-2m budget range.
Mr Hocart says that falling costs make it easier for a film to generate profits and, by financing a range of different productions, the diversification mitigates any downside caused if one flops. However, for a decent investment in this area, Mr Hocart recommends clients put up about £100,000 or more.
If direct film finance is not an option, the VCT/EIS route might be more appropriate. It is possible to invest in film funds managed by the likes of Ingenious Asset Management or even wine EISs from the same manager.
Two of the assets most commonly identified as alternative today, and perhaps also the most fraught with pitfalls, are fine wine and art. Each can be bought individually or through collective funds – and each is best left to the experts unless the investor is already well-versed on the topic. But, like many other alternatives, wealth managers and other advisers rarely provide advice in this area, instead choosing to steer clients to experts who can help them, such as brokers and dealers.
Thomas Woodham-Smith, creative director of Masterpiece, the art fair, says investing in works of art and antiques goes hand in hand with collecting these items. One thing that attracts many people to investing in art and antiques is the fact the pieces tend to retain their value over time. “If you bought a pair of armchairs from John Lewis, you would expect them to be worthless in due course, but if you bought them from an antiques dealer, you would expect them to have value,” Mr Woodham-Smith says.
But investing in this market is not easy. When it comes to art, it is possible to invest through the Fine Art Fund Group, but the minimum investment is £500,000. Fine wine is easier to access at the fund level, with minimum investments into The Fine Wine Investment Fund being £10,000 and for direct holdings this can be less, although that requires paying for brokerage and ongoing storage fees.
Navigating the Minefield
A wide range of assets and strategies fall into the alternative investment umbrella, none of which is easily comparable to the other but all share the distinction of not being a traditional bond or equity.
Overall, alternative investments are rising in popularity. Look no further than the number of times they have been mentioned in the national press and it is easy to see how they are being increasingly viewed as a viable way to diversify holdings and generate extra returns.
But none of these assets is straightforward, so good financial advice is key. When used as part of a diversified portfolio, many alternatives can be appropriate for the everyday investor. However, some of these assets can be considered too risky and sophisticated for an average person, so the benefits and drawbacks always need to be examined.
When it comes to the so-called mainstream alternatives, wealth managers see them as important tools to help diversify portfolios. The rest, however, are best left to enthusiasts with not only the money and knowledge to invest in markets such as film finance and wine, but also the capacity for loss if everything goes pear-shaped.
See article online here on the FT Adviser website