Below is the lead article I wrote for the Australian in today's Wealth section. It opens up possibilities to investors, but it also hints at closed doors. Barriers to entry are high in this asset class, and so are the fees. It is very easy to claim diversification, but as Shan Oliver of AMP says, "when you really need it (such as in the financial crisis) it's not there."
Invest outside the box
by: Richard Hemming
From: The Australian
October 26, 2011 12:00AM
A near-mint copy of the comic book Amazing Fantasy No 15, which features Spider Man's debut, sold for $1 million. When it first went on sale in 1962, it cost 12c. This equates to a compound return of 40 per cent across 50 years. Source: Supplied
WHEN something doesn't work, you look for alternatives. And right now many consider the mainstream choice where most people invest money - the stockmarket - has not been working, at least in the short term.
You just have to look at the main equities indices across the world during the past six or so months. Even after a bounce, the ASX All Ordinaries Index has fallen more than 14 per cent; the US benchmark, the S&P 500, has declined 12 per cent; while Britain's FTSE 100 is down 11 per cent.
Savvy investors look for other investments they hope will provide the 12 per cent to 14 per cent annual return needed to guarantee some sort of life post-retirement. They will have confided their dilemma to their financial planner.
"Have you heard of alternative investments?" the planner asks.
"Alternative, meaning 'alternative to poor performance'?" the investor responds, trying to look calm. The planner replies: "In a survey of super funds done recently, those that had a bigger weighting towards the alternative investment asset class outperformed those that didn't, quite considerably."
The planner is right. According to a survey released this month by SelectingSuper and Rainmaker Information, not-for-profit super funds that on average invest 14 per cent of their funds in the alternative investment class generated annual returns across the past 10 years of 5.2 per cent. In contrast, retail funds, which are managed by the private sector, returned 3.3 per cent. To give you an idea, these same industry funds invest between 30 per cent and 40 per cent in fixed-income products such as bonds; about the same amount in equities; and the balance in cash.
A big reason for the higher weighting of alternatives in the not-for-profit super funds is they are not constrained by investors choosing at any given moment to switch their funds into cash, which exists under the "choice of super fund" legislation that began in mid-2005.
So what are these mysterious assets?
"The starting point for considering any alternative is getting something that is lowly correlated to equities and bonds," AMP Capital Investors' chief economist Shane Oliver says.
"In theory they improve the quality of a portfolio because they diversify."
Diversification is a word you often hear when associated with alternative investment. The mainstream alternatives, as it were, are private equity, hedge funds and infrastructure. Outside Australia, unlisted property is considered alternative but Australians' love affair with bricks and mortar has meant it is considered to be mainstream.
But even those who advocate alternatives as an asset class admit all of the above have struggled to provide investors with the protection they desire.
This was highlighted in the financial crisis when investors were disillusioned by their inability to exit and extract returns from private equity and hedge fund investments that provide very little insight into their activities.
For hedge funds, the very mechanisms that they used to operate, such as leverage and short selling securities (selling without owning the underlying asset) was ripped from them. Plus, in a sector that is loosely regulated, there were some famous examples of fraud. In Australia there was Trio Capital, but there have been many examples across the world, all dwarfed by New York-based Bernie Madoff, whose Ponzi scheme blew up in December 2008.
"Finding decent alternatives that have a low correlation to shares is a bit like searching for the holy grail," Oliver says. "In theory it's there, but at the times when you need this type of correlation, it vanishes. The only thing that's proven regularly to have a negative correlation is government bonds."
That may be true, but you are not going to fund your retirement on the basis of an Australian government 10-year bond interest rate of 5.75 per cent, although you seem to be doing better than the average return from a super fund.
The true alternatives, according to Oliver, include fine art and other collectables. But this won't be the case if they enter the mainstream, he says: "If these collectables get greater exposure they too might end up having the same correlation as other alternatives."
Nick Ryder, global investment strategist with NAB Private Wealth, cautions you have to be careful with these investments because the government may not consider them eligible for your super fund. "Collectables like stamps, coins and art are difficult to put in your super fund. You have to make sure they are insured properly; and they're also not a good investment during a recession," he says.
In hard times, many are looking to sell their grandfather's watch, which lowers values. Another factor is many of these so-called alternative assets have been very difficult to invest in for all but institutions and very wealthy families. This may be a reason the mythical financial planner was so elusive about them.
Oliver's colleague Suzanne Tavill is head of alternatives at AMP Capital Investors. She is adamant that only with substantial amounts of capital that can be tied up for up to 10 years at a time can you get the proper benefit of alternative assets. Her expectation for the return from $15 million her team might invest in a private equity fund is that it will have doubled in value in a 10-year period, implying an annual return of 15 per cent.
"The issue with these more exotic alternatives in the illiquid space is that it is almost impossible for retail investors to get exposure," she says.
Alternative investments, which include hedge funds, private equity, infrastructure and a range of others, represent 18 per cent of AMP's $11 billion Future Directions Balanced fund. Her fund invests in assets not available to the retail investor, outside of three main classes mentioned above. Many of these opportunities emerged out of the financial crisis, where funding from traditional sources, such as banks, dried up.
AMP has invested in funds that have exposure to catastrophe risk, acting as a form of reinsurance; it invests in farmland and in water entitlement rights.
Tavill has a background in finance, having worked as an asset manager with Goldman Sachs in London before coming to Australia. She says because she is with an institution she has access to specialised advice, from timber expertise to an executive who knows the difference between a Learjet and a Gulfstream.
"The perception is that alternatives have been useless and people only think about hedge funds and this is just not the case. There are true alternatives out there that can diversify a portfolio," she says.