Investors turn increasingly to alternative assets to reduce risk and boost returns

Alternative assets – including hedge funds, private equity, infrastructure funds and art – provide major opportunities for investors to diversify away from traditional asset classes to benefit from reduced overall portfolio risk and a wider opportunity set.

Dr Nafees Hossain, Portfolio Manager at Prescient Investment Management, said: “Alternative investments utilise a different approach to investing compared to equity or fixed income investments.

“Given their ability to invest in areas and ways that traditional investments can’t, alternative assets have the potential to improve the overall risk-return characteristics of a portfolio.

“They represent wider and more exotic opportunities that are not correlated with other assets to deliver an asymmetrical profile to an overall investment portfolio.”

He added that alternative assets have become more main stream in recent years as investors look to minimise downside risk. The focus tends to be on absolute rather than relative returns.

Absolute return funds measure portfolio gains or losses as a percentage of invested capital, compared with the relative return measures often used by long-only funds that try to track and outperform a benchmark.

Long-only funds are not allowed to indulge in short selling, but hedge funds, for example, employ different strategies in order to produce a positive return regardless of the direction of the market. Absolute return managers tend to use short selling, leverage and high turnover in their portfolios.

However, Dr Hossain noted that alternative assets are often more illiquid, and hence have an embedded liquidity risk premium relative to traditional asset classes.

“Alternatives with proven track records and demonstrated success tend to become long-term investments on the part of sophisticated investors. Due to higher fees and sometimes the illiquidity of these types of investments, it can be a costly exercise to trade the assets.

“In addition, investments in artwork and infrastructure-related projects, for example, may take a long time to gain significant value. On the other side, due to lower liquidity alternative assets are often mispriced and offer opportunities for arbitrage.”

Despite unique risks and other considerations, Dr Hossain said alternative investments can be useful tools to improve the risk-return characteristics of a portfolio.

They can increase diversification and reduce volatility given low correlations to more traditional investments. And they can offer the potential for enhanced returns due to the wider investment opportunity set.

He cautioned, however, that investors need to undertake proper due diligence before allocating money to alternative assets.

“Alternative managers may invest in a wide variety of instruments, including derivatives. They will also utilise short selling. Understanding complex investment strategies requires more upfront and ongoing due diligence.”

Following the recent inclusion of hedge funds under legislation governing collective investment schemes, Dr Hossain called for stronger oversight of other alternative investments like renewable energy funds as this will make the asset class more accessible to investors.