Chapter 10

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Alternative Investments

A concise guide to non-traditional assets

‘Old age isn’t so bad when you consider the alternative.’

Maurice Chevalier

Whilst traditional asset classes make up the bulk of most portfolios, other assets can complement them, adding additional sources of return and enhancing diversification. Alternative investments (AI or alternatives) include non-traditional assets, such as:

1. Property.
2. Commodities.
3. Private equity.
4. Hedge funds.
5. Infrastructure.

Many other types of AI exist, for example leveraged loans, insurance-linked securities (ILS), timber and art. However, they are rarely accessible on DC pensions and ISAs.

Historically, alternatives were held exclusively by institutional investors and high net worth individuals (considered sophisticated investors) due to their relative expensiveness, complexity, limited regulatory oversight and illiquidity.

Most alternatives covered in this chapter, however, can be readily accessed in some form through regulated funds. You can do so with relatively small amounts, in a liquid, transparent and cost-effective way.

Property

‘Buy land, they’re not making it any more.’

Mark Twain

Unlike financial securities, property is bricks and mortar. It is tangible; you can touch it. It is different from other investments in many senses.

Everyone needs property – the public sector, corporations and individuals. Property is used across three broad categories: residential, commercial and industrial.

Property investing can play both a role in your investment portfolio and as a separate retirement solution. Owning your house and a portfolio of residential properties to let are two long-term savings solutions.

Property plays such an important role in financial planning that the next chapter focuses entirely on residential property. Also, you cannot own residential property in your pension – it is not a regular investment, but much more than that.

One challenge of property investing is that each property is expensive. You need a lot of money to buy a building. However, investing in property as part of your portfolio is feasible. The two common means are property funds, investing in direct commercial real estate (CRE), and Real Estate Investment Trusts (REITs). These can be considered as two separate asset classes.

Direct property

Direct property funds pool together the money of many investors to purchase ownerships in properties. Pooling assets allows each investor access with a relatively small sum of money, diversification and professional management.

Direct property funds typically invest in a diversified portfolio of CRE, selected from across the retail, office, industrial and other sectors. Some funds specialise in specific regions, such as the UK, Europe, USA and Japan.¹

The roles of CRE in portfolios are income, growth, keeping pace with inflation and diversification. Properties generate rental income by leasing them to tenants, paying the proceeds to investors.

Income divided by property price is called rental yield. For example, a £2 million property with a £5,000 monthly rent has a 3% rental yield.²

Property prices and rental income tend to appreciate when the economy grows, with increasing demand for office space, commercial areas and industrial zones. Prices and rents can fall when the economy slows down. They should keep pace with inflation over the long term.

One main risk of property is illiquidity. Selling property can be a lengthy process. Property investing involves high transaction costs. The stamp duty in the UK when buying non-residential property above a certain price has a highest rate of 5%. Property is appropriate only for a truly long-time horizon.

Property is not a financial asset. Companies issue equities and bonds to raise capital to finance their business. Property, instead, is needed for the operations of companies and the economy. Therefore, the factors affecting property performance differ from those affecting the performance of financial assets. This adds diversification to portfolios that include property.

The common index for UK CRE is the IPD UK Monthly Property Index.³

REITs

REITs are pooled vehicles investing in property. After raising capital from investors through an IPO to invest in property, they trade on the stock exchange. Over the short term, they exhibit equity-like volatility, with high correlation with the equity market. Over the long term, however, they should have higher correlation with the property market.

REITs pay high dividends, so they can fulfil a role of an income source in portfolios, as well as growth and diversification with other assets. Legislation normally forces REITs to pay out most of their profits as income.

REITs are a way to access the property market in a liquid way. The price of liquidity is high volatility. Transaction costs of REITs are much lower than those of direct property. Stamp duty in the UK when buying REITs is 0.5%.⁴

Similar to local versus global equities, globally investing in REITs brings benefits of enhanced diversification and a wider investment opportunity set.⁵

Currency risk is part of global investing. As REITs are a risk asset, hedging currency exposure depends on your view on currencies. If you think the British pound is likely to appreciate, hedge the foreign currency. If you think the pound is likely to depreciate, leave the foreign currency unhedged.

The common index for UK REITs is FTSE EPRA/NAREIT UK Index. FTSE Russell offers a series of REIT indices, covering different regions.⁶ You can easily follow some of the indices using ETFs or invest via active funds.⁷

Commodities

Commodities are essential resources and agriculture products. They include basic, in-demand, commercially used goods, supplied unbranded, without qualitative differentiation across the market. This means a barrel of oil is the same as the next barrel of oil from the same type.

The commodity universe includes three broad categories: energy (such as oil and gas), metals (base metals such as copper, precious metals such as gold) and agriculture (grains such as wheat, softs such as sugar, livestock such as cattle).

Hard commodities refer to natural resources that are mined or extracted (such as silver, coal) and soft commodities include grown, perishable agriculture and livestock (such as corn, hogs).

Oil is one of the most important commodities. Its price greatly affects the global economy. In the corporate sector, energy is the input of industrial and transportation corporations, for example. It is the output of corporations in the energy sector. Consumers use energy to warm houses in the winter and to drive cars. The world is addicted to fossil fuel.

The US consumer is the most powerful global economic force. Consumer spending makes about 70% of the GDP of the USA, the world’s biggest economy. When the oil price drops, the US consumer is left with more disposable income. When the consumer buys more goods and services, it lifts corporate earnings and the stock market.

Oil price is linked to inflation. A higher oil price translates into higher inflation whilst a lower oil price translates into lower inflation. Changes in oil price can affect the real economy and different asset classes, across equities and bonds.

Gold is another important commodity. Gold is the ultimate safe asset and storage of value. When financial markets crash, investors tend to buy gold.

Commodities are risk assets. Their roles within portfolios are growth, hedge inflation and diversification.

Some events affect commodities differently from the way they affect equity markets. When a disaster strikes, such as a war in the Middle East, the supply of oil is disrupted, moving its price upwards. The same event can have a negative impact on equity markets.

Commodity prices tend to follow long super cycles. The dynamics of supply and demand in commodity markets are slow, taking years to impact prices. For example, China has been a large tailwind for commodity prices for decades, as its economy grew at a fast pace, demanding large quantities of commodities for its industrialisation and urbanisation. China has started slowing down and so has its demand for commodities, adversely impacting their prices.

An example on the supply side is the US journey to energy independence, thanks to the shale oil boom and fracking technology.

Most commodity funds trade futures contracts on commodity indices. The funds do not directly trade the underlying commodities. The prices and behaviour of futures can differ from those of direct commodities (cash, physical or spot market).

The three sources of commodity futures’ returns are changes in commodity prices (spot price), returns from rolling futures contracts (roll yield) and yield on cash held as collateral for the futures (collateral yield).⁸

Investing in commodities takes a global approach. Since commodities are risk assets, hedging currency exposure is not mandatory. Commodities are priced in US dollar and have an inverse relation with its value.

The two common commodity indices are Bloomberg Commodity Index (BCOM) and S&P Goldman Sachs Commodity Index (GSCI). GSCI Light Energy Index is often used to limit the index’s exposure to oil and gas.⁹

Equity commodities

Investing in commodities is not as common as other asset classes in DC pensions and ISAs. Investing in companies within the commodity sector is more usual. Often, funds investing in such companies are called natural resources.

However, investing in stocks of companies in the commodity sector is equity investing, not direct commodity investing. Nevertheless, over the long term, these stocks should have a correlation with commodity prices. An indirect exposure to commodities is often better than not having one at all.

A common commodity equity index is S&P Commodity Producers Oil & Gas Exploration & Production Index.¹⁰ You can easily follow the index using ETFs.

Private equity

Private equity refers to companies whose securities are not listed (unquoted) on the stock exchange (quoted equities are public equity). Whilst it is called equity, private equity includes both stocks and debt.¹¹

Investing in private equity firms is not typically available for retail investors since it requires large minimum investments, a long investment horizon and hefty fees. However, you may be able to tax-efficiently invest in unquoted companies through the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS).

Retail investors can readily invest in listed equity of companies operating in the private equity sector. The advantages are accessibility, liquidity and indirect exposure to private equity. The disadvantages are large exposure to public equity, impure access to private equity and limited universe of only listed private equity firms.

Private equity is a risk asset. Its risk level and potential returns are higher than those of public equities. Private equity investing heavily depends on the skill of managers of private equity firms to choose successful investments. In fact, tapping manager skill is a prerequisite condition to justify investing in this asset class.

The common index for listed private equity is the S&P Listed Private Equity Index.¹² You can easily follow the index using ETFs.

Hedge funds

Hedge funds tend to hit the news due to billionaire hedge fund managers and spectacular failures of some funds. They are also famous for generating high returns for the rich.

Hedge funds are not an asset class. They are a group of actively managed funds with a number of characteristics distinguishing them from funds that are distributed to the general public.

Most hedge funds are unregulated, as they are often incorporated offshore in places like the Cayman Islands. This allows managers flexibility with investment techniques and strategies – free your manager.

Regulated funds sold to retail investors in the UK, USA and Europe have restrictions on the way they manage assets. The regulations’ objective is protecting investors’ interests by forcing fund managers to diversify, control risks and be transparent. Traditionally, hedge funds have not been sold to the wide retail market; only to qualified or accredited investors, considered sophisticated. Therefore, they could avoid such restrictive regulations.

Three areas where hedge funds have more freedom than regulated funds are:

1. Short selling.
2. Derivatives.
3. Leverage.

Whilst you, as an individual investor, are unlikely to use these techniques, it is important to comprehend them. These concepts are helpful not only to understand hedge funds, but also to explain subjects that we will discuss later on.

Hedge funds can short securities. Shorting is borrowing a security you do not own, selling it and profiting if its price declines when returning it to the lender. Simply put, shorting is a way to benefit from falling prices.

For example, you borrow and sell a stock for £1,000. Its price falls to £800. You buy it in the market for £800 and return it to the lender, profiting £200. Nice. But had the stock price climbed instead to £1,200, you would have lost £200. Had it rallied to £3,000, you would have lost £2,000.

When buying a stock, the maximum loss is the money invested. When short selling, your loss could be, theoretically, infinite since stock price can rise unlimitedly.

Buying a security is called going long. It benefits from increasing price. Regulated funds normally cannot go short – hence, their name long-only funds. Hedge funds can freely short securities, potentially benefiting from both upwards and downwards price movements.

Hedge funds have flexibility using derivatives. Derivatives are financial instruments deriving their price from other assets. Forward, futures, options and swaps are common derivatives. Listed derivatives are standardised and traded on exchanges. Others are customised, traded directly between parties or through a bank’s intermediation, and are called over-the-counter (OTC).

Long-only funds are regularly limited using derivatives for efficient portfolio management (EPM) purposes only. Hedge funds can use them more liberally, including speculating.

Hedge funds can use leverage (gearing). Long-only funds are restricted in using leverage since it increases risk. Leverage is borrowing money to invest or synthetically using derivatives for leverage.

For example, you want to invest £1 million in the stock market. One way is investing the full amount. If the stock market appreciates 10%, your return is 10%. If it drops 10%, you lose 10%. Your position is funded because you committed the entire capital. Simple.

Another way is using leverage. You do not have £1 million, only £100,000. You borrow £900,000 for 5% interest. If the stock market moves up 10%, you make a return of 55% on your investment, net of borrowing costs.¹³ But, if the stock market drops by 10%, you lose 145%.¹⁴ Oh dear!

Leverage is a double-edged sword. It amplifies returns to the upside and downside. This is the dark side of leverage – you can lose more than you own. Remember: never invest more than you can afford losing in risky investments.

Leveraged positions are unfunded since you commit only a fraction of the capital. You can use derivatives for unfunded positions since you get an exposure without committing all the capital to back it up.

Unregulated hedge funds are generally unavailable in DC pensions and ISAs for retail investors. However, regulated versions are available, in particular in SIPPs. These versions do not enjoy the full freedom of unregulated funds.

Hedge funds’ performance greatly depends on fund manager skill. Therefore, diligently select them. Their investment strategies range widely; they can be opaque and illiquid, and they can be pricier than long-only funds.

Hedge funds can be a risk or conservative asset, depending on their strategy and level of aggressiveness or defensiveness. They can fulfil different roles in portfolios, depending on each fund’s characteristics. Since they are not an asset class, each fund should be treated on a case-by-case basis.

Often, hedge funds are classified as return enhancers or risk diversifiers. Return enhancers are normally more aggressive, aiming to generate high returns. Risk diversifiers are normally more defensive, aiming to add diversification benefits.

Most hedge funds fall under one of four broad categories of strategies: global macro, equity long/short, event driven and market neutral. Another related category is managed futures or CTAs (Commodity Trading Advisors). Hedge funds can be further categorised by single or multi manager, single or multi strategy and single fund or fund of funds (FoF).

FoFs conduct fund selection and can offer a diversified exposure to hedge funds. However, they might be expensive due to a double layer of fees, one at the FoF level and one at the underlying funds’ level.

Hedge funds seem cool. Billionaire hedge fund managers often appear in the news, talking about how they made millions for investors. You hear less about hedge funds failing or just delivering disappointing returns.

Hedge funds used to be sold as delivering equity-like returns with bond-like volatility. However, their volatility can be misleading. It is sometimes based on smoothed returns of illiquid investments that are infrequently priced or they conceal risks, such as counterparty, liquidity and fat-tail risks.

One philosophy is investing only in what you understand. Investing in hedge funds requires expertise. If you do not have the time and resources to study hedge funds before buying them, steer clear.

A common family of hedge fund indices is HFRI.¹⁵

Infrastructure

Infrastructure is essential buildings and structures required for the functioning of society and the economy. It includes systems of transportation (roads, railways), water, electricity (the electricity grid), telecommunications, energy (gas, oil pipes) and sewage.

Infrastructure projects and structures tend to be capital-intensive, high-cost investments. The government funds projects publicly, but private or public-private partnership (PPP) funding is common, allowing investors to participate.

Investors in infrastructure receive a long-term stream of cash flows. For example, the owner and operator of a toll road collecting cash flows. Infrastructure investing has gained popularity as institutional investors were looking for long-duration investments to hedge long-term liabilities. Declining bond yields made infrastructure an attractive alternative to bonds.

For retail investors, infrastructure investing is typically available via listed infrastructure. Infrastructure funds invest in stocks of companies operating in the infrastructure sector. This is equity investment, but over the long term it should be correlated with the underlying infrastructure projects.

Listed infrastructure is a risk asset. It exhibits equity-like volatility since it is publicly traded equities.

Common indices for listed infrastructure are the Macquarie Global Infrastructure Index series, which is offered by FTSE Russell, and the S&P Global Infrastructure Index.¹⁶ You can easily follow the Macquarie index using ETFs.

Liquid alternatives

Often, alternatives are unlisted, illiquid and expensive. Property, private equity, hedge funds and infrastructure in their unlisted form are accessible mainly to large institutional investors and high-net-worth individuals.

We are after practical solutions that you, as a retail investor, can easily implement in your portfolio. Liquid or listed alternatives are therefore suggested wherever possible.

Listed alternatives are traded on a stock exchange. They exhibit equity-like volatility. Arguably, they are not truly alternatives. Rather, they are equities in their respective sectors. Investing in listed alternatives abandons the liquidity premium and some of the diversification benefits and characteristics of the underlying alternatives.

This is correct. However, given the choice between tapping listed alternatives and excluding alternatives, I opt for the former.

Adding listed alternatives to your portfolio expands its investment opportunity set, enhances diversification and accesses the underlying alternatives’ special risk factors. Whilst impure and indirect, it should work over the long term. You do need, however, the appropriate risk tolerance to live with the volatility.

When adding investments to your portfolio, there is a trade-off between benefits and complexity. Adding small allocations to esoteric investments you do not fully understand, requiring significant due diligence, might not be worth it.

If the allocation is small, potential benefits are small anyway, whilst added complexity can be burdensome. If you add alternatives, allocate enough to make them count so potential benefits merit the added complexity.

Article 10.1

Source: Suter, C. (2014) Wealthy investors’ alternative direction, Financial Times, 25 March, www.ft.com.

© The Financial Times Limited 2014. All Rights Reserved.

Summary

• Property funds and REITs are pooled vehicles, allowing you to add a diversified exposure to property to your portfolio. Property plays roles of income, growth, hedging inflation and diversification.
• Direct property needs a long investment horizon since it is illiquid and expensive. REITs are not as expensive as direct property is and can be included, even when the horizon is shorter.
• Commodities can add a source of growth to portfolios, their price keeps up with inflation and they diversify equities as they react differently to some events.
• Private equity is mainly accessible through listed private equity in DC pensions and ISAs. It is a risk asset whose role is growth.
• Hedge funds are not an asset class. They are unregulated, actively managed funds that can use flexible investment techniques, such as shorting, derivatives and leverage. Retail investors mostly access regulated hedge funds.
• Hedge funds can enhance returns and diversify risk, depending on their investment style. They heavily depend on manager skill, so selection requires extra diligence.
• Infrastructure is accessible to retail investors as listed infrastructure. It has the volatility of public equities. Over the long term it should deliver exposure to underlying infrastructure.
• Listed alternatives are a practical way to access alternatives for retail investors. They are liquid, transparent and normally affordable. Whilst listed alternatives exhibit equity-like volatility, including them can be better than not accessing alternatives at all.
• When considering adding new types of investments to your portfolio, consider the trade-off between benefits and complexity. Adding a small allocation to a complex investment has limited benefits whilst adding complexity. Add investments only if they can impact results.

Notes

¹ KPMG offers free reports on the property market on its website at www.kpmg.com/uk.

² 3% = 12 × £5,000 ÷ £2,000,000.

³ The index’s factsheet is available on the website of MSCI at www.msci.com.

⁴ Check www.gov.uk for rates of Stamp Duty Reserve Tax (SDRT), which applies to buying REITs, UK equities and options to buy shares, amongst others.

⁵ The countries with the largest weights in the FTSE EPRA/NAREIT Developed Index are the USA 52%, Japan 12%, Hong Kong 8%, UK 7% and Australia 6%.

⁶ The factsheets of the indices are available on the FTSE Russell website at www.ftserussell.com.

⁷ The European Public Real Estate Association (EPRA) at www.epra.com offers free research and indices on REITs.

⁸ Excess return indices include only changes in spot price and roll yield. Total return indices also include the collateral yield.

⁹ The factsheets of the indices are available online. Check www.bloombergindexes.com and us.spindices.com.

¹⁰ The index’s factsheet is available on the S&P website at us.spindices.com.

¹¹ Investment strategies in private equity include leverage buyouts, venture capital, growth capital, distressed investments and mezzanine capital.

¹² The factsheet of the index is available on the website of S&P at us.spindices.com. A quarterly benchmark of private equity (unquoted) is produced by Cambridge Associates and is available free at www.cambridgeassociates.com.

¹³ 55% = (10% × £1,000,000 − 5% × £900,000) ÷ £100,000.

¹⁴ −145% = (−10% × £1,000,000 −5% × £900,000) ÷ £100,000.

¹⁵ Information and performance of HFRI indices is available on the website of Hedge Fund Research at www.hedgefundresearch.com.

¹⁶ The factsheets of the indices are available on the FTSE Russell website at www.ftserussell.com and the S&P website at us.spindices.com.