Spoilt for choice

Retail investors can now combine any number of asset classes in their portfolios, yet remain reluctant to look beyond equities, bonds and cash. Simon Hildrey explains why it is time to consider alternative investments.

As a former prime minister Amight have said, retail investors have never had it so good. Changes in regulations are making it easier to access a wider range of asset classes than ever before.

The introduction of non-Ucits retail schemes (Nurs) and the implementation of Ucits III regulations have been followed by the announcement that the Financial Services Authority may authorise funds of hedge funds for retail investors.

The arrival of real estate investment trusts will complement covered warrants in providing exposure to non-traditional asset classes. Products are also being launched with relatively low minimum investments that provide access to multiple asset classes.

The focus on “alternative asset classes” such as hedge funds, private equity, commercial property and commodities has been strengthened in recent years by periods of very strong performance. Yet despite these trends, only a limited number of investors look beyond the holy trinity of equities, fixed interest and cash when constructing their portfolios. Indeed, many investors do not even stray far beyond UK equities and bonds.

This is illustrated by the asset allocation of the Association of Private Client Investment Managers’ Private Investor Indices. The income, growth and balanced portfolios have allocations to UK shares, international shares, bonds and cash but no other asset classes.

Why have investors not diversified across asset classes to a greater extent? It is partly because of regulatory and tax barriers, as well as high minimum investments and perceived illiquidity. It can also be attributed to investor behaviour and a belief that diversification can reduce returns.

While it is true that diversification can come at the expense of performance, the long-term returns of multi-asset class portfolios are often higher than a single-asset class portfolio.

The emphasis is on long-term allocations. Over the short term, there will always be a single asset class that provides a better return than a diversified portfolio. Without the ability to market time, however, and by looking beyond short-term returns, a diversified approach to portfolio construction should produce a higher return with lower risk.

The general home-country bias of investors is another barrier to diversification. Even where investors hold a globally diversified portfolio, it is not uncommon for them to turn back to their home stockmarket during periods of volatility, or when the domestic market outperforms the diversified portfolio over the short term.

The merits of a diversified strategy using historical data have also been questioned. This is because critics claim future returns are unpredictable and it is not always possible to extrapolate past behaviour into the future. But this argument can support allocations across multiple asset classes. If it is not possible to see into the future, this is all the more reason for diversifying across asset classes.

Is it time for other asset classes to become part of mainstream portfolio construction? Adding asset classes does not come without potential costs. Non-traditional asset classes may have less liquidity and less regulation, while too much diversification can reduce returns. Furthermore, greater knowledge is required to use multiple-asset class portfolios. Nevertheless, many fund strategists advocate that private investors should consider using more asset classes than just equities, bonds and cash. This has been exacerbated by the fact that developed equity markets have become more highly correlated over the past century.

There are several factors in favour of multi-asset class portfolios. The main driver is to capture the benefits of diversification. By diversifying investments across multiple asset classes, investors can reduce the average volatility for the whole portfolio compared to the individual asset classes within it, while also generating a higher return.

Over the short term, there will be an asset class with significantly higher returns than other asset classes. Over the long term, however, increased returns and a reduction in volatility can be achieved by combining the best-performing asset class with other asset classes within a portfolio, rather than by holding only the best-performing asset class.

Colin McInnes, investment manager at Berry Asset Management, says the greatest benefit of diversifying across asset classes is risk reduction for the portfolio. “The problem for investors is that if their portfolio is heavily exposed to one asset class, notably equities, then there are few places to run if things go wrong,” he says.

“The ideal is to have asset classes that have low correlation with each other. If asset classes have negative correlation then there is a danger that one will rise in value while the other falls, so the gains of one will be cancelled out by the losses of the other asset class.

“The advantage of alternative asset classes is that the returns tend to be more predictive, although that does not mean they are predictable. Commercial property and funds of hedge funds, for example, can deliver steady returns.”

The key to diversification is finding asset classes that have low correlations with each other. For this reason, says Jason Day, director of private clients at Allenbridge, multi-strategies funds of hedge funds can reduce volatility in a portfolio.

He points to 10-year correlation figures for equities, gilts, hedge funds and property to September 2003 (see table below). For example, hedge funds had a 0.62 correlation with equities during this period. Hedge funds had a zero correlation with gilts and 0.01 with property. Gilts had a -0.10 correlation with property, while equities had a 0.12 correlation with gilts and zero with property.

Investors also need to take care in how they access asset classes. For example, if they invest in property or commodity-listed companies, they are not achieving true diversification because they will be correlated to the performance of the stock market.

The importance of asset allocation is also shown by a study entitled Determinants of Portfolio Performance, by Gary Brinson, Randolph Hood and Gilbert Beebower. They studied the performance of 91 pension fund schemes over a 10-year period and calculated that asset class selection determined 94% of the variation in portfolio returns. They say 4% was a result of stock selection and 2% was attributed to market timing. The wider the choice of asset classes, the greater the flexibility over asset allocation.

Using multiple asset classes can also help clients meet their long-term objectives. Tim Price, chief investment officer of Ansbacher, says a more holistic approach needs to be taken than has traditionally been the case in the use of asset classes within portfolios.

“Investors should decide what their objectives are, over what period of time they want to meet these goals and the level of risk they are prepared to take,” says Price. “From this, investors can decide which asset classes they want to use to enable them to meet their objectives at an acceptable level of risk.

“Deciding to use equities, bonds and cash in a portfolio is a bit like putting the cart before the horse. The issue needs to be turned around. For example, which asset classes can protect against inflation, which can protect against deflation, which can provide capital growth and which can offer absolute protection.”

A key determinant behind the use of asset classes within portfolios, therefore, is the risk profile and objectives of clients, says Tim Cockerill, head of research at wealth managers Rowan & Co.

“If a client is seeking average annual returns of 8% then there is little point in having a risk profile for the portfolio to try to generate 10% to 12% a year,” he adds.

Day at Allenbridge says: “The use of asset classes will reflect the goals and risk profile of individual investors. If the client is in his 20s or 30s and is looking for long-term growth, then he should have an equity bias. He should be able to live with short-term volatility, although clients usually look at quarterly valuations even if they are investing for 20 years.

“Clients may invest in funds of hedge funds, for example, because they are seeking annualised returns of 10%. But then they question why their investments have risen 10% compared with 22% for the FTSE All-Share.

“If clients are looking for wealth protection then they need to look to other asset classes, including hedge funds.”

He adds that Allenbridge adopts the same approach as family offices. “They have been early movers into hedge funds as well as investing extensively in commodities and commercial property,” he says. “The investment approach of many family offices has been more defensive. This has partly been because they have managed their own wealth. This reflects our own approach as many of our clients are interested in preserving their wealth.”

One barrier to investors being able to diversify across asset classes has been the amount of money required to do so. Day, however, says the new Nurs funds are providing accessibility to multi-asset class funds, compared with the 250,000 required to construct bespoke portfolios.

Cockerill of Rowan & Co says a number of other funds have been launched to provide investors with access to multiple asset classes with lower minimum investments. He gives Old Mutual Prosper as an example. “There is a minimum investment of just 5,000 and it targets a return of 4% above libor,” he says. “It is subject to capital gains tax rather than income tax for hedge funds. If a client wants to allocate 10% of their portfolio to hedge funds then they only need to put 5,000 into Prosper.”

Another way of accessing multiple asset classes is through investment trusts. The difficulty is the fact that discounts or premiums can add an extra risk for investors. Indeed, some fund of hedge funds investment trusts have traded at a premium because of the demand for shares.

The greater liquidity offered by new funds is also making alternative asset classes more attractive, says Cockerill. “With the launch of products from Old Mutual and Matrix, funds of hedge funds are becoming more attractive because they are offering daily dealing,” he says. “The problem with some funds of hedge funds has been their less frequent trading, often monthly. Even then you may have to wait for two months as it is often a month until you can access the next dealing day.”

New Star Cautious Portfolio is a Nurs fund that was launched in November 2005. Craig Heron, co-manager of the fund, says it has a broad brief across asset classes.

He gives Tokyu Reit as an example of the spread of investments it can hold. Heron says Tokyu Reito is partly a play on the recovery in the Japanese property market and economy, and partly a play on the yen. “Since we invested in Tokyu Reit in November, it has delivered a 17% return for the fund,” he says.

Heron adds that he is looking for property investments elsewhere in Asia as well.

The fund has had exposure to commodities through the Winton Futures fund. “This fund has soft closed to new investors so we are looking for other futures funds,” Heron says.

Nurs funds can invest up to 20% of their portfolios in unregulated funds, while the New Star fund can have a maximum of 60% in equities to qualify for the Cautious Managed sector.

Heron highlights investment trusts as a good means of accessing multiple asset classes. For example, the portfolio holds Morant Wright Japan Income and Finsbury Growth investment trusts.

An alternative investment highlighted by Heron is leveraged loan notes. “We came across Cypress Tree Investment Management a number of years ago but could not invest in the fund until we launched the Nurs fund,” he says. “It can provide a return of Libor plus up to 200 basis points. Leveraged loan notes provide protection against inflation and movements in inflation.”

The decision on how to allocate a portfolio to different asset classes will be partly driven by the risk profile of the investor and partly by the macroeconomic environment. But it will also be the result of where the investment opportunities arise over the long term. One school of thought is to focus active fund management on less efficiently priced asset classes while using less aggressive, diversified approaches for more efficiently priced assets.

This is based on the view that in efficiently priced markets, active managers tend to “hug” the benchmark. This school of thought argues that in less efficient markets, active managers exhibit greater variability in returns. Inefficiencies in pricing typically lead to skilled managers delivering strong outperformance, whereas less-skilled managers deliver poor returns.

On this basis, a measure of dispersion provides a strong indication of where active management opportunities lie. Thus, the spread of returns between the first and third quartiles of actively managed funds should show that efficiently priced assets provide less opportunity for active managers and that less efficiently priced assets provide more opportunity.

The investment opportunity represented by less efficiently priced asset classes is demonstrated by the range of returns in the table collated by Yale Endowment (see table below). The smallest range of returns is for American fixed income, while the greatest dispersion of returns is in venture capital, leveraged buyouts and property.

The issue is complicated, however, by how to define the different asset classes, says Price. “Where does property sit? It has some of the same characteristics as equities, bonds and cash but does not sit in any of these three,” he says. “Hedge funds are not one homogenous asset class. We classify them as skills-based investing. Where do structured and guaranteed products sit? It is a question of finding the right products and asset classes to meet investors’ objectives.”

Day agrees that hedge funds should not be regarded as one asset class. “Lots of people assume hedge funds are a different asset class, but equity long/short, for example, is not a completely different asset class from equities,” he says. “Even though these funds can take short positions, clearly they will be affected by the performance of stock markets.”

The next question is whether to manage the allocation across asset classes on an active basis. Price believes in rebalancing portfolios rather than aggressive reallocation. “I believe that once the strategic allocation has been set then it just requires rebalancing, usually on an annual basis,” he says. “This is to ensure that one asset class does not become too dominant in a portfolio. The cost of transactions is one reason why investors should be wary of aggressively moving between asset classes.”

For people who are investing for the long term, investors should not only consider a large allocation to equities, says Price, but also not be too concerned with liquidity. “I think investors pay too much for liquidity,” he says. “If you are looking for long-term returns, then short-term volatility is simply noise in the market, while liquidity is not important. Indeed, illiquidity is a good thing if it means investors cannot sell in the short term.”

Using multi-asset class portfolios has become increasingly accessible to retail investors, enabling them to benefit from diversification. Understanding the theoretical advantages of asset class diversification is just the first step, however. Constructing a portfolio of low-correlated asset classes and selecting strong-performing funds is another step altogether.

Case study: Yale Endowment

The $15.2bn (8.67bn) Yale Endowment portfolio has generated an annual net investment return of 17.4% over the past 10 years and delivered a return of 16% a year over the past 20 years. The portfolio uses a combination of academic theory and what it describes as “informed market judgement” to allocate across multiple asset classes.

The theoretical framework relies on mean-variance analysis, an approach developed by Nobel laureates James Tobin and Harry Markowitz, both of whom conducted work on this portfolio management tool at Yale’s Cowles Foundation. Yale uses mean-variance analysis to estimate the expected risk and return profiles of various asset allocation alternatives and to test the results against changes in assumptions.

But Yale argues that market judgement, as well as quantitative analysis, must be used to construct multi-asset class portfolios. This is because returns and correlations are difficult to forecast and quantitative measures have difficulty in incorporating market liquidity and the influence of significant, low-probability events.

Over the past two decades, Yale has reduced the endowment’s dependence on domestic assets by reallocating capital to non-traditional asset classes. In 1985, more than 80% of the endowment was committed to US stocks, bonds and cash. Now less than 20% of the endowment is invested in US equities. In contrast, foreign equities, private equity, absolute return strategies and property comprise more than 80% of the endowment.

According to Yale, the heavy allocation to non-traditional asset classes stems from their return potential and diversifying power. It argues that today’s allocations have significantly higher expected returns and lower volatility than the 1985 portfolio. Yale says that alternative assets tend to be less efficiently priced than traditional asset classes, providing an opportunity to exploit market inefficiencies through active management. It adds that the endowment’s long time horizon is well suited to exploiting less efficient markets such as venture capital, leveraged buyouts, oil and gas, and property.

Yale defines the seven main asset classes according to their expected response to economic conditions, such as price inflation or changes in interest rates. The weightings given to different asset classes are determined by their relative risk-adjusted returns and correlations. Yale tries to combine these asset classes to provide the highest expected return for a given level of risk. The seven asset classes are American equities, fixed income, international equities, absolute returns, private equity, real assets and cash.

Yale says it became the first US institutional investor to use absolute return strategies as a distinct asset class in July 1990, with an allocation of 15%. That allocation has risen to 25% today. It seeks to use absolute return strategies to generate high long-term real returns coupled with low risk.

The real assets include property, oil, gas and timberland. Yale says real assets represent “claims or future streams of inflation-sensitive income”, supplying protection against inflation and providing diversification. It argues that real assets provide relative stability during periods of stock market turmoil at the cost of an inability to keep pace during bull markets. The illiquid nature of real assets and the “information-intensive aspects of the transaction process” enable managers to generate strong returns.

Yale focuses on illiquid as well as liquid assets. It argues that in pursuing more liquid investments, it is possible to miss out on the opportunity to establish positions in illiquid asset classes at a significant discount to fair value. Highly liquid large-cap stocks receive extensive coverage and it is therefore difficult for investors to gain a significant advantage. In contrast, less liquid and small-cap stocks have less available information and thus the opportunity to generate outperformance.

Furthermore, liquidity tends to increase and decrease as the popularity of the underlying assets waxes and wanes. Once illiquid investments succeed, liquidity follows as investors clamour for shares. If liquid investments fail then liquidity dries up as it falls from favour. Yale argues that investors should fear failure, not illiquidity. On June 30, 2005, Yale had 39.8% of its endowment invested in what it considers to be illiquid assets, 25.7% in quasi-liquid assets and 34.6% in liquid assets.