Alternatives going mainstream

“Incorporating Alternative Investments into an investment portfolio can improve its riskadjusted return.”

As we enter an environment of lower expected returns across most traditional asset classes, investors should look beyond market beta for other sources of return, and include Alternative Investments (AI) in their portfolios. Daniel Insunza and Ed Koh share their views on the benefits of including AI in clients’ portfolios, and what 2014 holds for investors looking to this investment class.
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Daniel Insunza                                Ed Koh
Director, Investment Funds              Director, Investment Products & Services,
& Hedge Funds Singapore               Advisory Solutions, Private Markets APAC

Diversify and reduce volatilities in your portfolio with AI

Private Markets and Hedge Funds are two AI that can create greater diversification, enhance returns, and reduce volatilities in your portfolio. Private Markets (PM) refer to investments through private equity, private debt and unlisted real asset. PM offer investors access to confidential information when they are investing in non-listed businesses/assets; the opportunity to exert more influence in managing the acquired portfolios; and a better alignment of interests with the management of the portfolios. The fact that PM is by definition ‘private’, i.e., not listed on public stock exchanges, has protected investors from overly exuberant or pessimistic market sentiments. By basing PM valuation on enterprise or fundamental value instead of volatile market forces, the investment offers a different return pattern with greater stability.

Hedge Fund managers, on the other hand, manage risk actively and strive to limit losses while generating returns based on their specialized skills. These skills include trading securities and markets, deciding when and how to invest, and limiting negative impact on portfolio markets. The fact that Hedge Funds are in no way constrained to reflect the market (i.e. are not benchmark-oriented) gives them the freedom to concentrate on their mandate, which is to protect against the loss of principal and to find compelling investment opportunities that deliver interesting risk-adjusted returns in the long term.

Long-term investment key to improving overall risk-adjusted returns

Allocating to AI typically requires a longer-term investment horizon, and a strategic approach to enable these investments to generate risk-adjusted outperformance over traditional asset classes, and achieve their portfolio enhancing objectives. We do not prefer to invest in alternatives with the intent of making tactical allocation changes, as this results in an inefficient approach likely to deliver sub-optimal performance. Maintaining a longterm perspective is especially critical for private market investments, as a diversified target allocation can only be achieved through consistent investments across multiple vintage years, due to the commitment and drawdown structures of these vehicles.

Building a quality portfolio with AI

Incorporating AI into an investment portfolio can improve its risk-adjusted return. As an example, let’s look at a balanced portfolio with 50% allocated each to equities and fixed income. If 20% of the portfolio had been allocated to AI over the past 20 years, annualized returns would have increased from 7.3% to 8.0%, while volatility would have reduced from 9.3% to 8.8%. This small change adds up to a significant outperformance over the longer term. The effect of adding varying proportions of hedge funds and private markets to a balanced portfolio is shown in the chart above.

Common to both Private Markets and Hedge Funds is their interesting return potential1 as well as the differ ent nature of their returns. UBS therefore prefers a Hedge Fund allocation of 12–15% for most clients, and 3–11% for clients able to digest the illiquidity of Private Markets.

Outlook for 2014

We consider it a good strategy to allocate into broadly diversified Hedge Fund portfolios. Currently, we also have a preference for Equity Hedge strategies, as we believe companyspecific fundamentals will drive stock price performance in an environment with low correlation and medium volatility. Differences across firms, regions, and sectors should create divergences in earnings, and favor skilled stock pickers. The relative simplicity of the strategy also means that clients may invest in it using the more liquid mutual fund structures2, and use Equity Hedge as an interesting alternative to traditional benchmarkoriented Equity investments. Our least preferred strategy is Systematic Trading which depends on the existence of persistent trends across a variety of asset classes.

As for Private Markets, we see good return potential driven by European Banks under pressure to reduce their balance sheets, which will force them to sell attractive assets at substantial discounts. Other opportunities in 2014 are contrarian plays, where the longterm nature of Private Markets can benefit from negative sentiment in the short term, such as investments in peripheral Europe or the Emerging Markets. Last but not least, we see opportunities in investments relative to the changing energy markets due to the emergence of Shale gas.

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1The UBS CIO expects broad Hedge Funds to generate 4–6% p.a. at a volatility of 5.5–6% over the coming 5 years. For Private Markets, the corresponding return is expected to be 11–13%, with volatility at 10–15%.

2UCITS funds may offer liquidity every two weeks.