Alternative investments defend hard-won patch

By Michael Coote

Thursday 5th February 2004

Recent statistics indicate 2003 was a big year for alternative investments.

The name is not particularly satisfactory for the broad and heterogeneous class of assets represented within it, typically hedge funds, capital-protected products and collateralised debt obligation (CDO) bonds. Some even add currencies, resources and property funds, to name just a few of the ever-expanding list of candidates for standard allocation of investor monies over and above common garden variety bonds and stocks.

"Alternative" mainly signifies that these investments are different overall to conventional Modern Portfolio Theory asset groupings of cash, fixed interest, commercial property and shares. In reality, any cluster of two or more investments represents alternatives, and thus the term is not illuminating.

There is some argument between experts as to whether alternative investments are different enough from traditional asset classes to give them an extra, fifth place in Modern Portfolio Theory. Those who disbelieve that alternatives are different would have them placed within conventional asset classes.

CDO bonds, for example, could be lodged in fixed interest. Hedge funds could largely fit into international equity, as could most capital-protected products.

The school that defends separate asset classification for alternatives unsurprisingly largely connected with their production points to absolute returns independent of market trends; short-selling and other distinctive trading strategies that are not common with conventional assets; odd asset types such as currencies and commodities; and the different and often highly complex structures used.

An additional term, "structured products," has come to be adopted for the likes of CDO bonds and capital-protected investments to express their somewhat Byzantine peculiarities of design, but again the term is not wholly apt as all investments are to some degree structured.

Despite terminological and classificational wrangles, alternatives are fast becoming big business. USA Today noted in an article on January 19 that hedge funds finally made the mainstream in the US marketplace in 2003. Global hedge fund assets grew 25% from 2002 levels to reach $US750 billion, with the target estimated at $US850 billion by end 2004. The number of hedge funds in operation more than doubled from 1998 to hit about 8000 in 2003.

Institutions have started to go for hedge funds, with the Harvard University endowment allocating 12% of funds to them and Calpers, the biggest US pension fund, putting up $US1 billion, with more under consideration. Retail investors have piled in as well since some US hedge funds cut their investment minimum to $US25,000.

On the British front, structured products have not been dragging their feet either. Australia's Liontamer Investment Management reports that in the UK, structured product sales have reached 75% of unit trust sales.

British launches of structureds were up from 307 in 2002 to 500 in 2003, all growth products. Similarly, companies providing structureds rose from 68 in 2002 to 86 in 2003, with nearly all British fund managers offering some kind.

As noted last week in discussion of CDO bonds and capital-protected products, the conditions that favoured investors moving in on alternatives were low interest rates and poor stockmarket performance.

With interest rates expected to move up over 2004 and sharemarkets on the mend, challenges facing the alternative investment industry include competing with traditional assets, staying relevant, and defending their hard-won and still-contended alternative patch in Modern Portfolio Theory turf wars.

Critics of alternatives will not be slow to act as traditional investments revert to more normal behaviour than was seen over the 2000-03 heyday for other options, culminating in the boom of last year.

One possible counter-attack for the purveyors of alternatives would be to argue that times have changed since Modern Portfolio Theory was devised in the early 1950s. Investment products were not sophisticated then and investors were confined to a few choices.

The theory could not have anticipated innovative growth of the derivatives markets, globalisation of capital, floating of exchange rates, increased legal and jurisdictional possibilities, intellectual, financial and technological developments, and economies of scale that would enable mass markets to be created for non-conventional asset structures and investment strategies.

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