Private Equity: Greater Returns, Greater Risks

Fidelity added private equity funds to its institutional platform as a result of advisor demand following stellar returns, but there are other factors to consider

Two years ago when asked in an interview on CNBC whether private equity was good for individual investors, Investure CEO Alice Handy said,  “I understand why the industry would want to be in 401(K)s [but] it’s sort of crazy for the average investor.” She went on to point out that the illiquidity in private equity funds, where lockups can run as long as 10 years, high fees and lack of transparency and regulation.

Despite these limitations, private equity funds as an asset class have had double-digit gains for years. Large institutions, very wealthy investors and even public pension funds have invested in these products for years, reaping returns that aren’t seen in any other asset class except maybe venture capital funds.

Cambridge Associates’ U.S. Private Equity Index shows that while most major stock indexes were down 2% to 7% through the end of the third quarter 2015, the private equity index was up 5%, despite being slightly down that quarter. Its longer term gains were 14.3% for three years and 11.5% for 10 years compared to 12.4% and 6.8%, respectively for the S&P 500.

So when Fidelity announced in late April that its institutional division would expand its alternative investment platform to include private equity funds, it was a sign of the times. Private equity funds are now accessible to clients with a minimum of $100,000, according to Fidelity.

“We’ve heard from the advisors we work with that they were looking for an efficient and streamlined way to provide their clients with access to private equity products, says Gary Gallagher, senior vice president of investment products at Fidelity Institutional. “So expanding our platform to include those products was a natural progression and something that’s been in the works for over a year.”

The firm added this access through three intermediaries: iCapital Network, CAIS and Goldman Sachs Asset Management. Each brings with them an expertise of vetting and selecting investment managers, especially private equity managers.

CAIS, which uses Mercer to perform due diligence, applies its own “commercial overlay” to select from Mercer’s recommendations, says Matthew C. Brown, CAIS founder and CEO.  He points out when asked about the risk of private equity to the public, “This isn’t Fidelity.com, this isn’t the retail business. Fidelity is expanding its institutional services, which is for professional advisors, people who are trained, licensed intermediaries. That’s an important distinction.”

But has the stellar performance of private equity over other funds in a tightening market masked some of the issues even advocates like Handy mentions, such as lockup risk, benchmarking and transparency?

“There’s really no reason why investors or clients need to have all their capital liquid all the time,” Brown says, providing as an example purchasing a house that is largely an illiquid investment.  He adds there are short-term lockup period funds, as short as one year, noting the lockup time depends on the fund’s strategy.

Lawrence Calcano, managing partner at iCapital Network, says that lockup periods associated with PE funds “are one of the largest issues that people have to grapple with before investing. But stepping back, there’s a real reason for the lockup periods…. For example, in the case of a buyout, the process of improving value in the underlying portfolio company takes time. If near- term liquidity is important to you, then private equity is not the asset class for you.”

In 2012, TowersWatson published a study on Private Equity Benchmarking and provided recommendations on how to benchmark these funds, including:

• investors/allocators should change a benchmark according to a fund’s implementation and goal
• managers should be  matched against their goals and interests
• both long and short term measures should apply
• benchmarks should “incorporate a balanced scorecard approach to ensure a more holistic view of both qualitative and quantitative factors affecting risk and return”

Although firms such as iCapital use Cambridge Associates’ PE Benchmark to view the overall private equity returns in the aggregate -- the benchmark is derived from performance data compiled for funds that represent the majority of institutional capital raised by private equity partnerships --  the firm drills deeper when performing due diligence on private equity funds, both before and after selection, Calcano says.

“We look at absolute returns, as well as comparisons to appropriate benchmarks that vary by type of fund,” Calcano says. That means comparing equity managers against their peers who invest using the same strategy. The focus of his firm, iCapital Network, is on selecting mainly first quartile managers.

If iCapital Network analysts are looking at a buyout fund, for example, it might compare it to the Russell 2000 or S&P 500. They dig into the details of the fund, and determine if returns were due to financial engineering or fundamental improvement in the underlying portfolio companies (which is preferable). Then they use that information write a report that is provided on their platform (and Fidelity platform) so advisors can make educated choices for portfolios, Calcano says.

Does he believe the new investment in private equity funds might dilute the asset class’ long-time stellar returns?

“Private equity has been around a long time as an asset class, and historically is an asset class that has largely only been available to institutions and the absolute wealthiest of individuals,”says Calcano.  “Part of what we’re really trying to do is democratize the asset class, so that qualified investors will have a chance to invest thoughtfully in it just like institutions do.” - thinkadvisor

3 Rules for Picking Alternatives

Alternative investments, or simply alternatives, have become buzzwords in the industry, namely for their perceived benefits beyond traditional stocks and bonds. Alternatives range from highly liquid commodities to hedge funds and even nontraded vehicles that may not be investments at all. Not all investments can fit into the exchange-traded fund (ETF) wrapper; however, a subset of these alternatives dubbed “liquid alternatives” has seen a wave of issuance and growth in the ETF space. These typically include strategies such as managed futures, long/short, merger arbitrage and multistrategy funds, among others.

Many of these ETFs have come under scrutiny for their lack of effectiveness or liquidity. But if you stick to what I call the “three C’s of liquid alts” – correlation, comprehension, and cost – then you and your clients will likely have a better experience with alternative ETFs.

Correlation

The entire goal of an alternative investment to traditional stocks and bonds is that it does not behave like traditional stocks and bonds. One of the best ways to measure that relationship is through correlation. Correlation measures how closely two securities move in relation to one another on a scale of negative 1 to 1. A correlation of zero shows no relationship between the two securities, with 1 being perfectly correlated and negative 1 being perfectly inverse. Generally, a correlation close to zero of an alternative ETF is preferred. Ideally, alternatives should perform when nothing else does, and correlation can help to identify those strategies. Typically, merger arbitrage, managed futures and some long/short strategies will have low and sometimes zero correlations. While correlation isn’t as readily available as some statistical measures, it is worth the extra digging.

Comprehension

It seems like a no-brainer, but understanding what these liquid alternative strategies do is very important. “Popping the hood” is a great idea with any ETF, but multi-asset and strategy focused funds can change risk characteristics quickly, so a proper understanding of the strategy and how it reacts in different market environments is crucial. Many liquid alternative ETFs are fairly new, but their strategies or indexes will often have a lengthier track record that can be analyzed. As an example, alternative ETFs may react differently based on the speed and severity of a downturn, perhaps making it appropriate to blend ETFs to minimize those risks.    

Cost

Finally, the costs — both implicit and explicit — of alternative ETFs are hugely important. Explicitly, it starts with the expense ratios and management fees of ETFs. In the universe of ETFs, those in the alternative space will generally be higher than average. However, access to these strategies has typically been available only to institutions or very wealthy investors and often comes at a price – both in high fees and restrictions to money movement. There are also costs of shorting securities that show up in the gross expense ratios of these ETFs. Shorting costs can be limited when using index-based futures but can get costly if the ETFs are actually selling short individual stocks. Implicitly, many alternative ETFs lack a high degree of “onscreen” liquidity and must be traded with caution.  Watch for wide bid/ask spreads and be sure to contact your ETF liquidity provider when trading.

The inclusion of alternatives into a traditional balanced portfolio has been shown to provide risk and return benefits over time. Weighing the aforementioned “C”s of correlation, comprehension and cost when choosing between alternative ETFs is an involved exercise but worth the extra time. As the alternative ETF world evolves, proper due diligence on these products will undoubtedly expand; however, clients will benefit from continued inexpensive access to strategies previously reserved for accredited investors. - fidelity

Pursuing a Better Investment Experience

We all enjoy great experiences. When you think about some of your favorite, typically they are going to include some type of service that helped create that unforgettable experience. There are occurrences in our daily lives that keep us going back to the same places … the grocery store, gas station, coffee shop.

Then there are decisions that we feel are more important and take more time to evaluate what is going to give us the experience we are looking for.

I recently started to do more traveling and can definitely pick out areas that make my travel and stay a memorable or forgettable experience. The airline, resort or hotel, and restaurants all play a major role. Most of the time, the people serving you at those places are going to play a major role in whether you consider your experience a pleasant or forgettable one.

So whether you are choosing a vacation destination, your doctor, dentist or mechanic, you tend to lean in the direction of great service to make your experience the best it can be.

In my profession, there are many different areas to add value to our clients. One of those areas, and probably one of the most common reasons clients start to look for an adviser, is when they need help with their investments. So without getting into everything that leads to a great overall experience with your adviser, let’s take a look at investments and what you can do as an investor to help create a positive and memorable experience.

Don’t try to outguess the market; let it work for you

Everyone understands the golden rule of investing is to buy low and sell high. What we don’t know for sure is when are these lows and highs? After consecutive days of decline, is the market going to continue to correct or turn in the other direction?

No one ever knows for sure, so take the guesswork out of your thought process and just let the market work. Over the course of time, long-term investors will most likely profit on their initial investment. Trying to time the market means having to be right twice, when to get out and when to get back in.

Resist chasing past performance

Past performance is one piece of factual information we have when looking where to invest. However, it is not always the best indicator of how investments will perform going forward.

Past performance does not guarantee future results. It simply provides us with information on how investments reacted to the different economic events during a period of time. There is very little chance that the next 20 years will look exactly like the past 20 years, so why expect performance to react the same way?

Practice smart diversification

Everyone has heard the word diversification a million times in the investment conversation. So why do you want to be diversified, and what do you do to make sure your portfolio has the proper diversification?

Well for starters, diversification helps reduce your risk by spreading your assets into more sectors. You may also consider taking this a step further and broadening your investment universe outside of our market and get some pieces of the global market as well. Our S&P 500 is made up of one country and 500 stocks. In comparison, the Global Market Index MSCI comprises 46 countries and 8,716 stocks.

We are all aware that we live in a world where our lives are affected by everything around the globe, and our investments are no different. You never know which segments are going to outperform from year to year, so by holding a globally diversified portfolio, you are positioning yourself to help reap returns wherever they may occur. Diversification does not guarantee positive results. Loss, including loss of principal may occur.

Manage your emotions and look beyond the headlines

Many people struggle to keep their emotions separate from their investments and therefore their return typically struggles as well. The markets are going to go up and down and the media is going to report on that. It is their job to create ratings, and they do that with headlines and stories that grab attention.

Reacting to media reports in a volatile market may lead to poor investment decisions at the worst times. Whether the media is creating anxiety about the future or commenting on the latest investment fad, stay the course and be disciplined, maintaining your long-term perspective.

In conclusion, focus on what you can control. Your financial adviser can help create a plan tailored to your personal needs and future goals. He/she will keep you focused on what actions may add value and lead to a better investment experience. - greenbaypressgazette

Alternative Investments Aren’t Just for the Rich

We’ve heard the saying that “the rich get richer,” and we all know that it takes money to make money. If it seems like wealthy people have special tools we don’t know about that help them grow their wealth more successfully, alternative investments could be the key.

Alternative investments — like private equity, direct real estate and reinsurance — have been staples in the high-net-worth portfolios of individuals and institutions for decades. For those new to the concept, alternatives are investments that tend to move independently from the stock market, unlike traditional asset classes such as stocks and bonds.

Average retail investors generally have been relegated to those traditional asset classes, and alternatives have been virtually unavailable to them — until recently.

Volatility

Since 2000, retail investors in the Standard & Poor’s 500 index have had to stomach two major market crashes, losing over 49% each time. Although the market has climbed back up each time, the swings can be unsettling, and advisors and chief investment officers predict that volatility will remain a key theme in 2016. With the future just as uncertain, and interest rates in flux, many everyday investors feel handcuffed, worried and confused about what to do next.

Indeed, the world and investing are not the same as they used to be. The traditional, diversified strategies that used to work may no longer be enough. So the question becomes: How can investors accomplish their goals in the modern market? The answer may lie in alternatives.

Correlation

At first glance, it might sound risky, but the benefit of “alternative” asset classes is that they can actually help reduce risk when added to a diversified portfolio.

In the past, when one part of the market went down, generally another would go up. For generations, investors could diversify portfolios across investments like large-capitalization stocks, small-capitalization stocks and international stocks to reduce risk and improve returns over the long run.

Recently, however, many parts of the market have started to move together. Data over the past two years indicate that large-cap stocks correlated 84% with global small-cap stocks and 76% with international stocks. Such high correlation rates indicate that these stocks are moving in the same direction in the market. Ideally, you want correlation to be as low as possible — if your investments are all moving the exact same way, then you essentially have only one investment.

The effect? More risk and less return. This drastic erosion in the risk-reducing power of traditional diversification has left many investors with riskier portfolios than they realize. The “noncorrelated” characteristic of alternatives might be the missing piece they’ve been looking for. Investors implementing alternative allocations are somewhat insulated from this new investment environment.

According to a study by investment firm Columbia Management, “adding just one zero-correlated asset to a portfolio reduces risk 29.5%, while adding a thousand 66% correlated assets reduces risk by only 19%. In short, correlation matters … a lot. One can make one correct and impactful portfolio choice, or a thousand fairly meaningless ones.”

In other words, just holding multiple investments does not necessarily mean your portfolio is diverse. If you’re adding only assets that correlate with your holdings, you won’t be lowering your risk. As the Columbia Management study indicates, by adding assets with zero correlation to how they move relative to other parts of your portfolio, annual volatility is lowered and better diversification is achieved.

Access to alternatives

But how does the average investor find access to these noncorrelated alternative investments? Thanks to modern technology and innovative investment vehicles, many alternative asset classes are accessible to everyday investors with everyday account balances — not just to institutional managers who could handle million-dollar minimums.

Although you may have to work with a financial advisor, many alternative asset classes are available for purchase daily, with the provision that investors may sell only during specific windows — usually quarterly. This limited liquidity provision allows the portfolio manager the ability to invest heavily in private alternative assets, while still giving investors daily pricing, lower minimums and the transparency required in a regulated structure.

Key considerations

Of course, it’s not all rainbows and unicorns. Just because an investment is “alternative” does not make it a good one. At best, it just makes it different. Investors must evaluate each alternative option on its own merits.

There are different costs and risks that need to be considered. For example, limited liquidity may not seem like a big deal until you need the money and cannot get it. Many alternative investments are also more concentrated, meaning it can be harder to spread out your risk because there are fewer underlying assets within the investment.

Before jumping in headfirst, be sure you are comfortable with the concepts of the investment. Make sure the allocation is appropriate for your situation, and confirm that you can manage the potential illiquidity of these types of products. And, of course, ensure that your portfolio is well diversified with other asset classes.

Proactive approach

Investors can no longer simply rely on the market, close their eyes and hope everything will work out. To be successful, investors need to be practical, proactive and progressive. An appropriate allocation into alternative asset classes might be a good place to start. - nasdaq

What is a Good Time to Exit Your Investments?

Gautam had invested in a few equity mutual funds for the long-term. He did not monitor the performance of the funds regularly, and they turned out to be a mixed bag. The markets have been quite volatile of late, and his funds' NAVs have not gained much over the past one year. He is wondering if this is the right time to exit his investments. Should he exit completely or only partially? Should he wait out the volatility and redeem only when he needs the funds? 

Gautam must have made the investments with a goal in mind—buying a bigger car, his child's education, a second home. If his investments have already fulfilled his objectives, then it might be a good time to exit the non-performing funds. 

He must not overshoot his investment horizon in a volatile market, since there is a chance that his gains will get wiped out, leaving him with no option but to stay invested for a significant period of time without reaching his investment goals. Also, he could consider a partial exit from his investments in case there is a change in his life goals or risk appetite , owing to some unforeseen circumstances, such as job loss or an illness. 

If a fund is a consistent underperformer compared to its benchmark and its peers in the same category, it might be a good idea for Gautam to exit that fund and select an alternative one to achieve his target. Further, he must ask questions such as: have there been any changes in the fund's structure, objectives or management strategy of late? If the answer is yes and it is causing a conflict with his personal investment objectives, then it might be a valid reason for him to consider exiting a fund.

Exiting investments in a volatile environment is not an easy call to take and he must not let the market scenario alone guide his investment decisions. He should base his decisions on rational reasons rather than panic, fear or greed. Gautam should evaluate his decision to exit mutual fund investments based on two parameters, the first is his personal portfolio objectives and second, any issues with the mutual fund itself that may require him to redeem and transfer funds into an alternative investment. - ET

Concentrated Investing Is For Those Who Don't Know What They're Doing

Summary

• We often hear that many of the richest investors are concentrated investors.
• The fact that most of the poorest investors also happen to be concentrated investors is rarely, if ever, mentioned.
• This is somewhat strange given that the latter (unlucky losers) vastly outnumber the former (lucky winners).
• In short, if you want to speculate with your financial future, concentrated investing is for you.
• If, however, you want to achieve a steadier return with less risk of loss, diversification is the superior approach.

Diversification is for incompetent idiots! Bill Gates didn't get to where he is today by diversifying!

Those words were rudely shouted at me by a hedge fund hotshot at an investment conference a few years ago. I must confess, had I been statistically illiterate (as many in the audience were), I'd have been tricked into agreeing with him. After all, it's true - Bill Gates didn't become one of the richest people in the world by diversifying. Neither did Warren Buffett. In fact, Forbes' wealthiest people list is almost entirely made up of individuals who, like Gates and Buffett, had been spectacularly rewarded for putting all of their eggs in one or a few baskets.

But before you attempt to follow in their billionaire footsteps by betting your life savings on the next Microsoft, don't forget check out the cemetery. Because when you do, you'll see a massive graveyard full of unlucky people who, just like the tiny population of life's lottery winners, also put all of their eggs in one basket and ended up with nothing. To ignore these losers is to be fooled by survivorship bias. It's financial suicide!

Indeed, concentrating your bets works fine - in theory. If you know exactly which stocks will offer the best returns, it makes total sense to only bet on the few that will give you the best bang for your buck. But we don't have a crystal ball. In our world, the "real" world, the future is clouded with uncertainty. Events rarely unfold in the manner that even the smartest investors, aided by sophisticated mathematics and ever increasing computing power, think they will. Sometimes the safest-looking stocks turn out to be the riskiest, and vice versa. Such randomness can cause serious damage to under-diversified portfolios.

Some are destined to learn this lesson the hard way, unfortunately. Like the fund manager I mentioned earlier. He ended up joining the graveyard of losers when his fund blew up during the 2014 oil price collapse. Looks like putting all of your eggs in one oily basket isn't so wise after all. Bill Ackman should heed this advice. His fund is currently suffering catastrophic losses, all because of an oversized bet on a pharmaceutical company using questionable accounting practices. But the professionals aren't the only ones guilty of under-diversification. A major reason why most retail investors underperform index funds is because the average investor holds just four stocks. Some under-diversify even further by only holding the stock offered by the company they work for (Enron employees made that mistake).

The problem here isn't that all of these unsuccessful concentrated investors are terrible stock pickers. Many of them might actually be extremely skilled. But skill alone doesn't guarantee success, at least not in investing. It's important to not confuse investing with skill-dominant activities like, say, chess. In chess, the grandmaster will consistently beat the lucky amateur. In investing, on the other hand, luck often wins out over skill. This was famously illustrated when a bunch of Playboy Playmates randomly picking five stocks each were able to beat Wall Street professional at their own game.

While it's impossible to completely eliminate Lady Luck from investing, diversification can significantly weaken her influence. To understand why, remember that variability goes down as the sample size grows larger. An outlier stock can swing performance wildly in a concentrated portfolio; in a diversified portfolio, these extreme swings will have less of an impact on overall performance. In other words, diversification protects you from the extreme lows, but you aren't going to win the lottery either. On the whole, you'll achieve a good return (which is what matters).

This "luck factor" is also an important consideration when choosing who to invest your money with. Say you have the option to choose between two money managers. We'll call them Mr. A and Mrs. B. Mr. A is a concentrated value investor who likes to purchase a small group of undervalued stocks and hold them for a long time. Needless to say, Mr. A doesn't trade very often. Mrs. B, in contrast, is a diversified day-trader who makes hundreds of small trades per month, thousands per year. Assume that Mr. A and Mrs. B have equally impressive track records - each generating an annualized net return of 20% over the last five years. Which of them would you entrust your hard-earned money with?

The most common answer is Mr. A. The precisely wrong answer! Why? Think about it. Mr. A has made so few trades that to assume that he's a skilled stock-picker would be like saying that someone who happened to flip heads 7 out of 10 times is a skilled coin-flipper. This flawed statistical logic completely ignores the significant role luck plays in probabilistic outcomes. Only a large sample size of trading decisions can reveal "true" skill, which is exactly what we get with Mrs. B. She's made thousands of trading decisions, so there's a lot more evidence that skill, not luck, is responsible for her success. To be clear, this doesn't mean that Mr. A is less skilled than Mrs. B - just that Mrs. B's track record is more statistically robust.

And this brings us to the ultimate question: How many stocks should you own to be sufficiently diversified? Should you just copy Mrs. B and buy hundreds of stocks? The short answer is no. Studies say the magic number is at least 20 to 30 stocks. I myself prefer to use the 1/N rule as it takes into account investors' subjective risk tolerances. The denominator "N" is the maximum percentage (of your equally-weighted portfolio) that you can afford to lose if one of your stocks goes bankrupt. For the typical investor, it's about 5% - the equivalent of owning 1 / 0.05 = 20 stocks. If you happened to be a more conservative investor, it might be 1% or even lower, in which case you should own at least 1 / 0.01 = 100 stocks.

The basic gist of all these articles is, to paraphrase Warren Buffett, that "diversification is protection against ignorance . . . that those who know what they do concentrate their bets." This is only half true. Diversification is protection against ignorance - all of us are ignorant; some of us, unfortunately, don't realize it yet. - seeking alpha

Sluggish Market Sends Investors Looking for Alternatives

With interest rates currently near zero, CDs, bonds and banks aren't providing attractive yields.

It is no secret the U.S. economy is performing poorly. First-quarter gross domestic product, the broadest measure of economic output, advanced at a dismal 0.5 percent seasonally adjusted annual rate according to the Commerce Department. It is the worst performance in two years. Both top and bottom lines for major U.S. corporations are being pressured, according to the Wall Street Journal. Apple Inc., Norfolk Southern Corp., 3M Co., Pepsi Co. and Procter & Gamble Co. all took hits.

With interest rates currently near zero, CDs, bonds and banks aren't providing attractive yields. This is problematic for individual investors who increasingly are considering alternative investments as they search for higher returns or yields.

What are alternative investments? Opinions vary, but to me they include private real estate funds, non-traded REITs, oil and gas programs, startup companies, private equity and venture capital funds. They are extremely complex and some are available only to accredited investors defined by securities investment laws.

Alternative investments require close scrutiny as each option is individually evaluated. There are documents, disclosures and agreements to be read carefully and fully understood. This will be time consuming — don't rely only on presentations and representations provided by management. If you are asked to invest without being provided with proper and complete legal documentation, walk away. Investing your hard-earned money is not a handshake deal!

The documents and agreements for a typical private placement generally include:

• An offering document or private placement memorandum known, as a PPM, that contains important details and disclosures about the company, its business, its prospects, the applicable risks (internal and external), use of funds and the costs and expenses of the transaction.

• A subscription agreement that contains the terms and conditions of the securities sale and purchase.

• Information regarding the accredited or nonaccredited status of the investor.

The securities being sold can bear many names — stock, shares, membership interests, limited partnership interests, convertible debt, warrants, options.

Below are eight considerations you should incorporate when doing your own due diligence. Remember, as a passive investor you will have little or no say in the management of the entity in which you invest.

First, examine the management team's professional qualifications, experience and past track record of investment performance. Is management putting in its own funds? Be wary if management has no skin in the game. Check to make sure that management has no criminal or other disciplinary history.

Second, examine the risk factors of the product or service. Is it new to market or a modification of something that exists? Would it involve new or significant change in sales practices?

Third, does the entity have enough money to execute its strategy? If not, the venture could fail quickly. In some transactions, you may be contractually required to invest additional capital in the future if management makes capital calls.

Fourth, examine the anticipated internal rate of return in the context of the entity's investment strategy. Is it realistic?

Fifth, understand the duration of the investment. Many investments do not have redemption rights. Your money could be tied up for years.

Sixth, examine all management fees and expenses paid to management and others. Review the use of funds. A company must describe how it will use the net proceeds raised from the offering and the approximate amount intended for each purpose. Beware of vague statements like "the proceeds will be used for general working capital purposes."

Seventh, closely examine the securities being sold. Understand the rights, restrictions and class of securities being offered, and management's ability to change the capitalization structure. Sometimes the founder or existing shareholders retain full voting control of an entity.

Finally, if you can afford to invest, determine if you can afford to lose all of your capital if the investment craters. - denverpost

A quote attributed to all perspective investors - "I am not so much concerned with the return on capital as I am with the return of capital." 

The Upside and Downside of Market Capture with Alternatives

Over the long run, alternative investments have outpaced traditional 60/40 stock/bond portfolios with lower volatility. What's the secret? Gaining more in up markets than they lose in down markets.

The Upside/Downside Capture Ratio

Successful alternative strategies are managed to capture some part of the equity market's upside and an even smaller part of the market's downside. The concept is to win by not losing, and it's reflected in the up/down capture ratio.

Let's take a strategy with an up/down capture ratio of 50/20. When markets are doing well, it delivers 50% of the upside; when markets are down, it delivers 20% of the downside. Capturing only half of the equity market's gains in an up market with an alternative strategy may not sound too appealing on the surface. But what's the flip side? In bear markets, investors experience only 20% of the downside.

Alternatives vs. Equity: The Tortoise and the Hare

Let's compare a hypothetical $10,000 investment made in 1995 - for 20 years - in the S&P 500 equity index with an equal investment in a hypothetical alternative strategy with a 50/20 up/down capture ratio (Display).

It ends up looking a lot like the fable of the tortoise and the hare. The S&P 500 - the "hare" in this scenario - got off to a fast start. During the tech bubble buildup in the late 1990s and early 2000s, the equity market dominated - and the gap between the two investment approaches widened.

But then the tech bubble burst, and the S&P 500 lost major ground. The 50/20 alternative strategy - the "tortoise" - which had been steadily, if modestly, plugging along at "half-speed" until the sell-off, pulled ahead. As we know, markets eventually stabilized and US equities resumed their upward march. But just as the S&P 500 started to catch back up, the 2008 financial crisis sent stocks reeling again. The S&P 500 lost 51% of its value by early 2009, while the 50/20 declined by only 10%. The importance of that is found in the time needed to recover the losses. In the recovery that followed, the 50/20 was back to its previous peak in nine months. The S&P 500 took more than three years. Indeed, despite very strong US equity market performance over the past several years, the S&P 500 has still not caught up.

Over a 20-year span of this tortoise and hare battle, the alternative strategy would have ended up delivering dramatically higher returns than the S&P 500 - but with less than half of the stock market's volatility. Pretty crafty turtle.

The Insurance Perspective

Why doesn't everyone find an alternative strategy with 50/20 up/down capture? After all, this isn't just hypothetical - the average up/down capture ratio of the entire HFRI Equity Hedge category, for example, is 65/32. In large part, it likely has to do with the investment experience. In other words, some investors would rather simply fire a manager who delivered just 50% of the market's upside in a rally.

When that frustration sets in, it's easier to dismiss a strategy's effectiveness in bear markets. This was magnified in the past few years by a central bank-supported "beta trade," with strong performance and generally short-lived downturns. That appears to be changing, but investors need to be diligent in searching for a strategy that fits their long-term needs.

It helps to think of a strategy's up/down capture ratio as an insurance policy. For the strategy with 50/20 up/down capture, the difference between the market's gain and the strategy's up capture - in this case, 50% of the full market gain - is the insurance premium you pay in terms of sacrificed upside potential during up markets. The "down" capture of 20% can be viewed as a deductible - you experience a loss of 20% on the alternative strategy before its "policy" kicks in and protects the downside.

Finding the Right Fit

Alternative strategies come with many different combinations of upside and downside market capture. We think the best way to approach the choice is by following three steps:

1) Find a strategy with a level of upside capture you're comfortable with

2) Make sure there's a complementary downside capture

3) Gain confidence that the manager can continue to deliver that experience consistently

It all comes back to a point we've emphasized before: Investors should know what they want when they're looking for an alternative strategy. And they should identify the right manager who can consistently deliver the return experience they're looking for. - seekingalpha

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams

Stay Steady with Alternatives When Markets Swing Up and Down

The need to diversify a portfolio beyond equities and bonds is more pressing in today's world, as prices of these asset classes now move more in tandem.

An International Monetary Fund financial stability report last year showed that returns from equities, bonds and commodities have become more correlated since the global financial crisis. That tends to increase the volatility of portfolios holding just these two kinds of assets.

To reduce portfolio volatility, investors can allocate a portion of their portfolios to alternative strategies, said Mr Matthew Riley, head of research for the portfolio research and consulting group, and Ms Madeline Ho, managing director and head of wholesale fund distribution for Asia-Pacific.

The case for doing so is boosted by the recent performance and outlook of these asset classes.

With bond yields at all-time lows, potential returns look uncertain, said Mr Riley. Equity markets also seem increasingly volatile. This makes diversification away from these asset classes more compelling. Such diversification would likely have reduced portfolio volatility and limited losses had they been implemented in the past, they added.

The portfolio research and consulting group analysed 2,500 client portfolios and conducted 2,000 fund comparisons for clients last year.

Q How are alternative strategies different from traditional equity and bond investing?

A Under traditional investing, an investor holds bonds or equities and earns a return when prices go up. However with alternative approaches, they make money from sources beyond such price increases.

These sources include falling prices, rising interest rates, weakening currency, leverage and so on.

Q Why is tapping a wider range of return sources a good thing?

A Some of the return generators of these strategies are different from those of equities and bonds. This means that returns from these sources are not always correlated with returns from holding stocks and bonds.

Using this strategy together with traditional ones tends to lead to less fluctuation in returns and a lower maximum portfolio loss over time.

We researched what would happen if 20 per cent of a typical moderate-risk Singaporean portfolio was allocated to alternative strategies from 1998 to 2016. Portfolio returns per unit of volatility for the resulting portfolios were often higher.

Q Why might investors want to consider alternatives now?

A If you look at bonds, over the last 35 years, interest rates have been falling. It's been a great time to be invested in bonds, as they do well when interest rates are falling.

Interest rates are now practically zero in most of the developed world and so this falling of rates can't continue forever. The Fed, for instance, raised rates in December last year. At some point, rates are going to rise again and when this happens fixed income typically does poorly.

Equity markets, we're finding, are more volatile these days. Plus there's more uncertainty in the world, for instance, over whether China is going to have a hard landing or if the US economy is going to enter a recession.

Given the headwinds facing these traditional asset classes, why not use a wider set of tools - alternative strategies - because they have the capability to make money independently of bond and equity markets.

Over time, the returns between fixed income and equity have also become more correlated. Thus diversifying only into fixed income is no longer as effective in reducing portfolio volatility.

Q What are some examples of alternative strategies?

A An example is the managed futures strategy. Under this strategy, a model signals to buy an asset when it senses the market is on an uptrend, and sell or short an asset when it judges there is a downtrend.

The model may for instance discern an uptrend when it sees the price of the asset cross and go above the 200-day moving average price of the asset.

Conversely, it may detect that the asset is on a downtrend when the price crosses and goes below the 200-day moving average.

The model's sell and buy signals can be executed automatically by computer programs.

Q How are returns sources for this strategy different from a traditional strategy?

A One example is that in a bear market, shares can be shorted at the beginning of the downtrend and then bought back after prices have dropped. This would not be possible if one were just limited to buying and holding stocks.

Q What is another alternative strategy?

A Another is the global macro strategy. A fund manager predicts where the global economy is going and then makes asset bets to leverage on that growth path.

For instance, if the asset manager predicts that China is going to grow, he could then purchase China stocks or bonds or currency.

If he expects that the Fed is going to raise rates, he could then invest in interest rate futures that would benefit from that.

Q How are sources of returns here different?

A Return drivers go beyond an upward movement in stock and bond price. Macro strategies may leverage on movements in currency and interest rate futures, for instance.

Q Are Singapore investors now more interested in investing in alternative strategies?

A In our survey of Singapore investors last year, many said they would consider alternative investments. Alternative investments include commodities, precious metals, hedge funds, managed futures and so on.

Among Singaporean investors with an adviser, around 80 per cent said they would consider these if their advisers recommended such products. Less than half said they understood these products.

Hence there is a keen interest in alternative assets, but a low level of understanding. The survey had 500 Singapore respondents and was performed in February last year.

Q How can someone get exposure to the managed futures or global macro strategies?

A They can invest in mutual funds or unit trusts. For global macro funds, investors can invest in the H2O MultiBonds Fund or H2O Adagio Fund managed by H2O Asset Management, an affiliate of our company. Currently, these funds are available to accredited investors in Singapore.

Some relatively well-known managed futures funds by other fund managers would be the Winton Futures Fund and Man AHL Diversified Futures Fund.

We plan to introduce a managed futures fund from one of our investment affiliates, US-based Alpha Simplex.

Q How should an investor choose such a mutual fund?

A For a fund that will make a core part of your alternative assets strategy, you want a manager to control fund volatility. He or she should set a volatility target and stick to it. You don't want the volatility to be 3 per cent in one year and 20 per cent in another year.

You also want a manager that can be flexible and employ different investment tools, as no strategy works in every single market.

Such a manager would have different tools; for example, tools one to three work when equity markets are falling, three to five work when bond interest rates are rising, etc.

Also, choose to invest in alternative assets or strategies for the long term.

Sometimes you get the manager wrong or the strategy doesn't work in the short term. But if you hold on for alternatives for a reasonably long period, then it's beneficial. - straitstimes.com

Private Equity vs. Hedge Funds: A Battle of Expectations

Investors had “more ambitious return targets” for private equity than hedge funds, but were under-allocated to the asset class, according to Preqin.
Asset owners turned to private equity for higher absolute returns than to hedge funds—and have been rewarded accordingly, Preqin has found.

According to the data firm, investors’ median target return for private equity ranged between 14% and 15%, higher than 8% to 9% for hedge funds.

“The prospect of high absolute returns was the most commonly cited reason for investing in private equity, followed by diversification and high risk-adjusted returns,” Preqin said.

Investors “put less emphasis on absolute returns” when it came to hedge funds, instead focusing on diversification benefits, low correlation to other asset classes, and reduced portfolio volatility. Preqin found private equity delivering on these expectations and successfully meeting return targets. 

Private equity’s internal rate of return for the three years to June 2015 reached 16.2%. The figure dropped slightly for five-year returns at 15.4% and 10-year returns at 16.1%.

Hedge funds, on the other hand, fell to the lower end of investors’ target range, with Preqin’s all strategies hedge fund benchmark’s annualized three-year returns lingering at 4.5%. Five-year returns were slightly higher at 4.7%, and 10-year returns reached 7.8%. 

Despite disappointing recent performance, investors’ allocations to hedge funds were generally close to their targets—with average current allocations of 13.8% compared to an average target of 14.2%.

Preqin also found a significant number of investors continuing to invest new capital: Nearly three-quarters of investors interviewed for an H1 2016 survey told the firm they planned to maintain or increase their hedge fund allocations over the long term.

In contrast, asset owners were under-allocated to private equity, the report said, with average commitments reaching only 9.8% versus an 10.9% target. This allocation percentage is expected to grow with 94% of surveyed investors planning to maintain or increase their investments. - cio.com

Source: Preqin Investor Outlook: Alternative Assets H2 2015

Why Alternative Investments Are the New Key to Portfolio Growth

Some of these strategies have generated annual income of five to 10% with very low volatility and others have typically outperformed the equity market.

Once upon a time a Government of Canada 10-year bond paid eight per cent a year. In fact, as recently as 1995 these interest rates were available.

Back then, investment gurus recommended that your bond weighting be in line with your age. Basically, if you were 75 years old, you should have an investment portfolio of 75 per cent in bonds. But, using that logic today, you are looking at significantly lower returns than in the past. A lot has changed in the last 21 years, and so must your portfolio.

The reason people recommended such a high bond weighting was in large part related to the volatility of investing. There was a sense that the older you were and the more that you were potentially relying on your investment portfolio for income, the less risky the investments should be.

Our desire for for lower volatility and high income hasn’t changed, but it’s not longer coming from traditional bonds. But, if you are using stocks to get high income, you may find they come with a lot of volatility. Crescent Point Energy is a classic example of what we see in portfolios for those seeking income: Three years ago it was paying $2.76 per share in dividends; the stock was trading at about $39 and was yielding over seven per cent. Today the dividend is 36 cents per share and the stock is trading around $19.

So, if bonds won’t provide high enough income, and high income stocks won’t provide enough safety, do you have any options?

One of the areas that we have looked to for insight has been leading pension plans and endowment funds. These plans have been reducing their bonds and, to a lesser extent, their publicly traded stock portfolios. Under the catch-all phrase of alternative investments, many pensions and endowments have instead been investing between 25 per cent and as much as 75 per cent (Yale University Endowment Fund) in alternative investments.

Alternative investments are essentially any asset that is not a public stock, bond or cash security. They are included in portfolios because they can either provide diversification benefits, income, enhanced returns, greater stability or, in certain cases, all of the above. They are often more sophisticated in nature, can include more complex financial instruments or invest directly in private markets. While the types of alternative investments are quite broad, ranging from real estate and venture capital to commodities and art, I will focus here mostly on those that provide higher and more stable income.

All of the income-focused strategies listed below have generated annual income of five to 10 per cent depending on risk level with very low volatility. The growth oriented strategies have typically outperformed the equity market, but with similar volatility levels.

Private-debt funds provide short- to medium-term lending to companies at rates in the 10 to 15 per cent range. At those rates, why wouldn’t these companies go to their local bank for lower rate loans? Since the financial crisis of 2008, banks have changed their approach to lending to small and medium businesses. Overall, they do much less lending in this area because the banks now have to set aside much higher amounts of “regulatory capital” on these loans — making them less profitable for the bank. In addition, banks can sometimes move more slowly when approving commercial loans than before, due to all of the additional regulations. If a business can make 25 per cent on its money, and it needs to pay 13 per cent to achieve that growth, it can make perfect sense to borrow funds more quickly at those rates.  

Factoring funds These managers provide immediate cash to companies experiencing rapid growth. A typical example is a company that provides a product to a large retail chain. The retail chain loves the product and purchases more, but only pays their invoices in 90 or 120 days. The company providing the product goes to the factoring company and offers to “sell the invoice for 95 cents on the dollar.” The company gets immediate cash, while the investment manager receives 100 cents on the dollar in three or four months from the department store; if they can do that three times a year, that is a 15 per cent return on their cash. This is a niche market in Canada, providing high rates of income with low volatility.

Mortgage Investment Corporations (MICs) These investment funds provide financing to builders, developers and property owners so that they can refurbish or purchase income-generating properties. These are private deals, so they can charge much higher rates than the banks. Due to the high property prices in Canada, we have focused on MICs with expertise of lending in the U.S. or that only provide first mortgages in Canada. Many of these investments are averaging steady six to 12 per cent returns, depending on the risk level. 

Private real estate Real estate is one of the largest alternative asset classes, and it can range from ownership of properties, where investors earn a yield from rental income, to property development. Funds that own properties tend to provide similar distribution rates as REITs, but with much lower volatility. Funds focused on development tend to offer much higher potential returns, but they will fluctuate much more and a greater portion of the return will be capital gains. 

Infrastructure is a direct investment in an essential facility, such as ports, airports and pipelines. Unlike investing in public infrastructure, such as a TransCanada pipeline, for example, private infrastructure values do not rise and fall with market sentiment, so returns tend to be very stable and pay out a high rate of income. The utility contracts tend to be long-term, e.g. 20-30 years often with the government being the key customer.

Hedge funds are essentially any investment fund that can employ complex financial instruments, such as derivatives, shorting or leverage and where a large portion of the return is derived from active investment management. Hedge fund managers typically focus on one area of the market, like stocks, or focus on niche areas, such as arbitrage.  For low volatility, we have tended to focus on Market Neutral funds, which attempt to generate modest, positive returns in all market conditions by focusing on their best investment ideas and using hedging strategies, such as shorting or options, to reduce downside risk. 

Other ideas that have become large investment areas in the U.S. include life settlements, which is essentially buying up a large pool of life insurance policies from people who have paid into them for years but now want to sell them. Another area is investing in legal settlements from contingency cases — essentially providing lawyers with the money to fund a number of cases where the payout on any one can be large, but some will not pay out at all. It is basically investing in the equity of litigation lawyers, who get paid very well.

Alternative investments are not for everyone as, unlike stock or bond investments, you cannot sell them on a daily basis — there can be a wait of anywhere from 30 days to one year to sell your investment. You also have less transparency concerning what investments you own. But, they can provide you with the benefits of high, stable income, lower portfolio volatility, and enhanced returns, making them both helpful and necessary in this low yield environment. 

Historically, these types of investments have been for Institutions and very wealthy individuals. Today many of these investments remain aimed at the higher net worth, but for those with household investment assets of $500,000-plus, alternative investments are now increasingly available.

It’s 2016. The world has changed. It is time for your portfolio to change as well. - Financial Post

Alternative - The Next Big Thing in Real Estate Investment

Crowdfunding platform Prodigy Network raised S$255 million to fund the BD Bacata skyscraper project. Investors in Singapore may want to look at real estate crowdfunding as a viable option. Photo: Prodigy Network

Flip through any newspaper over the weekend and you will see a buffet of investment options in the real estate market. Typically, there are investment options from Melbourne, Sydney, London, Ho Chi Minh City, Tokyo, Bangkok, and the list goes on.

However, as many investors have found out, owning a property overseas can entail a lot of pain: The pain of finding a good absentee manager, the pain of sourcing tenants, the pain of paying the high cost of ownership, the pain to ensure compliance with taxation laws, and the pain in selling off the investment.

Perhaps it is time for a rethink. Investors in Singapore might want to rethink their allocation of resources and look at real estate crowdfunding as a viable alternative.

Real estate crowdfunding: Can it take off in Singapore?

Crowdfunding is a way to collect small individual amounts from many people to fund opportunities or causes.

In the United States, several real estate crowdfunding platforms such as Prodigy Network, Fundrise, Realty Mogul and RealtyShares have collectively raised millions for real estate projects. One of the most prominent, and perhaps the largest, crowdfunding project in the world was started in Bogota, Colombia, where Prodigy Network pulled together funds from more than 4,000 people, raising a total of US$190 million (S$255 million) to fund BD Bacata.

BD Bacata will be the tallest skyscraper in Bogota and the second tallest in South America, with 67 floors destined to be used as a hotel, apartments and a shopping centre.

Growth of similar platforms is observed in Australia, the United Kingdom and China, among others. Massolution, a leading research house on real estate crowdfunding, estimated that real estate crowdfunding value will increase by 150 per cent to US$2.57 billion in 2015, making it one of the fastest-growing industry segments of crowd capitalism. In our opinion, investing in real estate in Singapore will follow the same trend as in New York and other developed markets.

Just look at how crowdfunding has already started to change the small- and medium-sized enterprises (SME) loan market in Singapore.

What special deals can crowdfunding platforms offer?

Studying the evolution of the crowdfunding market in the US, we evaluated the offerings of one of the earliest crowdfunding platforms, Prodigy Network. Prodigy Network lets investors into commercial real estate markets in New York City.

Imagine owning part of a commercial building in New York’s renowned Wall Street or Park Avenue! Investing in real estate in major cities such as New York is attractive for two main reasons: It is a tangible asset and, considering that the demand for real estate in New York is far higher than the supply, the value of the properties has a high probability of appreciating over time. Now when it comes to what type of real estate to invest in, the choices normally come down to two: Residential versus commercial.

From an investing perspective, commercial tends to be the most sought-after strategy, given that it has lower risk and that its cash-flow generating operation increases the value of the property through time.

Historically, access to these kinds of investments was restricted to the very wealthy or financial institutions, given that most commercial real estate properties in Manhattan are valued in between US$100-US$250 million.

But now, due to the JOBS Act, which is the regulation that permitted crowdfunding in the US, and due to the power of technology, which allows millions of individuals to be connected through their mobile devices, platforms such as Prodigy Network are pooling together investments starting at US$50,000 from around the world in order to fund these projects. In other words, real estate crowdfunding is democratising some of the most attractive and profitable opportunities in the real estate sector. We think that, over time, developers in Singapore will start to explore fundraising efforts in the same way they have evolved in the US.

Technology enables, but do not forget real estate fundamentals

Even the best technology will not salvage a bad deal. Investors should be aware that while technology enables, they should not lose sight of analysis of the risks involved and whether they are equipped to accept the risk.

Understand legal structure of the investment

Investors should always remember that in a bad market there could be good investments that are well structured, and in a good market there could be badly structured investments. In a typical crowdfunding structure, investors typically buy into shares of a special purpose company (SPC) or units in a trust. This SPC or trust will then invest in the property. Such investments could be in the form of shares of a development company, a secondary loan to developers or joint ownership of a completed property. Investors need to understand the liabilities and the rights to returns or dividends when investing in such structures.

Assess the risk versus the rewards

Investors need to start to assess the risk of each investment and whether the returns are sufficient to compensate them for the risk. Do not be taken in by “guaranteed returns” as 100 per cent fail-safe investments. Even governments can default on sovereign debt.

Investors also need to start to recognise returns are either fixed or variable. In the case of fixed returns, they should ask where the fundraiser got the money to “guarantee” their returns and what the chances are of the fundraiser not being able to find money to pay those “guaranteed returns”.

Share expertise and join the community

The other important feature for crowdfunding platforms versus traditional investment models is that investors should be more willing to engage in discussions among themselves or with the fundraisers on the crowdfunding platform or social media. This concept of crowd-policing of investments might be the best way to ensure that dubious investment schemes and individuals are kept out of the investment market.

Ask the right questions before investing


Investors should look at crowdfunding platforms as an enabler of the process of collective investment. Responsible platforms are more likely to conduct due diligence on projects before these are allowed for fundraising. The new trend in real estate investment markets is rapidly changing and investors might want to start to understand more about investment structures, questions they need to ask and what is involved before getting into any deals. - todayonline