The financial industry is constantly evolving: new products are being created that offer investors an ever-broader choice when making investment decisions. Alongside retail collective investment funds, investors also may have access to alternative investment funds, which can employ less constrained investment strategies and encompass everything from hedge funds to aircraft finance vehicles to private equity. The growth of derivatives has also opened up new investment classes such as structured products. The range of opportunities in real estate and physical infrastructure is constantly expanding. What role do more sophisticated products and in some cases more complex products play in a portfolio, and what factors should investors consider?
Investing in complex products
It is a frequent assumption that just because an investment is complex and off-limits to many retail investors due to consumer protection rules, it must therefore be more attractive or lucrative than a more straightforward alternative. This isn’t necessarily true. However, incorporating more sophisticated products into their portfolio can enable investors to achieve a better diversification and risk/reward profile.
The investment strategies of many alternative funds are uncorrelated with traditional equity and bond markets, and can therefore help protect a portfolio from heavier losses at times of securities market stress or distress – for example, securities have recently suffered from the volatility engendered by the coronavirus pandemic and the economic and social lockdowns imposed by governments to contain it whereas Private assets show more resilience to market swings.
Alternative funds, sometimes somewhat misleadingly called hedge funds, have greater freedom than retail fund structures such as UCITS. They may be able to make greater use of derivatives to provide insurance against falling markets or invest in private assets – specialist property, for example, or leasing – that are not eligible investments for retail UCITS funds.
This can be useful in building a more diversified portfolio, especially as recent market turmoil has demonstrated that traditional assumptions about the correlation of assets can break down under conditions of extreme economic stress. Over the past decade, diversification may have seemed less important to investors, as all financial markets enjoyed a steady and seemingly inexorable rise – but this year reality has intruded.
There is evidence from the recent market turmoil that non-correlated AIF strategies hedge to steady portfolio returns when other asset classes are struggling. During March 2020 the HFRI Asset Weighted Composite Index, which reflects more than 1,500 funds tracked by Hedge Fund Research, was down by 7.73%, compared with 12.51% for the S&P500 US stock index and 14.79% for the Euro Stoxx 600.
A similar pattern was seen during the global financial crisis more than a decade ago, when AIF achieved prominence not only by in some cases achieving very large profits betting on the collapse of the US housing market, but in general by protecting investors from much of the losses suffered by traditional funds when stock markets plummeted.
Liquidity and downside risks
However, being sophisticated does not in itself necessarily make investment products a sure thing, nor appropriate for all circumstances or all investors. Hedge funds long maintained a mystique because many were closed to new investment, gaining appeal by their inaccessibility.
But while some funds have continued to do well for their investors over the past decade of overall market growth, other high-profile vehicles have disappointed, obtaining only lacklustre performance despite fees significantly higher than those charged by retail funds. Investors need to know what they are buying, and some alternative investment strategies can be opaque, even to seasoned institutional investors.
It’s also worth bearing in mind that many alternative products are less liquid than funds that trade assets listed in public markets. This need not be a problem for long-term investors, but will not suit those that might need to access their capital in a hurry. Their strategies may also run what are perceived to be bigger risks, involving complex derivatives or making more concentrated investments in individual company shares or debt than are permitted for mainstream funds.
The risk of bigger losses if individual investments or markets turn down might be less important for those with a longer investment horizon and who are prepared if necessary to wait for asset values to recoup losses, but investors should be aware of the potential risks before they invest. Just as much as with a conventional equity and bond portfolio, complex products need to be selected with care and as part of a broader investment strategy.
Building a robust investment portfolio takes time and requires an awareness of the financial market environment and economic climate, as well as knowledge of the potential risks and benefits of individual investments, whether shares, bonds, investment funds, structured products and AIF. That’s why expert advice is particularly important for investors considering investment in less mainstream, less liquid or more complex financial instruments or products. That doesn’t mean surrendering control over the portfolio or ceding decision-making power to an adviser, but it does mean investors having access to the specialist help they need in assessing how more sophisticated products can fit with their risk and reward profile.
A strong partnership between adviser and client can ensure proper consideration of the risks and benefits presented by different types of investment and how they can fit with the investor’s long-term financial goals.
If it’s too good to be true…
Another key benefit of developing a long-term relationship with a trusted adviser is that they can protect their clients against the possibility of being seduced by questionable investment schemes advanced by fluent and plausible promoters – and there are plenty of them.
Exotic opportunities such as financing an Indonesian tin mine should always set off alarm bells, but in recent years many wealthy investors have fallen foul of complicated schemes, for example involving film finance, designed to offset other tax liabilities. Increasingly such schemes are ending in tears, or the courts, as investors find themselves out of pocket and with substantial tax bills to pay. If something looks too good to be true, it usually is.
Investors ready to consider more sophisticated financial strategies and products are more likely to be targeted by scammers offering investment ideas that turn out to be imaginary or that involve aggressive tax planning that carries substantial risk. Willingness to take greater risks and consider a wider range of investment products or asset classes should not mean failing to conduct proper research or apply common sense to investment options, from plain vanilla equity funds to alternative asset classes.
“A strong partnership between adviser and client can ensure proper consideration of the risks and benefits of different types of investment and how they can fit with the investor’s long-term financial goals.”