An Introduction to Alternative Investment Strategies

When financial markets demonstrate higher levels of correlation between asset classes and peaks in volatility, is a stark reminder to us all of the sensitivity of investors’ behaviour - to headline news (the China growth slowdown, interpretations of ECB and FED announcements, etc.).  It’s times like these when having investments that can react differently to these types of market swings is not just good for one’s constitution by creating a “smoother ride”, but is also a good means of diversifying one’s investment risks whilst seeking additional sources of positive returns.  Such is the mantra of Alternative Investment Strategies.

But what are alternative investments?

As the word suggests, Alternative investments offer investors a choice over traditional investment strategies that generally allocate capital on a “buy and hold” basis (i.e. “long only funds”) to stocks, bonds and cash.  In fact, a more accurate appellation would be Complementary and Alternative Investment Strategies, and any well-constructed investment portfolio should include Alternative strategies as part of its DNA. Alternative investment fund managers seek to create positive performance in all market conditions (otherwise known as absolute returns) over a given investment horizon. As such, performance is not measured versus a broad market index, or a benchmark, but in absolute terms (i.e. a loss is a loss… a gain is a gain).

Why choose alternative investment strategies?

Alternative Investments can provide a consistent source of uncorrelated, absolute returns whilst seeking to limit against, and perform in, declining markets by the use of specific investment techniques, dynamic investment strategies, deep fundamental research and greater diversification and active asset allocation.  They can also improve the risk-return profile of an investment portfolio.  From the conservative to the more dynamic investor profile, they are an additional source of uncorrelated returns, the key to success being the choice of the right Alternative manager and the right strategy in line with one’s investment profile.

How does it work?

Whether markets are moving up or down, the Alternative fund manager will employ specific investment technics, often across the full range of financial instruments, in the pursuit of positive absolute returns.  The most well-known technique being the “short” sell: whereby a manager will seek to make a profit from a stock’s over-valued price.  Hence, this explains the theory that an Alternative fund manager has the possibility to generate positive returns in a falling (“bear”) market (or at least reduce the downside) as well as in a rising (“bull”) market.

Another technique that is applied by Alternative managers is the use of leverage to essentially amplify the results of their investment decisions.  For example, this amplification effect allows strategies that maintain a low exposure to equity markets (i.e. the sum of all stock purchases less the sum of all “short” stock sales is close to zero)  to enhance the resulting  incremental gains into something more significant.  The level of amplification has a regulatory limit (according to the type of fund), and is controlled by the fund manager or his risk department based on an ever-evolving battery of controls and risk measurements.  As such, a manager may increase (or turn-up) his leverage on the basis of strong positive market signals or reduce it (or turn it down) in times of uncertainty.

An alignment of interests between investors and fund managers

Alternative investment managers apply performance-related fees to their funds that are only levied when the manager has out-performed his previous best (i.e. when the Net Asset Value per share – the fund’s price - surpasses its previous high).  As a general practice, Alternative managers invest their own money into establishing their businesses as well as into launching their funds, and as such, ensuring alignment of interests between manager and investor (being both in the same boat).

And what about risks?

As with most investments, positive returns are not guaranteed.  Alternative funds are also exposed to the same asset class and market liquidity issues as other investments, as well as other specific risks such as through the use of leverage or key-man risk that is associated investment houses that rely on one or a few talented individuals to define and implement their investment strategies (i.e. these people are essential contributors to the success of the strategy).       

Watch this space as we will take you through some of the different strategies and techniques that are used by Alternative fund managers in our future posts.