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Playing the percentages : an alternative view

Finance : Alternative Investments

Institutional investors have been investing major sums of money in alternatives for some time without compromising their portfolios. As more and more wealthy individuals join in, Rodrigo Amaral asks just how much of your portfolio you should gamble.

Rodrigo Amaral is a freelance journalist based in the UK.

With private equity companies delivering annual returns over 30% in Europe, property prices booming in many parts of the world and commodity markets boosted by an apparently insatiable China, alternative investments seem to be the current toast of wealth managers everywhere. What is not clear, however, is if such products, which sometimes bring the promise of high profits but also the risk of painful losses, are to everyone's taste.

Big institutional investors have been playing the alternative investment game for some time already, capable as they are of betting huge amounts of money without compromising their portfolios. But now, a growing number of wealthy individuals are following suit. Research by Capgemini and Merrill Lynch estimates that, in 2005, 36% of assets belonging to individuals with more than $1 million were kept in alternative investments, against 25% three years before. These investors are wooed by performances such as the 187% increase in UK house prices in the 10 years to September 2006, or the 1000% growth of the Merrill Lynch Gold & General commodity fund since it was launched in 1988.

On the other hand, it is salutary to remember the other side of the coin – there are cases where investments in alternative products bring nothing but pain. You just have to look at American hedge fund Amaranth, which took daring positions in the gas market last year; as the price of this commodity took a dip, it lost more than $3 billion. Poor performances by commodity indexes early this year, frequent warnings about the imminent burst of property bubbles and a growing distaste for private equity firms by the public in several countries may also create doubts inside the cautious investor's mind.

It seems clear, though, that the days when a wealthy individual would be happy with a simple but efficient formula of asset allocation – say, 40% equities, 40% bonds and 20% cash – seem over. The particular challenge presented by alternative investments is how to take advantage of them while avoiding the hazards that lie on the way to potential riches.

At present, investors still seem to be erring on the cautious side. A recent survey by Morningstar found out that the portfolio of an average American investor would have no more than 10% of assets allocated to alternative investments. But many portfolio strategists believe that at least a fifth of an individual's assets should have that destination in order to bring optimum returns, and that is particularly true of the very rich.

"If you don't have a lot of money to invest, it is probably better to avoid alternative investments", says Nicolas Sarkis, a partner at London-based wealth management advisors AlphaOne. "But for those who have enough to spread their bets judiciously, alternative investments provide a powerful tool to boost performance and reduce risks."

This is far from an isolated view. Specialist firms like Deutsche Bank Private Wealth Management are reportedly recommending that up to 30% of a portfolio be kept in alternative investments (including hedge funds), while Citigroup Private Bank considers that some clients are in a position to allocate 20% of their assets in private equity and other illiquid investments. The same share is also going to hedge funds, which used to be the preserve of the most reckless investors, but now, with the spreading of funds of hedge funds, have become very much mainstream.

Wealth managers will usually concede that it is impossible to come up with a one-size-fits-all formula. The decision of how much of a portfolio goes to alternative investments will inevitably be conditioned to investors' expectations and their appetite for risk.

"We've had clients who decided to put 100% of their investable assets in alternatives," remarks Cedric Meeschaert, president of Parisian private wealth management specialists Meeschaert Gestion Privée. "It is not something that we would recommend, but sometimes clients want to take the risk." Anyway, some particularities of these products should be taken into account even by those not prone to such a gung-ho approach.

First of all, of course, comes the willingness to take risks. "We divide alternative investments in two categories: those that will make you rich and those that will help you sustain the wealth you've already created," explains Meeschaert. "You should keep in mind, though, that the products that can help you achieve 25–30% returns in an annual basis may yield minus 30% as well."

Some alternative investments, such as structured products that guarantee the future reimbursement of 100% of the money originally put into them, are often seen as useful tools to hedge portfolio risk. But others are much less straightforward propositions.

Commodity funds are a clear case of investments with a considerable degree of risk, subject as they are to sudden climatic changes and geopolitical turbulences. The same goes to some extent to private equity, where the performance of the investment is closely linked to the management expertise of the company that has set up the fund and has invested in a new business.

If the new management team fails to turn a company around, the money invested in the fund used to buy it out can be lost. A similar danger exists with venture capital, as new businesses can simply prove to be not as promising as they looked at first. Mezzanine funds, where money is lent to established companies that need capitalisation, are usually seen as less risky propositions.

Investors should also evaluate the liquidity requirements of their family or business before allocating huge chunks of a portfolio to alternative investments. Giant American pension fund Calpers, for instance, expects private equity investments to result in low or even negative returns for the first five years, as the new owners make the necessary managerial and operational changes to put companies back on track. However, if a multi-billion dollar fund can easily bear the wait, private investors may be much less disposed to.

And investors should be aware of not pushing too hard on the use of alternative investments for diversification purposes. Some of them, like commodity funds, have a low correlation with other asset classes like shares, and can therefore help to offset the effects of equity markets meltdowns. But too much diversification can also reduce the probability of yielding good results – the money can end up in a great number of average-performing products.

Novices into the world of alternative investments could do worse than to have a look at investment strategies privileged by the likes of managers of endowments of American universities, who are among the brightest minds in the business and have long experience in exposing their funds to such products. Meeschaert remarks that they tend to point the directions the market is moving to, so it is well worth following their strategic thinking.

For instance, Yale University, which has the second largest endowment, behind Harvard, keeps 16.4% of its assets in private equity, while commodities and real estate account for a further 27.8%. As hedge funds are also used, more than two-thirds of Yale's endowment is invested outside the traditional equities, bonds and cash formula. During the last fiscal year, the strategy yielded impressive 22.9% returns; however, they were up a meagre 0.7% in the 12 months to June 2002.

The question remains: are you willing to take the risk?

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