Since You Asked: Defining alternatives

(June 2007) Advisor.ca is pleased to introduce a new monthly investment column by Pierre Saint-Laurent. “Since You Asked” will answer advisor frequently-asked questions concerning investments.

Many advisors get confused by what alternative investments entail. Typically, one associates alternative investments, or alts for short, with hedge funds. However, there is much more to alts than just hedge funds.

Mark Anson, alts expert extraordinaire, former Chief Investment Officer of CalPERS (The California version of an OMERS) and author of The Handbook of Alternative Assets (if you read only one book on the subject, this should be it), has actually defined alternative investments as composed of four groups: hedge funds; private equity; real estate; and managed futures. This is a sensible breakdown, one that has been acknowledged by the CAIA Association, the body that, similar to the CFA, oversees and bestows the Chartered Alternative Investment Analyst designation.

Hedge funds: According to recent reports, assets under management in hedge funds surpass US$2 trillion worldwide at this juncture. Lest you think that this is an unbelievably large number, I invite you to add up the assets under management and administration at the ten largest banks in the world. I believe this will put hedge fund assets in perspective! However, this is not pocket change, and because of leverage, short positions and reduced transparency, hedge funds have influence in the financial world. In a nutshell, hedge funds can be succinctly defined as investment strategies making use of derivatives, applying leverage, and taking short positions.

Of course, not all hedge funds apply considerable leverage, and some are quite limited in the short positions they may take. But then, many hedge funds don’t hedge at all and take views (sometimes leveraged ones) on market, sector, or asset directions. In my view, the main attraction of hedge funds is to allow the investor access to different approaches and strategies on existing markets, which prove complementary to what’s already in the portfolio.

To find out more about hedge funds, I cannot but highly recommend AIMA Canada’s Hedge Fund Primer, which you can obtain free of charge just by downloading it (along with other wonderful tools such as AIMA Canada’s Hedge Fund Investor Checklist) at http://www.aima-canada.org/aima_can_publications.html.

Private equity: Who hasn’t seen the latest mega-buyout deal in today’s newspaper, such as the play for BCE, for example? There is a huge buyout spree out there going on, and it is largely driven by private equity firms. Private equity is just that: private partners get together and make deals for significant portions of businesses. Venture capital is included in private equity, as VC is pre-IPO in nature. How big is private equity? 2006 commitments have been reported to have been at $700 billion worldwide, not an insignificant number and growing fast. Private equity performs much better than publicly-traded equity (at least for the first-quartile private equity funds), as confirmed yet again by the 2007 Private Equity Performance Monitor.

That’s why large pension plans such as OMERS, Teachers and the Caisse de Dépôt are heavily involved (you may know that following a private equity deal, the Caisse now runs, with a partner, Heathrow and other London-area airports!). What about private investors and their advisors? There is a privately accessible fund in Canada, offered by Kensington Capital Partners. I suspect more will come. As usual, the proof will be in the outcome: relatively high net returns. If private equity track records are any indication, this is an area you may want to follow relatively closely.

Real estate: In a certain sense, real estate isn’t ‘alternative’ at all. It’s always been around — the Pyramids, the Parthenon, the Colosseum in Rome represent great real estate! However, it’s the ability to view and transact real estate for its return/risk/correlation characteristics that qualify it for alternative investment status. Indeed, real estate is a good diversifier, and an inflation protector. And although it is highly cyclical, well-managed real estate portfolios have produced very handsome returns.

Once again, this is why major Canadian pension plans have considerable positions in real estate in all major Canadian cities and around the world. Take a look at the latest OMERS or Teachers annual report- you’ll understand why. On the retail side, besides owning rental property, let alone a cottage, real estate investing is tantamount to securitized real estate — à la REIT — offering participation in a real estate pool through securitized offerings, i.e., investing in the cash flows of the underlying real estate package. This allows retail investors to participate, for instance, in commercial or industrial real estate, which is hard to do on an individual, non-securitized basis.

Managed futures: This is the domain of the Commodity Trading Advisors. These investments, based on the futures markets, apply proprietary “black-box” trading algorithms and methodologies to generate returns. Managed futures are arguably the most diversifying investment out there with very low correlations to traditional ‘long-only’ assets such as stocks and bonds. However, these investments tend to be volatile and lack in transparency, the black-box nature of the trading strategies being an inherent component of the managed futures approach. All in all, a small position in managed futures will contribute to diversify a portfolio, if one can accept the highs and lows that will occur along the way.

Now it’s your turn: Any questions?

Pierre Saint-Laurent, CFA, CAIA, is president of AssetCounsel Inc. He can be reached at PSL@AssetCounsel.com.