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Alternative Investments: Hedge Funds Look Increasingly Attractive On Relative Basis

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Mark Haefele, global chief investment officer, Wealth Management at UBS focused on alternative investments in the latest issue of the CIO Monthly Letter after observing that many clients around the world are interested in the topic.

Haefele reiterated in his monthly letter that a holding a well-diversified, long-term portfolio of liquid, listed assets is significant for investors to keep their investments in the right direction.

According to him, investors should adapt their investing methods in a world of lower interest rates. Haefele emphasized that UBS increased its alternative investments as a strategy to adapt to the current environment of lower interest rates, which are increasing near-term returns.

Haefele believed that the latest round of stimulus implemented by central banks around the work should continue to support their diversified portfolio. He also emphasized that diversification is a proven to be effective in insulating portfolios against the perceived idiosyncratic risks in 2015 such as the declining oil prices and the weakening of the euro.

Reasons investors should consider alternative investments

In his monthly letter, Haefele identified several reasons why private investors should practice alternative investments. He noted that illiquidity is one of the main reasons why private investors avoid investing in alternative assets.

However, Haefele believed that private investors should invest in alternative assets. His reason, “illiquidity premium on offer in many alternative assets gives a powerful investment advantage to clients who don’t need constant access to a portion of their assets,” in a low-yield world.

He noted a recent academic study indicating that the least quartile of stocks in the United States from 1972 to 2011 achieved an average returns of 16.4%. The returns of the most heavily traded stocks ere 11%. He added that investing in U.S. private equity growth capital funds over the past decade delivered an average of 5% in annual returns over the equity index.

“A 5% annual illiquidity premium has always been nice to have. In a low-yield world, it becomes essential. In the same way that a balanced portfolio should contain a diverse range of assets, it should also contain assets with different levels of liquidity,” said Haefele.

The second reason investors should consider alternative investments is the fact that they are protected from behavioral biases that can negatively affect even the most sophisticated investors.

According to Haefele, DALBAR studies showed that a behavioral gap of 4.2% in 2013—the performance of an average mutual fund investor losses in buying high and selling low instead of sticking to a strategy.

The third reason for investors to consider alternative investments is diversification with traditional asset classes such as equities and bonds. He explained increasing exposure to alternative assets can potentially lower the overall level of risk of a portfolio without compromising returns.

Hedge are relatively good risk-adjusted performers

Haefele does not think that a majority of hedge funds achieved success in recent years. The broad index of funds was only up 3% over the year, but he noted that hedge funds added diversified returns to their portfolio (adjusted for volatility).

According to him, a balanced portfolio of hedge fund strategies generated an average post-fee performance of 5.2% over the past ten years. He emphasized that the 3% returns of hedge funds was offset by just 3.2% volatility last year.

Haefele said hedge funds are relatively good risk-adjusted performers (0.9x) given the minimal volatility, which he expects to decline over the next quarters.

I know that risk-adjusted returns mean little if returns are very low. But again, today’s lower interest rate world means that returns across all financial assets will be more modest, and hedge funds then look increasingly attractive on a relative basis.

Alternative Investments

Real estate and private market as alternative investments

According to Haefele, the value of commercial properties in the United States increased 44% from its lowest level during the financial crisis. The prices are currently 2% higher than the peak prior to the crisis.

Haefele pointed out that properties are relatively good hedge against inflation. Owners can expect rent revenues to increase in line with inflation. He estimates that a portfolio of building could offer a return premium of approximately 250 basis points higher than government bonds.

“To get the alternative benefits of real estate, one should look beyond listed real estate securities, which are subject to equity market volatility,” said Haefele.

On the other hand, Haefele said he made the most profitable investments in private markets in his career. He pointed out that such investments must be performers because the risk, illiquidity, and long investment commitments require compensation.

He noted that investors US growth enjoyed an average annual outperformance of 819 basis points higher than equity markets over the past decade based on the performance of the funds monitored by Cambridge Associates.

Alternative Investments

Outlook on gold prices is not good

Meanwhile, Haefele noted that gold is included in the list of alternative investments throughout history. Objectively, he thinks that gold does not deliver cash flow, and it has no obvious risk-premium. He added that gold delivered more volatility than bonds or equities on risk-adjusted basis in recent years. He said the outlook for gold prices is not good even on a tactical basis.

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