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Why consider alternatives?
What are alternative investments?
Hedge funds
Managed futures / trading funds
Private equity
Commodities
Gold and other precious metals
Infrastructure
Other alternatives
Are alternative investments risky?
How Select manages these risks
For added diversification, be select.alternatives portfolio
Select’s Education Guide to Alternative Investments
Leading the way in Alternatives since 2002
Page | 2
Why consider alternatives?Alternative investments are growing in popularity because they provide investors with the important benefi ts of diversifi cation. Their
lower correlation with traditional asset classes means that when blended with mainstream investments they can help to smooth out
an investor’s portfolio returns over time. This is important as many investors have signifi cant exposure to traditional market risk and
diversifi cation is particularly valuable for investors during times of market volatility and uncertainty.
The limitations of diversifi cation across many traditional asset classes has been highlighted, particularly during times of market stress,
with many traditional investments exhibiting losses and similar behaviour at precisely the time that investors need diversifi cation
the most. Over the last 30 years academic theory around constructing investment portfolios has not changed signifi cantly, while the
markets themselves and investor risk tolerances have in some cases both changed dramatically. In fact many traditional asset classes
have become more correlated with one another over time, a reason why many institutional investors are seeking increased exposure to
alternative investments.
Although alternative investments are often considered somewhat niche, there is a wide spectrum of alternative investments available
which can offer investors access to a range of risk and return sources not available from traditional investments, such as share markets
to which many investors are heavily exposed. Some carefully selected alternative investments can provide access to returns that are
uncorrelated with mainstream investments, and these can protect capital in periods of market downturns without eroding the overall
performance over time.
Page | 3
What are alternative investments?Alternative investments are those investments which lie outside the mainstream universe of shares, property and fi xed interest.
They include non-mainstream asset classes such as private equity, commodities, infrastructure and precious metals, and alternative
investment strategies where fund managers may invest in mainstream markets, but in a different way, for example long/short equity to
generate returns less dependent on the market direction. Examples include hedge funds and managed futures/trading funds.
There is no precise defi nition of ‘alternative’ or even ‘mainstream’, as the defi nition may change over time. This is because some
alternative investments become more accepted as greater numbers of investors start to include them in their portfolios. It also
varies between investment markets. For example, in some countries real estate is still considered an alternative investment
whereas in Australia it is generally regarded as mainstream.
Figure 1 - The universe of alternative investments.
Source - Select Asset Management.
Page | 4
Hedge funds are now regarded globally as a well-established alternative investment option. This type of investment utilises
specialised trading strategies in order to capture opportunities in specifi c market sectors or asset classes.
Hedge fund returns are typically less reliant on positive market conditions, and are more dependent on the skills of the portfolio
manager. Typically, hedge fund managers have a great deal of fl exibility in terms of their investment mandate and can have both
short and long positions across a wide variety of investment holding periods.
As a whole, hedge funds undertake a wider range of investment and trading activities than mainstream long-only investment funds,
and may invest in a broad range of markets including shares, bonds, currencies and commodities. As the name implies, hedge funds
often seek to hedge some of the risks inherent in their investments using a variety of methods, notably short selling and derivatives.
At Select, we believe that when constructing a well-balanced investment portfolio, the addition of lowly correlated hedge funds will
assist in generating more consistent returns across varying market conditions.
What is short selling or taking a short position?
If, for example, a fund manager believes a share price will fall, they can borrow the shares and then sell them (point A on the chart at $69).
If the share price falls, the fund manager can then buy the shares back at a lower price (point B in this example at $43) and return
the same number of shares to the lender.
The difference between selling the shares (at point A) and buying the shares back (at point B), is profi t ($69 - $43 = $26 per share).
Short selling has the ability to generate profi ts in falling markets - essentially the opposite of holding shares in a long position.
Hedge funds
Figure 2 - Short selling.
Note: If the share price rises then
a loss would occur. The purpose
of this chart is to illustrate the
concept of “short selling” and does
not represent the performance of
a specifi c share. This example also
ignores borrowing and execution
costs, and also the potential for
losses through short selling.
Source - Select Asset Management.
Page | 5
Different types of hedge funds:
There are several different types of hedge fund strategies which can be broadly categorised as follows:
• Relative value managers invest based on the attractiveness and potential return of one instrument or security relative to
another, measured in terms of price, liquidity and their structural, historic or economic relationship – for example, the shares of
the same company listed in both Australia and the United States.
• Event driven strategies exploit pricing ineffi ciencies caused by announced or anticipated specifi c corporate events. For example,
a corporate takeover would allow a manager to decide which of the two companies (the acquirer or the target) is likely to perform
better in the short period of merger activity, or they could take a long position in one and a short position in the other over the
period of the transaction.
• Long/short equity strategies combine core holdings of equities/shares with short selling techniques. Managers typically seek to buy
stocks that they fi nd attractive and short sell unattractive stocks based on similar analytics to those used by mainstream equity
fund managers.
• Global macro funds attempt to profi t by anticipating global macroeconomic events, investing in a variety of markets and
instruments to generate a return – for example, interest rate, government bond and currency markets.
Potential benefi ts to investors
• Provide access to specialist investment opportunities that can often be diffi cult for retail investors to access.
• Some hedge fund strategies can achieve positive gains regardless of market direction, which can help to reduce overall
portfolio volatility.
• Low correlation to mainstream markets means that when blended with mainstream investments, hedge funds can offer
increased diversifi cation and improve overall portfolio returns.
Potential risks of hedge funds
Despite a “hedge” being a means of reducing the risk of an investment, investing in hedge funds can carry risk. Hedge funds can
have some of the following risks:
• Leverage - a hedge fund will often borrow money to magnify returns - this means that losses as well as gains can be magnifi ed.
• Short selling - due to the nature of short selling, the losses that can be incurred on a losing investment are in theory limitless,
unless the short position directly hedges a corresponding long position.
• Liquidity - certain styles of hedge fund investments can be subject to liquidity risk through investments, for example, in
private markets.
Page | 6
Managed futures or trading funds are often included as a subset of hedge funds and are a valuable component in a diversifi ed
alternative investment portfolio.
Managers have the fl exibility to sell short (sell in anticipation of declining prices) or go long (buy in anticipation of rising prices) in a
variety of futures and currency forward markets. The number and range of different markets traded in managed futures investments
can provide substantial diversifi cation to an investment portfolio and include global currency, interest rate, stock indices, industrial
and precious metals, energy and agricultural markets.
Historically, managed futures have displayed low correlations to mainstream investments such as shares and bonds and, as
demonstrated in Figure 3, have historically generated positive returns during many extreme market conditions.
A comparison of the performance of managed futures against the seven worst performing events for world share markets shows
that, in six of the seven events, managed futures delivered positive returns.
Potential benefi ts to investors
• Potential to generate positive returns during times of market stress/crisis, when they are needed most.
• Managed futures strategies provide diversifi cation from mainstream markets and from other hedge fund strategies.
• Managed futures investments are typically very liquid as are the underlying markets in which they invest.
Potential risks of managed futures
Managed futures managers can incur losses:
• During prolonged periods where markets are directionless i.e. do not rise or fall much.
• When markets ’whip-saw’ i.e. when potential price trends start to develop but reverse before actual trends are realised.
Managed futures / trading funds
Page | 7
Figure 3 - Managed futures can generate positive returns during extreme market conditions.
Source - Managed futures are represented by the Barclay CTA Index and World Share Markets are represented by the Vanguard
International Share Fund. Both are in Australian dollars. Neither past performance nor volatility is a reliable indicator of what may
happen in the future.
Page | 8
Private equity involves providing capital to companies at various stages of development. Many young companies with strong growth
potential do not have access to mainstream forms of fi nancing such as bank loans, listing on the stock exchange or bond markets.
Private equity is investment capital provided to companies to start up a business, develop new products, strengthen balance sheets
or restructure when already established (e.g. leveraged buyouts). Famous examples of companies which received private equity early in
their development include Microsoft, Apple and Federal Express. Getting early access to private equity opportunities can be diffi cult and
a fund of funds solution is often a more effective way for retail investors to gain exposure.
Investors can also access opportunities through listed private equity funds, which are available on some major share markets.
Example of private equity investing
In 2005 CHAMP private equity bought Amdel for $60million. Amdel provides analytical testing to resources companies. Due to the
demand for Australian resources and resource expertise the value of Amdel grew signifi cantly. In 2008 CHAMP sold Amdel to Bureau
Veritas SA for $427million.
Potential benefi ts to investors
• Attractive returns - potential to deliver higher absolute returns than share markets.
• Additional diversifi cation - through exposure to a range of industries and companies that may not be represented in mainstream
listed markets.
• Active involvement by private equity managers can deliver more value – by infl uencing the management and operations of companies.
• Unique investments - opportunity to invest in companies managed by some of the world’s leading entrepreneurs.
Potential risks of private equity investing
• Capital risk - like any equity investment there is the potential to lose some or all of your invested capital.
• Access to capital - given the early stage of investments it can be diffi cult to exit from private equity.
Private equity
Page | 9
Figure 4 - Types of private equity investing. Stage refers to company life cycle, not to the investment.
Source - Select Asset Management.
Page | 10
“An allocation to the Select Alternatives Portfolio provides investors with exposure to a diversifi ed range of alternative strategies such as hedge funds and managed futures, and alternative assets such as commodities and infrastructure, all within a sound fund structure with weekly liquidity.”
Dominic McCormick, Chief Investment Offi cer, Select
Page | 11
Commodities are raw materials used to create the products consumers buy everyday from food to furniture to petrol.
Commodities include agricultural products such as wheat, base metal products such as zinc and energy products such as oil and
natural gas.
With the development of commodity futures indices, fi nancial investment in commodities has become more accepted. As
commodities are physical or real assets, they can react differently to other mainstream fi nancial assets thus providing additional
diversifi cation for a portfolio.
There are two broad ways for investors to gain exposure to the commodity markets:
• Direct exposure via physical holdings or futures contracts.
• Indirect exposure via listed or unlisted companies involved in the production of commodities e.g. mining companies, timber
companies and agricultural producers.
Potential benefi ts to investors
• Attractive returns - commodities tend to benefi t from rising infl ation as commodity prices generally rise when infl ation is increasing.
• Exposure to different economic drivers within commodities as a whole - e.g. food production versus steel production (people
need to eat but they can postpone buying a car).
• Protection against event risk - e.g. the breakout of war which could cause some commodity prices such as oil to rise.
Potential risks of commodity investing
• Market risk - commodity prices can vary substantially and are subject to demand and supply dynamics.
• Geopolitical risk - international disagreements over the control of natural resources can occur disrupting production and
operations of commodity producers.
• Production risk - companies involved in the production of commodities are subject to labour shortages as well as infrastructure
for shipping/delivery and other costs which can vary both production levels and profi tability.
Commodities
Page | 12
Gold and other precious metals such as silver and platinum are priced primarily by their investment demand, as well as physical demand.
Gold in particular has historically played a role as a currency in its own right which means that its drivers are quite different to most other
commodities, and it also has shown to be one of the most negatively correlated assets to equities.
Exposure can be obtained through:
• Direct exposure to gold bullion or the price of gold via gold-backed exchange traded funds and futures contracts.
• Indirect exposure to the gold price via gold mining companies.
The following chart shows the recent history of the value of gold. It shows that holding physical gold bullion over the last fi ve years would
have returned in excess of 15% per annum in Australian dollar terms.
Potential benefi ts to investors
• Gold can provide a safe haven in times of fi nancial and geopolitical stress.
• Additional diversifi cation - historically low correlation to mainstream assets.
• Strong fundamentals - long term demand continues to exceed new production, and many central banks globally have been increasing
their physical gold reserves.
Potential risks of gold or precious metal investing
• Volatility - gold markets can be very volatile.
• Sentiment - like any listed share market investment gold mining shares can be prone to boom and bust cycles.
GOLD ETF
Gold and other precious metals
Figure 5 - Price history of gold
in Australian dollar terms,
represented by an ASX listed fund
(ASX code GOLD) from June 2006
to June 2011. It shows that holding
gold bullion over the last fi ve years
would have returned in excess of
15% per annum.
Source - ASX.
Page | 13
“Gold in particular has historically played a role as a currency in its own right which means that its drivers are quite different to most other commodities and it also has
shown to be one of the most negatively correlated assets to equities.”
David Baker, Portfolio Manager & Founder of Baker Steel Capital Managers
Page | 14
Infrastructure is now a major alternative asset class as many governments around the world privatise infrastructure assets, and
superannuation funds have also been driving demand for infrastructure assets in Australia. The long-life, infl ation-indexed cashfl ows
associated with infrastructure assets can provide a good match for the long-dated liability matching of superannuation and pension funds.
Many infrastructure assets have now been listed on stock exchanges. Infrastructure funds allow investors to own part of a professionally
managed portfolio of infrastructure assets such as:
• Airports.
• Toll roads.
• Rail and port facilities.
• Utilities such as gas pipelines and electricity power lines.
• Communication assets such as broadcast towers.
Potential benefi ts to investors
• Attractive, predictable and long term cash fl ows - as the assets typically operate in environments with high barriers to entry,
and often little competition.
• Protection against infl ation - cash fl ows are usually indexed to infl ation.
Potential risks to infrastructure investing
• Patronage risk - this is important when consumers can choose alternative services such as with toll roads, railways and even ports.
Occasionally, the Government absorbs this risk explicitly or by default.
• Financial risk - of specifi c relevance to infrastructure projects are foreign exchange and interest rate risks. Most of the time these are
hedged if part of a broader fund.
• Operating risk - this risk emerges due to underestimation of operating costs and occasionally, an overestimation of the revenue from
the proposed infrastructure facility.
Infrastructure
Page | 15
Figure 6 - Examples of infrastructure projects.
Source - Select Asset Management.
Page | 16
There are many opportunities to gain exposure to investments which have a low or negative correlation to mainstream markets.
One of the characteristics of the alternative investments universe is that it can include anything not considered to be a
mainstream investment.
At Select, we have the ability to invest in some of the less well known or specialised alternative investments when we fi nd
attractive opportunities.
Examples include:
• Agribusiness investments such as cattle farms, plantations, orchards or vineyards which can generate sustainable returns and offer
some protection against infl ation.
• Asset-based or alternative debt strategies which have the potential to generate a stable income stream.
At Select, we are constantly looking for the best investment ideas across the whole market environment. We believe that the world is
constantly evolving and other potential alternative investment areas could include:
• Royalty models - music and fi lm.
• Insurance related - catastrophe risk and weather risk.
• Electricity markets - electricity futures and weather derivatives.
• Commodities - carbon futures / emissions trading and water rights.
• Shipping - freight derivatives and forward freight agreements.
• Intellectual property rights.
• Litigation investing.
• Microfi nance.
In the future, investments currently considered alternative may also become a more mainstream part of the average investor’s portfolio.
Other alternatives
Page | 17
“While considering a broad range of established alternative strategies and assets which have the potential to provide diversifi cation in a range of market
environments, at Select we also have the ability to invest in some less well known and emerging alternative investment areas as well. These range from farmland
and agribusiness to more esoteric and emerging asset classes.”
Robert Graham-Smith, Head of Portfolio Management, Select
Page | 18
Alternative investments can provide attractive return opportunities with different risk characteristics. However, like any investment,
there are issues to consider before investing in alternatives. Some considerations are:
Access and active management
Many alternative investments are not typically accessible to retail investors. However, diversifi ed products like the Select
Alternatives Portfolio can provide investors with access to a range of alternative investments within a single product and can blend
them appropriately.
Liquidity
Some alternative investments are less liquid than mainstream assets and require multi-year investment periods. At Select, we
manage liquidity risk and provide acceptable withdrawal periods for your investments.
Lack of transparency and complexity
Some alternative investments are complex. At Select, our job is to understand the assets in which we invest so that we can make
informed investment decisions, based on appropriate transparency provided by underlying managers. We continually monitor
underlying investments to ensure that their return and risk profi les are appropriate for inclusion in our Portfolios.
Fees
Fees are higher for some alternative investments due to the focus of managers on generating positive returns in a variety of
market conditions, as well as overall complexity. Our size allows us to negotiate fee discounts with underlying managers which
in all cases are passed back to our investors. We are mindful of fees, however, the after fee performance is also important when
assessing alternative investments.
Tax effectiveness
Some alternative investments are not particularly tax effective. Investors may need to treat them like other tax ineffi cient investments.
Are alternative investments risky?
Page | 19
Select maintains a comprehensive and disciplined approach to risk management at both the investment and portfolio levels.
A core principle is that before making any investment, Select identifi es the particular criteria that will be monitored to determine
whether that investment’s behaviour is as expected, sets appropriate limits for these criteria, and determines the actions that will be
followed should these limits be breached at any time (i.e. should unexpected behaviour be detected). Such criteria may be market or
investment manager related. Alongside this we also maintain and monitor a list of more qualitative ‘key risks’ for each investment,
such as key staff or capacity constraints.
In addition Select employs sophisticated proprietary risk modelling systems for scenario analysis and stress testing to understand
expected portfolio behaviour under different economic and market conditions.
In essence our philosophy is about identifying and managing risk, not attempting to avoid it. Some of the key areas of risk considered
include: operational, market, liquidity, leverage, currency and derivatives.
How Select manages these risks
Select Asset Management Limited ABN 94 101 103 011
Level 10, 2 Bulletin Place, Sydney NSW 2000
P: +61 2 8252 2200 · F: +61 2 8252 2201 · E: [email protected]
Australian Financial Services Licence No. 223271
selectfunds.com.au
Disclaimer
This education guide does not take into account any particular person’s objectives, fi nancial situation or needs. Investors should seek professional advice before making
investment decisions. We are the issuer of interests in the Select Alternatives Portfolio. A product disclosure statement (PDS) for the offer is available free of charge
from our website or by contacting us. The PDS should be considered before deciding to acquire, or continue to hold an investment in the Select Alternatives Portfolio.
Applications can only be made on the basis of an application form attached to the current PDS. Neither past performance nor volatility is a reliable indicator of what may
happen in the future. Neither capital nor returns are guaranteed.
© Select Asset Management Limited 2011.
Contact your adviser or Select to learn more or to receive a copy of
Select’s Adviser Guide to the Select Alternatives Portfolio.
