Many self managed super fund (SMSF) investors will have heard the term ‘alternatives’ in relation to investments. However, to many it remains a mystery or at least an asset class outside the realm of everyday investing. So, what are alternative investments and how they might benefit SMSFs?
What is an alternative investment?
An alternative investment is an asset or strategy that is one that is not made up of conventional investment types such as stocks, bonds and cash. Alternative investments include private equity, hedge funds, commercial real estate, infrastructure, commodities and various forms of derivatives. While some of these (like commercial real estate) may be familiar to SMSFs, others such as hedge funds, derivatives and private equity are not.
What’s the benefit?
In simple terms, the role of alternatives is to provide returns that may not be correlated to the major asset classes. Asset correlation is a measure of how investments move in relation to one another and when. When assets move in the same direction at the same time, they are considered to be highly correlated. When one asset tends to move up when the other goes down, the two assets are considered to be negatively correlated. When they move independently they are uncorrelated.
In theory the value of alternative investments is that they will rise or remain steady when the value of traditional asset classes fall, also noting that the reverse can also be true. If investors want to remain exposed to assets that have the potential to generate a strong return such as shares, but also want protection in the event of a market fall, alternatives may help limit losses.
One other benefit of alternatives is that they can help portfolios achieve their target returns with lower overall volatility which is helpful for investors in or near retirement.
Alternatives and asset allocation
One of the decisions SMSF investors have to make is what proportion of their portfolio will comprise alternatives and this will depend on the members’ own situation.
The allocation should match the overall objective of the fund as outlined in the investment strategy. Craig Day, Executive Manager at Colonial First State, says that for most SMSFs, “The share of the portfolio allocated to alternatives would be between 5% to 10% of overall holdings. This gives investors sufficient diversification benefits without being overly weighted towards alternatives.”
How can SMSF investors access alternatives?
While in the past alternatives have been difficult for SMSF investors to use because some require a high initial investment – for instance, investing in a commercial property can cost hundreds of thousands if not millions of dollars – they are now much easier to access.
You can access some alternatives through a managed investment or an exchange-traded product, which is a way to reduce the risks attached to alternatives given these structures provide diversification. Many managed investment vehicles use a “fund of funds” approach, meaning the fund is invested in a number of other funds. This reduces risk by not putting all your eggs in one basket through investing in just one private equity fund. Investing in a diversified alternatives fund means investors have access to multiple strategies spread across many different asset classes. So if one investment doesn’t perform, the whole portfolio won’t be lost.
For those who are more hands on and want more control, exchange traded funds (ETFs) now provide the opportunity to invest in alternative asset categories that were previously difficult and costly for the smaller investor to access. An SMSF could build their own fund of ETFs by putting together a range of alternative exposures including commodities such as gold and oil (to provide a hedge against inflation), currencies, infrastructure and commercial property. One of the attractions being ETFs often have a lower management fee than managed investments.
Hedge funds are another way of investing in a range of non-traditional strategies or asset classes. They are often actively managed and are a type of alternative investment that can provide diversity for investors. They are a specialised type of investment and the risk involved can be high. They aim to earn returns for investors that are better than traditional investments such as shares, fixed income and credit markets. They can have a very wide investment reach, investing globally and attempting to take advantage of falling markets by shorting.
Risks to consider
Alternatives cover such a wide range of investment assets that it’s difficult to list the specific risks for all. Some things to consider when choosing an alternative investment and the vehicle to access these investments:
- Generally have higher minimum investments and fee structures (including performance fees)
- Potentially complex investment structure and investment strategy
- Lower liquidity compared to traditional assets because these investments are not traded on an open market so may be more difficult for investors to sell these investment and cash out. Investors may be required to keep their money with the alternative investments or hedge fund for a set period of time
- Use of derivatives and short selling strategies can increase volatility and magnitude of gains and losses from investments. Also these arrangements may be with counterparties which may not fulfil their obligations
- The concentrated nature of the investment strategies of some hedge funds can leave them vulnerable to potentially very large losses
Alternatives cover a very wide range of asset classes and their performance and associated risks can differ greatly. However, alternatives can be a useful diversification tool in a broader SMSF portfolio because alternative investments can have a low correlation to the existing fund investments. Alternatives have emerged as an important option for all investors.
As always, it’s important to do your research before making a decision to invest and due to the complexity of alternative options seeking good advice is essential.