Dig deeper

Liquid alternatives should be a bigger part of your investment jigsaw, writes Brian Flanagan.

Drawdowns are the biggest enemy to wealth creation and broad diversification across many different uncorrelated risks is the very best protection against this threat. At the time of writing this article, it seems 2016 is shaping up to be a poor year for equities. But how bad can it be?

Drawdown figures of the global financial crisis reveal that US equities fell 50% in the crisis and the Eurostoxx 50, with dividends re-invested, fell 58%, requiring a return of the magnitude of 138% to get back to the previous high point on the index.

The Global Financial Crisis has been labelled a one-in-80 year ‘non-normal’ event. However, we know non-normal events happen more frequently than every 80 years. Remember the WorldCom Scandal, 9/11 terrorist attacks, the technology bubble collapse, Flash Crash, European debt crisis, the Russian debt default, the ERM crisis, the collapse of LTCM, the Asian financial crisis, the Japanese banking collapse, the Latin American debt crisis and 1987 equity collapse? The drawdowns attached to these events again and again destroyed wealth that had been accumulated.

Given that these events occurred every few years, and the workings on the benefits of diversification have been in circulation in the financial markets since the 1950s, you might ask why investors and advisers keep getting caught out so badly again and again? But there are probably several answers to this question.

ACCESSING ALTERNATIVES

In previous crisis’s in the ’80s and ’90s, capital markets were still opening up and access to markets alone, never mind alternatives, was not that easy. For example, it wasn’t until 1991 that investors could access a commodities index when Goldman Sachs launched the GSCI.

So truthfully, there were not many alternative asset classes that retail investors could actually buy. In short, the smaller investor couldn’t diversify enough because the choice wasn’t there.

There is an old saying in the investment management business, likely coined in a bear market which simply says: “the only thing that goes up in a down market is correlation”.

So although some investors had alternatives in their portfolio, the alternatives they had were not liquid enough and ended up, due to the illiquidity, falling at the same time as equities fell and became more correlated.

So are investors and advisers more prepared now than they were previously? My guess is that some are, some think they are but their alternatives are not liquid enough, and some just aren’t.

The vast majority of current products out there which are fitting into portfolios as alternatives did not exist at the time of the financial crisis in 2008.

Since 2008, it has all been about monetary policy stimulus, which are aimed to do ‘whatever it takes’ to bring growth back to the world’s largest economies. We have a near zero interest rate market, and a raging bull market.

Alternative products in the period 2009-2015 have found it hard to keep up with the torrid pace delivered by equities. If you have alternatives that have managed to keep up with these unyielding equity markets, then fair play to you for the near term wealth accumulation and foresight. But my guess is many alternative plays are really some form of leveraged beta plays, and from a risk- budgeting standpoint, you might want to take a closer look, and soon.

Liquid alternatives came into being for precisely the reason of diversification and that they remain uncorrelated to equity markets.

Brian Flanagan, Friends First

FUTURE PROOF INVESTMENTS

When looking at alternatives funds choice take the time to dig deeper than the fund prospectus. Think about the following points: Are they really just products or long-term solutions; do they operate in truly proven liquid markets; will they be the desired shock absorber in the next equity bear market; did the performances and correlations deliver the unexpected in 2008; and will they preserve the wealth building desires of your clients over the long-term?

Since 2008, it has all been about monetary policy stimulus, which are aimed to do ‘whatever it takes’ to bring growth back to the world’s largest economies

You can wait to know the answers to all these questions when the next bear market ends or you can look deeper into these alternative funds now and do well in the next bear market.

Alternative funds currently available for pensions and investments in the Irish markets are, currency funds, property, commodities, market neutral, global macro hedge funds, long short funds, emerging markets, absolute return funds, and most recently, target volatility equity funds.