Paul Smith of Triple A Partners explains how clients should approach investments in alternatives – especially hedge funds – and looks at how investors can avoid making common mistakes.
Date: May 2011
For instance, it might be anything from 100% of their portfolio, down to the more typical 5% to 15%.
Investors should also be clear in their understanding that the term “alternatives” covers a very broad range of investments, making it difficult to talk about them in any single group. So at one extreme there is private equity, then the classic hedge funds, then more obscure things like carbon trading or forestry, and at the other end of the spectrum the emerging and frontier market buckets.
Identifying which of these are suitable to different investors really depends on individual objectives and risk appetite, said Smith.
What to look for in hedge funds
When looking at investing in hedge funds, Smith said that investors need to understand that a classic hedge fund is actually a conservatively-managed vehicle.
It is meant to hedge investors against market falls. So typically, he explained, the average hedge fund aims to capture two-thirds of the upside in a bull market and hopefully only on-third of the downside in a bear market. Over a complete investment cycle, therefore, it will come out ahead and compound-out much better than tradition investments, said Smith.
However, he added, most Asian investors who look at hedge funds want something results-driven rather than conservatively-driven.
This is why, historically, Asian clients have often invested in the worst type of hedge funds, he said – those which are short-term and performance-driven, and therefore eye-catching in terms of the potential return profile, yet not necessarily sustainable in the long term.
Part of the problem, explained Smith, is that most hedge funds which are based in Europe and North America have already been sold in those parts of the world before coming to Asia, so only become available in this region at the tail end of their investment cycle – or in other words, meaning investors in Asia tend to buy at the top and sell at the bottom.
Plus, he added, Asian investors fundamentally don’t view hedge funds as long-term investment propositions.
Falling under the high-returns spell
According to Smith, the hedge fund industry is always looking to find products which investors will buy, so this inevitably means catering to a person’s greed through offering high returns. This results in leveraged vehicles which promise a superior return but usually at considerable risk.
Given that the classic hedge fund is a relatively boring proposition to many investors in Asia, it is hard to sell, he said.
While people should want a real return of 5% to 6% per year given today’s low interest-rate environment, they want instead to aim for returns of 25% to 30%, despite the fact that this is only possible by over-stretching from a risk perspective.
The problem, said Smith, is that investors in Asia think they can make 15% to 20% per year consistently by investing themselves in their home equity markets, so don’t want anything less than that from a fund manager.
Effective due diligence
According to Smith, the best due diligence any investor can do on a hedge fund is to find other people who have invested with the fund and get a personal reference.
While it is still essential to look at managers’ track records, third-party service providers, accounts and to do other sensible checks, he said the key thing when conducting due diligence is to find someone you know and trust who has invested over a number of years in the same investment, and get their honest opinion on their experience.