Investing in alternatives and SMSFs

What’s the benefit of investing in alternatives?

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 and when investments move in relation to one another. 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. (But keep in mind the reverse can also be true!) If investors want to invest in assets with the potential to generate strong returns (such as shares), but they also want some protection in the event of a market fall, alternatives may help limit their losses.

Alternatives and asset allocation

If you’re interested in investing in alternatives through your SMSF, you’ll need to decide what proportion of your portfolio will comprise alternatives. What’s right for your fund will depend on your individual 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?

In the past, alternatives have been difficult for SMSF investors to use because some of them require a high initial investment – for instance, investing in a commercial property can cost hundreds of thousands, or even millions of dollars. But these days, alternatives are now much easier to access.

You can access some alternatives through a managed investment or an exchange-traded product. This can be a way to reduce the risks attached to alternatives, as 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 (compared to 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 of ETFs is they 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 they can provide diversity for investors. Since they are specialised investments, the risks involved can be high. Hedge funds 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 of them. But here are some of the things you should consider when looking at alternative investments:

• Alternatives generally have higher minimum investments and fee structures (including performance fees).
• They may have potentially complex investment structures and investment strategies.
• Compared to traditional assets, alternative investments tend to have lower liquidity because they’re not traded on an open market. This means it may be more difficult for investors to sell alternative investments 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 alternative investments. Also, these arrangements may be with counterparties who 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.
  
  

Summary

Alternatives cover a very wide range of asset classes, so their performance and associated risks can differ greatly. However, alternatives can be a useful diversification tool in a broader SMSF portfolio because they may have a low correlation to the fund’s existing investments. Alternatives have emerged as an important option for all investors.

As always, you should do your research before making a decision to invest. Because of the complex nature of alternative investments, it’s also wise to seek professional advice.

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