Investors are increasingly looking for cover from the global stock markets, which have seen significant levels of volatility since the financial meltdown in 2008.
While strong global economic growth this year is expected to boost earnings, investors are seeing that they need to diversify their holdings beyond just conventional assets.
RHB Head of Wealth Insight, Ryan Tong Yee Chow, CFA, CAIA, says that as mainstream assets face limitations, sophisticated investors are seeking customisable investment products with different risk and return characteristics.
“Alternative investments, such as private equity, long-short funds and structured products, used to be a black box with high barriers to entry. On top of that, they were deemed expensive, risky and difficult to understand.”
As time passes, alternative investments are becoming popular with strong demand, witnessed by its expectation to grow at 9.3% annually to US $13 trillion by 2020, according to the PWC report “Asset Management 2020: A Brave New World”.
In fact, the report goes on to say that alternatives will effectively move into the mainstream to the extent that the term “alternative” may no longer remain in common usage by 2020 in some parts of the world.
“With markets having become accustomed to the ultra-low interest rate environment for the past decade. The negative yielding government bonds at US$10 trillion in 2017 has been a deterrent for investors. As a result, investors are shifting away from mainstream investments, such as the US Treasuries, to alternative investment, which offer a higher yield,” says Tong.
Alternatives will become part of the toolset employed in retail products as investors seek strategies with the prospect of alpha and protection against downside risks.Avoiding tail risk: key lesson from global financial crisis
Some types of structured products based on derivatives — such as credit default swaps, collateralised debt obligations and mortgage-backed securities — had racked up a poor reputation and were blamed for causing the global ﬁnancial crisis in 2008.
“However, the main criticism shall be deregulation. Banks were allowed to use deposits to invest in derivatives. The practice was later driven by greed, with the assumption that housing prices would grow indefinitely. The musical chairs stopped when the US property bubble burst, resulting in a mortgage crisis in the country, then a spillover to become a global ﬁnancial crisis,” explains Tong.
He adds that investors who were heavily invested in tail-risk-embedded structured products suffered major blows to their portfolios at that point.
“Morgan Stanley has issued a warning that the bull market might be coming to an end, so we suggest investors to avoid structured investments that are exposed to tail risk or short volatilities. Products that are less correlated with mainstream assets are recommended,” he says. Morgan Stanley cited that the market has priced in the ﬁscal stimulus, including the tax cut, and valuation was nearing its peak.
Alternative investments range from very conservative products where the principal sum is protected upon maturity, to short-tenured and very aggressive products, through which investors could lose more than they had initially invested.
But these opportunities are not for everyone, says Tong. “It requires patience before one can reap the beneﬁts, with some investors even holding on to an undervalued stock for many years but barely seeing any movement.
“Besides, when the overall market sentiments are negative towards a particular undervalued asset, it is not easy to take on such positions, which are against the majority, as investors tend to herd when it comes to decision-making.
“Therefore, we suggest investors to explore avenues offered by financial advisors and fund managers to capture undervalued opportunities instead of randomly betting on it,” he says.
He adds that alternative investments, such as structured products are customisable, so the tenure can range from days to years while the returns can vary.Illustration of alternative
Products like private equity provide access to investors to pool their money and invest in companies before their initial public offering. In general, however, private equity offerings are illiquid and carry higher risks, but also greater rewards.
Long-short funds allow investors to buy into equities that are expected to increase in value and short sell equities that are expected to lose their value.
“These strategies tend to have a low correlation with equities and bond markets, with the aim to deliver absolute returns during all market cycles,” says Tong.
“Structured products, are investments that will typically have ‘interest payment’ and ‘redemption upon maturity’. However, the amount of the payoff depends on the movement of stock prices, indices, exchange rates or future interest rates, using customisable structures. These products can provide great flexibility in terms of the payoff, tenure, and even the underlying principles but they can be complex with less liquidity,” he adds.
Tong points out, however, that alternative investments are becoming mainstream with more individual and institutional investors opting for diversiﬁcation while most of the conventional assets closely correlated during crisis (refer to chart).
For an optimal portfolio, Tong says that one can opt to allocate up to 20% in alternative asset classes but there are no “holy grail solutions” when it comes to asset allocation. This depends on the investors’ appetite for risks and market conditions.
“Alternative investments should not form the core of one’s portfolio, but can complement the performance, especially in a volatile market,” he says.
He says that roughly 23% of alternative investments make up the composition of the global sovereign wealth funds.
“For example, on the tactical front, dual currency investments would enable one to capture some potential upside (with also downside risks) in the major currencies or even commodities like gold. “We ﬁnd the euro, yen and pound sterling will have upside potential, underpinned by strong economic growth and labour markets,” he says.
On top of that, income boosters (available in the form of structured products and unit trusts) would be a good ﬁt for investors who are trying to participate in potential market upside while aiming to protect their capital, upon maturity.
Range Accrual: principal-protected investment upon maturity with potential coupon payment depends on the movement of the underlying factors such as currency pairing, interest rate.
One Touch: principal-protected investment upon maturity with potential coupon if underlying asset pricing have touched the pre-defined trigger rate.2. For balanced investors
Dual currency investment: where clients select a currency pairing (or gold) and the tenure. They then receive a fixed coupon and stand the risk of converting into weaker currency upon maturity, which is not principal-protected.
Income booster: Principal-protected investment upon maturity with potential income payment (with multiplier, if any) and depends on the movement of the underlying such as an unit trust fund.3. For aggressive investors
Knock in Knock out option: a structured product consisting of two barriers. The payoff for the coupon and principal varies according to the movement of the underlying, in it can be a stock or an index.
Tong adds that the demand for alternative investments will continue to rise as this year is expected to be a turning point in the global markets with the return of manic volatility across equities, bonds and currency exchanges.
“Yet, we ﬁnd opportunities in commodities, which are poised to rally further, with (crude) oil leading the pack. On the other hand, alternative investments might provide potential returns in equities, bonds or even the forex markets with relatively lower volatilities, provided that they are held until maturity,” he says.