Now more than ever, portfolio diversification is critical. Recent market upheaval following the Brexit vote has begged the question: how diverse should a portfolio be? What should this look like in practice? And given that funds tend to be the most straightforward way for individuals to invest, what alternatives are there to mainstream quoted equity funds, and how can they be accessed?
Alternative funds can take many forms, but I’m talking particularly about small, niche funds run by management companies which are not big brands and have no ambition to become the next Fidelity or BlackRock. Their skill lies in spotting value that bigger rivals miss and pursuing strategies which don’t follow the herd.
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They may focus on assets which are “uncorrelated” to wider market movements, emerging market strategies or offer access to assets in other currencies – all attractive considerations as the FTSE and sterling see-saw – as a way of reducing risk and generating alternative sources of returns.
For example, third party commercial litigation funding is a fast growing area, in which investors help finance expensive commercial litigation in return for a share of the proceeds of successful claims. Since cases are resolved by the courts, irrespective of what is happening to asset prices in the wider economy, investors gain exposure to a non-cyclical, alternative asset, which can deliver attractive risk-adjusted returns.
It’s important to note that many of these alternative funds not only offset the impact of wider market volatility within portfolios, they can thrive on it too.
Hedge funds are a case in point. A hedge fund our clients recently participated in, designed to profit in both rising and falling markets, closed up over 2 per cent on the month in June, just as mainstream markets experienced high levels of volatility. Another, a global fund whose model relies on snapping up hedge fund interests in the secondary market at a discount, has seen its strategy boosted by the current uncertainty.
Volatility also plays into the hands of mezzanine finance funds such as those providing leverage to private equity deals. While private equity firms are keen to take advantage of price adjustments in the current climate, bank lending remains constrained, leaving an opening for alternative debt providers to step in on favourable terms.
Investors should view these as long-term investments forming a relatively small proportion of portfolios, balanced alongside cash, bonds, equities and property.
So how can they be accessed? These are not the sort of investments on offer from the traditional intermediary market, so private investors need to find their own way in. Moreover, they need a selection to provide choice and minimise over-reliance on any one fund.
High minimum entry levels rule out direct access for the most part, and such funds normally only deal with institutional investors. One way is to participate via a structured syndicate that pools capital from multiple private investors, managed by investment professionals acting as an institutional investor. This is an option which is increasingly gaining traction.
These kinds of funds aren’t suitable for everyone, but for experienced, sophisticated investors, they could be a good way of reducing portfolio risk and taking advantage of a volatile market. It’s all about finding the silver lining.