The need to diversify a portfolio beyond equities and bonds is more pressing in today's world, as prices of these asset classes now move more in tandem.
An International Monetary Fund financial stability report last year showed that returns from equities, bonds and commodities have become more correlated since the global financial crisis. That tends to increase the volatility of portfolios holding just these two kinds of assets.
To reduce portfolio volatility, investors can allocate a portion of their portfolios to alternative strategies, said Mr Matthew Riley, head of research for the portfolio research and consulting group, and Ms Madeline Ho, managing director and head of wholesale fund distribution for Asia-Pacific.
The case for doing so is boosted by the recent performance and outlook of these asset classes.
With bond yields at all-time lows, potential returns look uncertain, said Mr Riley. Equity markets also seem increasingly volatile. This makes diversification away from these asset classes more compelling. Such diversification would likely have reduced portfolio volatility and limited losses had they been implemented in the past, they added.
The portfolio research and consulting group analysed 2,500 client portfolios and conducted 2,000 fund comparisons for clients last year.
Q How are alternative strategies different from traditional equity and bond investing?
A Under traditional investing, an investor holds bonds or equities and earns a return when prices go up. However with alternative approaches, they make money from sources beyond such price increases.
These sources include falling prices, rising interest rates, weakening currency, leverage and so on.
Q Why is tapping a wider range of return sources a good thing?
A Some of the return generators of these strategies are different from those of equities and bonds. This means that returns from these sources are not always correlated with returns from holding stocks and bonds.
Using this strategy together with traditional ones tends to lead to less fluctuation in returns and a lower maximium portfolio loss over time.
We researched what would happen if 20 per cent of a typical moderate-risk Singaporean portfolio was allocated to alternative strategies from 1998 to 2016. Portfolio returns per unit of volatility for the resulting portfolios were often higher.
Q Why might investors want to consider alternatives now?
A If you look at bonds, over the last 35 years, interest rates have been falling. It's been a great time to be invested in bonds, as they do well when interest rates are falling.
Interest rates are now practically zero in most of the developed world and so this falling of rates can't continue forever. The Fed, for instance, raised rates in December last year. At some point, rates are going to rise again and when this happens fixed income typically does poorly.
Equity markets, we're finding, are more volatile these days. Plus there's more uncertainty in the world, for instance, over whether China is going to have a hard landing or if the US economy is going to enter a recession.
Given the headwinds facing these traditional asset classes, why not use a wider set of tools - alternative strategies - because they have the capability to make money independently of bond and equity markets.
Over time, the returns between fixed income and equity have also become more correlated. Thus diversifying only into fixed income is no longer as effective in reducing portfolio volatility.
Q What are some examples of alternative strategies?
A An example is the managed futures strategy. Under this strategy, a model signals to buy an asset when it senses the market is on an uptrend, and sell or short an asset when it judges there is a downtrend.
The model may for instance discern an uptrend when it sees the price of the asset cross and go above the 200-day moving average price of the asset.
Conversely, it may detect that the asset is on a downtrend when the price crosses and goes below the 200-day moving average.
The model's sell and buy signals can be executed automatically by computer programs.
Q How are returns sources for this strategy different from a traditional strategy?
A One example is that in a bear market, shares can be shorted at the beginning of the downtrend and then bought back after prices have dropped. This would not be possible if one were just limited to buying and holding stocks.
Q What is another alternative strategy?
A Another is the global macro strategy. A fund manager predicts where the global economy is going and then makes asset bets to leverage on that growth path.
For instance, if the asset manager predicts that China is going to grow, he could then purchase China stocks or bonds or currency.
If he expects that the Fed is going to raise rates, he could then invest in interest rate futures that would benefit from that.
Q How are sources of returns here different?
A Return drivers go beyond an upward movement in stock and bond price. Macro strategies may leverage on movements in currency and interest rate futures, for instance.
Q Are Singapore investors now more interested in investing in alternative strategies?
A In our survey of Singapore investors last year, many said they would consider alternative investments. Alternative investments include commodities, precious metals, hedge funds, managed futures and so on.
Among Singaporean investors with an adviser, around 80 per cent said they would consider these if their advisers recommended such products. Less than half said they understood these products.
Hence there is a keen interest in alternative assets, but a low level of understanding. The survey had 500 Singapore respondents and was performed in February last year.
Q How can someone get exposure to the managed futures or global macro strategies?
A They can invest in mutual funds or unit trusts. For global macro funds, investors can invest in the H2O MultiBonds Fund or H2O Adagio Fund managed by H2O Asset Management, an affiliate of our company. Currently, these funds are available to accredited investors in Singapore.
Some relatively well-known managed futures funds by other fund managers would be the Winton Futures Fund and Man AHL Diversified Futures Fund.
We plan to introduce a managed futures fund from one of our investment affiliates, US-based Alpha Simplex.
Q How should an investor choose such a mutual fund?
A For a fund that will make a core part of your alternative assets strategy, you want a manager to control fund volatility. He or she should set a volatility target and stick to it. You don't want the volatility to be 3 per cent in one year and 20 per cent in another year.
You also want a manager that can be flexible and employ different investment tools, as no strategy works in every single market.
Such a manager would have different tools; for example, tools one to three work when equity markets are falling, three to five work when bond interest rates are rising, etc.
Also, choose to invest in alternative assets or strategies for the long term.
Sometimes you get the manager wrong or the strategy doesn't work in the short term. But if you hold on for alternatives for a reasonably long period, then it's beneficial.