Alternative Assets Pose Risks

Terry Flanagan

With the economy still in the doldrums and bond yields at historic lows, investor appetite for alternative assets has increased, which means more risk management challenges for portfolio managers.

“Given the uncertain economic recovery and the fact that nobody expects bonds to deliver good returns over the next five to ten years, where do investors go?” said Laurence Wormald, head of research at SunGard APT, which provides portfolio risk management products and services. “We might have seen all the growth in equities so far this year, and rates can’t go any lower, so therefore you need proper diversification across a lot of other asset classes, which will challenge the risk management tools currently available.”

The characteristics of alternative asset classes such as private equity, high-yield bonds and emerging market debt are “less transparency and greater complexity,” Wormald said. “Macroeconomists talk about the ‘future path’ of the economy, but risk professionals don’t have a good model for predicting a future path of investments. Creating a model for risk is a genuine challenge.”

SunGard APT provides integrated risk management for the buy side. “Whatever your investment strategy, market risk management is a critical requirement for an investment firm,” Wormald said. “It provides the basis for effective action to address the potential downside for you or your clients in all market conditions.”

The Financial Industry Regulatory Authority has recently warned investors considering investing in alternative funds to be aware of the unique characteristics and risks of these investments.

Alternative or “alt” mutual funds are publicly offered, SEC-registered funds that hold more non-traditional investments and employ more complex trading strategies than traditional mutual funds.

“Investors should fully understand the strategies and risks of any alternative mutual fund they are considering. Finra is warning investors to carefully consider not only how an alt fund works, but how it might fit into their overall portfolio before investing,” said Gerri Walsh, Finra’s senior vice president for investor education.

Alt funds might invest in assets such as global real estate, commodities, leveraged loans, start-up companies and unlisted securities that offer exposure beyond traditional stocks, bonds and cash.

These funds also may employ complex strategies, including hedging and leveraging through derivatives and short selling.
Some alt funds are structured as a fund containing numerous alternative funds. Although the strategies and investments of alt funds may bring to mind those of hedge funds, alt funds are regulated under the Investment Company Act of 1940, which limits their operations in ways that do not apply to unregistered hedge funds.

Finra’s investor alert asks investors considering these funds to ensure that they fully understand the alt fund’s investment structure. An alternative fund of funds may offer greater diversification than a single-strategy or even multi-strategy alt fund. At the same time, this greater diversification may lead to a flattening of return and potentially less transparency.

One fund might be designed to capitalize on management expertise in a specific area (e.g. investing in distressed companies), while another might seek exposure to commodities, currencies and other alternative investments.

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