MT Wealth: Hedge Funds and other alternatives

In this instalment of our quarterly series on personal finance, in association with UBS Wealth Management, Steve Lodge broadens the portfolio.

Last Updated: 31 Aug 2010

Once upon a time, investors liked to think shares would double in value in five years, but over the past five years, many stock market investors will have made no profit at all. The bursting of the technology investment bubble in 2000 and the halving of the UK stock market's level through to 2003 have inevitably led to a greater focus on reducing risks and a search for new ways of making decent returns.

Buy-to-let residential property has been the most obvious beneficiary of this disillusionment with shares. But a new group of alternative investments has entered the mainstream, as hedge funds, private equity and venture capital, commodities and commercial property are increasingly considered.

According to many experts, these alternatives should add up to about 20% of affluent Britons' holdings. Their appeal has, inevitably, been boosted by strong performance in recent years. Advisers claim that the key attraction of alternatives is their ability to perform when other stock market investments fall in value, thus smoothing overall returns.

Says Paul O'Donnell, a managing director at UBS Wealth Management: 'Nowadays, clients talk about risk first, return second - they want to make money no matter what the conditions.'

This combination of performance and non-correlation is illustrated in the table opposite. It also shows how residential property has come out ahead of every asset type over the past five years. Residential property remains an alluring proposition for many investors, not least because of new rules offering tax relief and tax-free returns on properties held in pensions from next April. Against this, of course, are fears of falling prices.

For a really alternative way of trading, spread betting can be used to make money from falling house prices or other investments (see p73). By contrast, the 'alternative tax wheezes' box highlights the tax breaks available to help boost returns or at least provide a cushion against losses.

Here's how each of these increasingly popular investment alternatives works, how to invest in them and what to look out for.


The aim: absolute return in all market conditions

For some, hedge funds bring to mind George Soros' £1 billion profit from sterling's ejection from the European exchange rate mechanism in 1992. Others may recall the collapse of US firm Long Term Capital Management in 1998, the potential effects of which were considered so severe that the hedge fund was bailed out by the Federal Reserve.

This year, hedge funds have been variously dubbed 'locusts' by the SPD party in Germany, as short-termist and opaque by CBI president John Sunderland, and as risky as betting on horses by the Centre for Economics and Business Research think-tank. And that's before performance worries, including one estimate of as much as £18 billion of losses following the downgrading of General Motors and Ford bonds in May. Yet there has been an exponential expansion in the sector in recent years to 8,000 different funds and $1 trillion of assets.

'Hedge fund' is a wide-ranging description: what these funds invest in, how they invest and the risks they take vary enormously - and can be enormously complicated. But a common characteristic is the aim to deliver profits regardless of what happens to stock markets.

This 'absolute return' contrasts with that of traditional investment funds, which generally seek just to outperform a stock market index - even if that still means losing money. To achieve this target, hedge funds might go short (borrowing assets and then selling in the hope of buying them back more cheaply), gear up with borrowed money to increase exposure, and use derivatives. A typical strategy is 'equity long/short' - buying shares the fund thinks will rise in value while selling those it thinks will fall, so reducing overall exposure.

The aim to make money in all market conditions is clearly attractive to investors burnt by falling share prices, but it does make performance acutely dependent on how well the fund is managed. In practice, returns have been mixed. Overall, as the table shows, although hedge funds may have proved their ability to make money in the 2000-03 bear market, subsequently they have lagged behind the recovery in shares, while not always even beating cash.

Some argue that the flood of money into hedge funds has made it harder to profit from previous market opportunities and anomalies; others note that many managers have no special abilities. Funds can go bust, and most experts recommend a fund-of-funds to spread this risk. Individual funds are generally based offshore and require a serious investment of perhaps $100,000; funds-of-funds can be easily accessed in established investment trust format in the UK.

Management costs are another issue: typically, up to 2% of your investment a year plus 20% of any profits - high costs that, say critics, encourage managers to take huge bets in return for huge personal rewards. The FSA is considering making direct access to hedge funds easier, but UCITS 3 rule changes also allow traditional stock market funds to adopt some hedge fund-type techniques, such as going short.

Given the choice and sheer complications of the hedge fund universe, expert advice is vital. But as Justin Modray of advisers Bestinvest points out: 'If you're happy to take a long enough view, there's nothing wrong with a traditional stock market portfolio.' Or, indeed, shares with a good dollop of non-correlating cash.


Seeking to outdo shares in long-term returns

Business people should need little reminding that private equity is booming: well-known big businesses to be taken private in recent times include Somerfield, the AA, Debenhams and Yell, while nearly half of all recent M&A activity has been estimated as private equity-related. Moreover, nearly one in five of the UK's private-sector workforce is in a private equity-owned firm, while chief executives are said to be able to triple their reward packages by working in such businesses.

The typical private-equity deal involves a buy-out with lots of cheap debt, then direct involvement by the private-equity firm in transforming the business - with the aim of selling it on within three to five years at a big profit. Target companies tend to be established and with proven profits and revenues. Venture capital involves much smaller companies - often start-ups - that can occasionally go global, but frequently go nowhere or even go bust. This normally means higher risk, but private equity and venture capital have a common theme - to deliver long-term returns superior to those available on the stock market.

Venture capital investment has been driven by tax breaks in the form of Venture Capital Trusts (VCTs) - tax-free funds that also give 40% upfront income tax relief - and Enterprise Investment Schemes (EISs), which invest in single companies but also allow investors to defer capital gains tax (CGT) liabilities. EISs can also offer private investors direct involvement in the company as so-called business angels.

Investment trusts such as 3i and Candover are the easiest routes through which to access the private equity market. As funds, these will have a range of private-equity holdings and can be held in Isas for tax-free returns. They are also easily tradeable, which offsets the underlying commitment - so-called illiquidity - inherent in private equity investment.

The uniqueness of the underlying deals means that different funds can deliver very different returns, and investors should go for private-equity managers with a good track record in the types of businesses that they plan to take stakes in. Despite their tax breaks, returns from VCTs have not been impressive, and concerns have been expressed about high costs and the viability of small funds. However, both VCTs and EISs can also invest in AIM-quoted shares, which can reduce risks.

By contrast, private equity has delivered strong returns in recent years as managers have sold off fund-holdings at good prices. In turn, this has attracted a flood of institutional money. But this means that it may not be a good time at present for private investors to jump in, according to Simon Moore, an analyst at Bestinvest. In theory, the best time to make private-equity investments is in a recession, when businesses can be bought cheaply.

The UK private-equity industry is said to have £80 billion to spend this year. But the danger is that managers will overpay for deals and struggle to deliver decent returns when they resell in a few years' time.


High demand sends them booming

The high petrol price is just one sign that commodity prices are generally on the up these days. Although both geopolitical and climatic uncertainty played their part in the rising cost of oil - some experts predict that it might hit $100 a barrel if there was another severe supply shock - commodities have generally been booming as a consequence of high demand from China and other fast-developing emerging economies.

The prices of copper, gold and platinum have also hit highs recently, and some analysts predict that this is the start of a long-term commodity 'super-cycle'. In terms of non-correlation, gold has traditionally been regarded as a store of value in uncertain times and when investors are nervous about stock markets, while commodities generally do well when inflation rises.

The authoritative Barclays Equity-Gilt study has highlighted the diversification benefits of a 10% holding of commodities in portfolios, particularly at times of poor share and bond performance, when commodities often have good runs. Yet commodity investment can be a rollercoaster ride, with funds investing in natural resource companies rising or falling by as much as 10% in a single month, according to adviser Bates Investment Services.

Investing directly in commodities can be impractical and involve extra costs (and no income), so most investors will look at commodity company shares or vehicles for tracking commodity prices, such as spread betting.

There are also bonds that give an upside based on commodity price rises but protect your original capital.

Oil corporations BP and Shell are obvious plays on the oil market, but a high proportion of companies on the smaller AIM stock market are also oil or mining businesses.

Although these are much more speculative, AIM investments are exempt from inheritance tax after two years, and also qualify for favourable capital gains tax treatment.

Since emerging markets such as China haven't always converted high economic growth into high returns for equity investors, commodities could also be seen as something of a play on that growth story. Against that perception, fears of slowing world growth may hold back further rises in commodities, while some analysts have already warned of an unsustainable bubble.


Income rather than capital growth is the driver of returns

Most investors will already be heavily exposed to property through the value of their own homes (and perhaps buy-to-let), so it is fair to ask whether putting money into commercial property will help overall investment diversification, let alone bring good returns.

Commercial property has had a great run and experienced record investment last year, mainly from institutions that have long had significant holdings through pension and other funds. Compared with residential, commercial property has generally offered more stable returns and a higher yield, typically 5% or so currently - that income underpinned by upwards-only rent reviews and longer leases. 'Income rather than capital growth is the driver of commercial property returns,' says Rob Page of fund manager New Star.

Commercial property is generally also a play on economic growth, ebbing and flowing as it does with the expansion and contraction of businesses - which, in theory, means it tends to lag stock market movements. Investing directly in commercial property is probably beyond most investors - a single property might cost £500,000 - and risks skewing your portfolio too much to one investment. However, owning business premises through a pension is a tax-efficient option for many smaller businesses.

In most cases, the choice is between a fund investing directly in commercial property or property company shares. Property companies can borrow money, so are typically more risky and volatile performers, but you can always get out at short notice by selling your shares. Directly invested funds may limit disinvestment if it would make them forced sellers of underlying properties.

Given its lower risk, income and non-correlation attractions, commercial property could warrant a holding of up to 15% in some portfolios, says Paul Ilott of Bates Investment Services.

New Star's Page says continuing good performance lies in a benign economic environment without the commercial property oversupply of previous cycles.

But others believe prices have been bid up too far and could start to slide.


The more right you are, the more you win

Are you tempted by the idea of making money from falling house prices?

Or profiting from price drops in other assets such as shares and oil - or even the failings of your favourite football team? Spread betting is an increasingly popular way of trading - or, depending on your view, gambling - on financial prices and other events. It originated as a way to trade the gold market in the 1970s, and remains a potentially useful vehicle for unusual or otherwise difficult-to-access price movements.

One of the advantages is that winnings are tax-free and, despite the gambling tag, it's regulated by the FSA financial watchdog. To understand how it works, take the example of house prices. IG Index, the oldest and biggest spread betting firm, offers trades on national and regional house prices as measured by the Halifax's index. In July the average national house price was £162,600 (£239,000 in London). IG quotes possible prices for up to a year in the future, in this case £157,500 for June 2006 (£232,400 in London) - drops of about 3%. (Those end-prices move all the time, reflecting changing sentiment - for example, earlier this year, the year-on-year price implied a scarier 9% fall.)

If you think prices will fall by more than that 3%, you might place a 'sell' bet of, say, £100. If prices as measured by the Halifax turn out to be lower, say £150,000 (an actual drop of nearly 8%), this means that for every £1,000 of difference compared with the price you sold at, you would win £100, or £750 in this example. But if, instead, house prices rise or don't fall as far as IG suggests, then you lose £100 for each thousand pounds you are out.

Importantly, and as distinct from fixed-odds betting, the more right you are the more money you win, but also the more wrong you are the more you lose. This ability to lose more than your stake and for losses to mount quickly makes spread betting high-risk. At the extremes, some people have made or lost six figures on individual bets.

However, spread betting offers one of the few available ways to make money directly from the movements in property prices without buying bricks-and-mortar. If you think markets will just stay flat, spread betting offers an alternative way to make big gains from trading relatively small price changes.

For property bulls, it could be an alternative to the hassles of buy-to-let investment or a second home; if you had just sold your home, it could also be a way of keeping up with rising prices. And betting on falling house prices could be a way of making money to offset a drop in the value of your home - which you might well not want to sell.

As with the general boom in gambling on the internet, most spread betting is now done online. IG Index's Will Armitage claims that spread betters now form an 'eclectic range' from corporate executives to a 'very successful' greengrocer (unnamed), who bets using stock market charts.


- Venture Capital Trusts (VCTs) - Upfront income tax relief of 40% and tax-free income and profits, subject to holding for three years

- Enterprise Investment Schemes (EISs) - Upfront income tax relief of 20%, plus ability to defer previous capital gains tax (CGT) liability

- AIM (Alternative Investment Market) shares - Free of inheritance tax for shares held for two years, plus CGT taper relief

- ISAs - Tax-free income and profits from investments, including many private equity and commodity funds, and hedge funds-of-funds. Funds investing directly in commercial property will qualify for ISAs from April 2006

- Pensions - Upfront income tax relief of 40% on contributions, which can be invested in funds and directly in commercial property. From next April, it will be extended to alternative investments, such as gold, as well as residential property.

- Spread betting - No stamp duty payable and tax-free profits on trades that include falling house prices and oil or gold prices.

HOW HAS BEING DIFFERENT PAID OFF? Year-on-year returns (%) Investment index 2004/05 2000/01 2000-05 total Residential property (Halifax) 2 10 94 Gold (HSBC Global Mining) 27 23 83 Commercial property (Jones Lang LaSalle UK property) 14 10 77 Private equity (AITC investment trusts) 29 2 47 Commodities (Goldman Sachs commodity) 23 3 41 Oil & gas (S&P Oil & Gas) 38 16 39 Emerging markets (IFC Global Composite) 41 -16 33 Hedge funds (CSFB/Tremont) 8 13 19 Cash savings (Moneyfacts) 2 3 13 UK shares (FTSE All Share) 19 -8 -2 European shares (FTSE Europe ex-UK) 19 -17 -12 US equities (S&P 500) 8 -8 -25 UK smaller companies (FTSE AIM) 13 -33 -40 Source:

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