When sharemarkets are volatile, investors run to defensive assets. These days there are plenty of alternatives to the more traditional fixed interest and bonds. 
 
Story Barbara Drury 
 
It’s been a testing year for investors, with sharemarkets in turmoil and global property teetering on shaky foundations. At times like this, investors scan the horizon for alternatives and they are finding them in some unlikely places. From hedge funds to timber plantations, airports and gold, alternative investments are moving out of the wings and onto centre stage. 
 
Basically, alternative investments are anything that doesn’t fit into the mainstream categories of equity, property or fixed interest. 
 
When sharemarkets fall as quickly as they did earlier this year, investors need to rely on the diversification of their asset allocation to ensure that a crash in shares or any single asset class can’t wipe them off the board. Traditionally, bonds and fixed interest are used as defensive assets to fall back on when financial markets are volatile. Increasingly, alternative assets perform this role. 
 
Now that financial markets have developed the technology to securitise big lumpy assets such as timber plantations or power stations, assets that were once the province of institutional investors and extremely wealthy individuals can now be bought and sold on the Australian Securities Exchange (ASX) or via an investment platform by regular folk. 
 
Asset Allocation 
To get some idea of the value of alternative investments in a balanced portfolio you need go no further than the superannuation industry. 
 
Over the past five years industry super funds have outperformed retail funds, thanks n part to their early adoption of alternative investments. Over the past five years the median industry fund has returned 11.59 per cent a year compared with 9.84 per cent a ear for the median retail master trust. That’s differential of 1.75 per cent. 
 
Jeff Bresnahan of SuperRatings says part of the outperformance is due to the lower fees charged by industry funds, but some is also due to asset allocation. 
 
The typical industry super fund balanced portfolio has 15 per cent of its money in alternatives, with infrastructure and private equity the preferred investments. MTAA Super, which has been the top performing super fund for the past seven years, has a staggering 42 per cent of its balanced portfolio invested in alternatives. By comparison, the allocation to alternatives in a typical master trust is 5 per cent. 
 
“MTAA took the decision about 10 years ago to get hold of good quality assets such as airports and toll roads. A lot of funds are now looking overseas for these types of assets,” says Bresnahan. 
 
In most cases the shift to alternatives has been at the expense of fixed interest. In other words, alternatives have assumed the defensive role once performed by bonds. But they can also be used to improve overall portfolio returns, reduce risk and provide capital protection in falling markets. 
 
Rashmi Mehrotra, head of retail at Mercer, explains that alternatives fall into a very wide bucket, so before you go fishing around for products it’s worth grouping them according to their function and risk/return characteristics. 
 
The first distinction is between alternative asset classes and alternative strategies. 
 
With the former, returns will come from the underlying market, be it timber, private equity or infrastructure. With alternative strategies, namely hedge funds, returns come from the manager’s skill in outperforming the market. Mehrotra says alternative can be further divided in terms of whether you want to generate returns or reduce risk. 
 
For example, private equity, infrastructure and timber can be used to provide returns when the value of mainstream asset classes is falling. And hedge funds can be used to reduce portfolio risk by curbing volatility and smoothing long-term returns. 
 
But it gets more complicated than that. Mehrotra points out that while some hedge funds can be used to reduce risk, others are loaded up with leverage to maximise returns. 
 
“Within every asset class there are defensive and aggressive investments. You have to look at the underlying assets”, she 
says. 
 
While some big super funds can make a case for having almost half of their money allocated to alternatives, it is more difficult for individuals to get their hands on quality investments. Fees are often high, liquidity can be low, products can be complex and you may be expected to tie up your money for a long time. 
 
Individual investors can’t compete with the professionals for a chunk of big infrastructure projects or private equity investments, but there is a growing range of managed investments that provide access to these previously inaccessible corners of the investment universe. 
 
Mercer, Van Eyk and Select Asset Management have released diversified funds which pre-package a range of alternative asset classes and managers. 
 
For example, Mercer’s Diversified Alternatives Fund invests in a range of managers, assets and strategies including hedge funds, private equity, infrastructure, debt and structured products. It has a minimum investment of $100,000 via a product disclosure statement but is available on major platforms. 
 
The alternative market has developed so rapidly over the past decade that there is something for everyone, provided you do your research and go in with your eyes open. 
 
Infrastructure 
Infrastructure assets such as toll roads, airports, power stations and car parks typically offer long-term cash flows often guaranteed by governments and monopoly positions that insulate them from economic downturns. Returns also tend to be less volatile than returns from equities but higher up the risk and return scale than fixed interest. 
 
Over the past decade returns from infrastructure funds have ranged from 9 per cent to 13 per cent a year, before tax but after fees. 
 
While the current market turmoil makes returns difficult to predict, Lonsec infrastructure analyst Paul Pavlidis forecasts long-term returns of 8-10 per cent a year, with local infrastructure investments returning closer to 8 per cent and global products at the higher end of the range. 
 
Ken Marshman, managing director of investment consultancy JANA Investment Advisers wrote recently that infrastructure returns have been supported by low interest rates, global economic growth and the availability of cheap debt to fund acquisitions. Unfortunately, these favourable conditions have all but evaporated. 
 
On the plus side, Marshman says rising inflation is less of a concern because revenues from many infrastructure assets are linked closely to inflation. As a result, rising inflation could produce excellent relative returns for infrastructure investors. 
 
Growing demand for these investments has resulted in more players seeking a dwindling pool of quality assets, making some of the deals being done less attractive for investors and altering the risk/return equation. 
 
Pavlidis says the best way for retail investors to gain exposure to infrastructure is via a diversified unlisted fund. Two funds highly rated by Lonsec are Macquarie International Infrastructure Securities Fund and Magellan Infrastructure Fund. 
 
More recently, a number of hybrid funds have come onto the market. Typically, these funds invest in a mix of unlisted funds and listed infrastructure assets. “This provides more stability for investors,” says Pavlidis, who recommends AMP Capital Core 
Infrastructure Fund. 
 
“The key is to be well diversified,” says Pavlidis, who points out that infrastructure securities funds typically invest in 20-80 global stocks, each with multiple assets in a wide range of locations. 
 
Private Equity 
Until recently, private equity was the domain of über-wealthy buyout specialists who scanned the globe for promising but underperforming companies they could knock into shape, sell and reap the often huge financial rewards. 
 
It’s only in the last few years that individual investors of relatively modest means have been given the opportunity to grab a slice of the action. 
 
ING PEAL (Private Equity Access Limited) is a listed fund with a multi-manager portfolio invested in more than 70 underlying investments. While long-term capital growth is the main objective, it also provides a dividend yield of around 6.5 per cent. Macquarie Global Private Equity Securities Fund also offers a diversified portfolio of private equity investments, with some yield on top of the anticipated capital growth. 
 
Agricultural Commodities  
There are very good reasons for investing in agriculture. As the global population grows and wealth increases, demand for food is also on the rise, especially for premium products such as red meat, dairy products and grains such as wheat. 
 
At the same time, land scarcity, soil degradation and water shortages are putting pressure on supply, not just of food products but commodities such as timber. So what could go wrong? 
 
Food production is often held hostage to seasonal conditions, drought, flood and climate change. Volatile commodity prices and market distortions created by legislative changes and government protectionism in many countries make agriculture a high risk, cyclical industry. 
 
Last year the Federal Government announced that the Australian Taxation Office would scrap the 100 per cent upfront tax deduction on contributions to nonforestry managed investment schemes (MIS) from 1 July this year. This will apply to agribusiness schemes operating a wide variety of beef cattle, horticulture, viticulture, aquaculture and cropping ventures. 
 
Forestry MIS will continue to offer a tax deduction beyond 30 June provided that at least 70 per cent of the expenditure is spent developing plantations. 
 
Without the financial stimulus of tax deductions it will be increasingly difficult for agribusiness schemes to raise capital for new projects. 
 
The ATO is preparing a test case to test whether investors in agribusiness MIS are carrying on a business for tax purposes or whether their investment should be treated as a capital investment. 
 
Tim Lee, research manager at Australian Agribusiness Group doubts there will be a court decision before 30 June, 2008. Unless the ATO announces an extension of the current arrangements, investors seeking tax benefits will be limited to timber projects next financial year. 
 
For investors who want to avoid the MIS uncertainty, Lee says there are two listed agribusiness funds. The Timbercorp Primary Infrastructure Fund aims to buy and develop agricultural properties including associated infrastructure and permanent water rights. The Ark Fund is an agricultural property fund set up by the Rewards Group. 
 
While these funds are structured as equity, Lee says they act more like property trusts in terms of their risk and return profile. On the MIS front, Lee says some of the plantation timber offerings from Gunns, ITC, Rewards Group, Tropical Forestry Services (TFS) and Forest Enterprises Australia (FEA) still offer good value. 
 
Lee says returns from timber, on an after-tax, internal rate of return (IRR) basis, range from 6.5 per cent to 8.5 per cent for woodchip, and 10 to 12 per cent for nonmainstream timbers such as sandalwood and mahogany. 
 
The lower returns from woodchip reflect its status as a shorter-term, lower value commodity, with a typical investment term of 10-13 years. By comparison, higher value timbers take up to 20 years to mature, so their higher returns come with higher risk. 
 
Hedge Funds 
By their very nature, hedge funds are designed to smooth out investment returns but require a long-term commitment of at least five years to do their job. The aim is not to shoot out the lights but the long-term preservation of capital. 
 
There are thousands of hedge funds – more than 1100 in the Asian region alone. Last year, despite the market turmoil, Asian hedge funds had their best year since 2003, with an average return of 18.9 per cent. Hedge funds use a mixture of strategies, including short selling where investors take a punt on a share price or market falling. 
 
Short selling is the practice of selling borrowed securities the seller does not own, in the hope of repurchasing them again later at a lower price. 
 
Most retail investors are advised to begin with a hedge fund-of-funds, an umbrella trust which includes a diversified portfolio of hedge fund managers and strategies. These funds typically aim for low volatility and low correlation with shares and bonds, but they are not immune from short-term market turmoil. Even so, investors could expect smaller falls on the way down and lower highs on the way up. 
 
Lonsec hedge fund analyst Bronwen Moncrieff says that after several high profile collapses, Lonsec is watching the managers on its radar very closely. She currently has seven hedge fund-of-funds on her recommended list, with HFA Diversified Investment Fund rated highly recommended. HFA targets an absolute return of 8-12 per cent a year, net of fees, and achieved an annualised return of 9 per cent over the five years to the end of February. 
 
Investors after more specialised single manager strategies can choose from a wide range of Australian and global equities long/ short funds, that is, funds that aim to make money whether share prices are moving up or down. The price of specialisation is often an increase in volatility and the risk/return profile. 
 
For example, Smallco Investment Fund, a long/short fund specialising in small cap Australian equities, aims for long-term absolute returns of 15 per cent. It achieved this and better in the five years to the end of February, producing returns of 24 per cent a year net of fees despite a negative return of 30 per cent for the latest 12 months. 
 
Hedge funds are sold through privately distributed prospectuses or, increasingly, listed managed funds. Most are available on major investment platforms, some with a minimum investment of as low as $2000. 
 
GOLD 
Gold has asserted its traditional role as a safe haven in recent months, as investors shy away from the ailing US dollar. The yellow metal broke through the $US1000 an ounce barrier in March, after being as low as $US650 an ounce only last August. While governments no longer tie their currency to the gold standard, gold is still used as a proxy currency and a natural hedge against inflation when paper money is in oversupply and falling in value, as it is in the US. 
 
While the strengthening Aussie dollar has taken some shine off the gold price for local investors, there are still a number of ways individuals can make money from gold, short of stocking up on gold jewellery, coins or bullion bars. 
 
The ASX offers two listed gold tracker funds which provide securitised ownership of gold without having to buy actual bullion. For each unit of Gold Bullion Securities, investors receive one-tenth of an ounce of gold bullion, held in a London bank vault, for one tenth of the gold price. 
 
Similarly, Perth Mint Gold Quoted Product gives investors the right to buy one-hundredth of an ounce of gold on or before a specified date. The price of each unit at any time is one-hundredth the dollar gold price. 
 
If you are interested in a pure exposure to the gold price, shares in gold mining companies are not recommended because they come with sharemarket risk, exploration risk and hedging risk attached. However, there are a number of listed exchange traded funds (ETFs) specialising in gold stocks – the largest is streetTRACKS Gold Shares – which track major sharemarket indices and offer the benefits of diversification across the gold sector. 
 
Gold’s status as a safe haven in uncertain times is likely to underpin the gold price for some time, with some volatility along the way, providing long-term positive returns for investors.