Green light for new alternatives

FSA plans to allow funds of alternative investment funds (FAIFs) to be marketed to retail investors from next year could see these vehicles enter mainstream investors’ portfolios.

Recent stock market volatility has highlighted the usefulness of funds that make money in any market condition, and supporters of FAIFs, which include funds of hedge funds, believe their introduction will provide retail investors with another diversification tool.

So how will these funds fit into traditional asset allocation? What will they look like? And what alternatives are available to retail investors in the meantime?

Alternative investments already exist in various forms outside the FSA’s jurisdiction. These include close-ended funds listed on stock exchanges and offshore open-ended versions. Fund of hedge funds managers like Gottex, Sigma and Dexion, all of whom run successful London-listed portfolios, may not be household names but are used regularly in the private client world.

Structured products and multi-asset funds - a popular launch by multi-managers following the government’s decision last January to allow the more flexible Non Ucits Retail Schemes (NURS) to be held in ISAs – could also be classified within the alternative category.

Pryesh Emrith, hedge fund and structured product analyst at Charles Stanley, says it views alternative investments as a separate asset class and uses them to diversify portfolio risk further.

Their lack of correlation with traditional assets like equities, bonds and property is particularly attractive. Research by the broker shows that since 1990 the HFR conservative funds of funds index, which measures the average returns of funds of hedge funds, has not only outperformed the MSCI but been less volatile and less risky, Emrith says. “Funds of hedge funds have made good gains when the market is down and equities have been unable to catch up.”

However, most alternative investments demand high minimum investments and fees, are relatively illiquid and lack transparency. They are also complicated to explain to clients.

Jim Wood-Smith, head of research at Willaims DeBroe, believes this could prevent them being embraced swiftly by the mainstream, although he adds that fees are coming down and transparency is slowly being addressed.

Williams DeBroe uses FAIFs regularly in portfolio construction. Interestingly, Wood-Smith says it has recently been advising clients to make a wholesale switch from commercial property - usually comprising about 5% of a typical portfolio - to funds of hedge funds. With commercial property prices looking stretched, he believes Faifs are a better lower risk option. “Funds of hedge funds provide the sleep at night element,” he said.

A number of groups with hedge fund capabilities including Schroders, Old Mutual and Gartmore have indicated they are interested in entering the retail FAIF space, pending the FSA’s final proposals.

Simon Wilson, head of marketing at Old Mutual, says the risk/reward characteristic of funds of hedge funds has made them a popular tool in pension fund management and retirement planning and he believes demand is growing. “We are seeing much more appetite than three years ago.”

To allow the development of FAIFs, the FSA plans to lift the existing 20% investment restriction into unregulated funds for NURS products. This will mean they can invest 100% in unreguated funds although there is still debate about whether certain alternative investments will not be allowed under the revised NURS rules.

Because of this providers say it is too early to predict what retail FAIFs will look like.

Furthermore, Simon Vernon, head of fund regulatory strategy at Schroders, believes retail expansion will not be quick. “It has taken time for the full power of Ucits III products to gain traction and so it will probably take a long time for these products [FAIFs] to see the light of day.”