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Enter at your own risk

When markets become boring, as ours seems to have done recently, it is tempting to look elsewhere for investment excitement. Not that this is necessarily easy to find. Like me, you are probably disenchanted with the number of unsolicited phone calls extolling the virtues of landbanks, carbon trading or solar panels. No wonder the regulators are becoming exercised over the practices adopted by many so-called alternative investment providers.

When I started my investment career, alternative investments were hardly ever mentioned. They existed in some form but only for the very wealthy. Property was the most common but there were opportunities in commodities, private equity and venture capital, too, not to mention fine art, wine and antiques. It was domestically based, with punitive taxation discouraging overseas ventures.

Today, the list has widened considerably. Infrastructure projects, agricultural products, property of all types and, of course, the skills of the hedge fund manager all might reasonably be described as alternative. Moreover, many have been packaged in such a way that even investors of relatively limited means can consider them as part of a diversified portfolio. But do they really add much for the average investor?

The argument in their favour is that they can broaden risk away from assets that have degree of correlation in terms of likely performance. This is true in some measure but can be misleading. For example, at times of great financial stress, such as the period immediately after the collapse of Lehman Brothers, all assets have a distressing tendency to fall in unison as investors look to turn their portfolios into the only perceived truly safe haven cash.

Then the degree of correlation can be concealed or even not recognised at all. The failure of LongTerm Capital Management, a hedge fund that included a number of Nobel laureates as advisers, more than a decade ago was less to do with unreasonable bets than failing to understand that the diversification of the risks taken was flawed. A collapse in the value of one subasset class held led to a sell-off in another, placing the fund under strain. But still investors and their advisers seek the pot of gold that can lead to untold riches if the circumstances turn out right. In some instances, better returns might reasonably be expected – but only because greater risks are being undertaken. Private equity, as a further example, led the performance tables for closed-ended funds for many years until the credit crunch exposed the added risk of refinancing deals that were only made attractive by the level of gearing undertaken at the outset.

To dismiss all alternative investments simply on the basis that they are too difficult to understand properly would be unreasonable but it does concern me that some advisers have in the past made recommendations based more on the marketing hype than proper considered research into the product. Hedge funds, for example, embrace as many asset classes and investment styles as the whole universe of open-ended funds and hedge fund managers are just as capable of going through difficult performance periods as any other manager.

I have made a selection of alternative investment calls of my own over time. Perhaps my concern at the way in which they can be used inappropriately is down to the fact that they number among the least successful investments I have made. The choice has always been mine and my subsequent disappointment has hardly been mitigated by learning that the risks were apparent but simply unrecognised by me. Any adviser venturing into this territory needs to take even greater care than usual.

Brian Tora is an Associate with Investment Managers, JM Finn & Co

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