The art of alternatives

Investors are always being told that diversification is the key to minimising risk. It is sound advice and generally true. Unless, of course, the asset classes you have used all fall at the same time, which is exactly what happened to many investors during the financial crisis. As a result, investors have been left with scars and investments that will take time to heal.

This is not just because the wounds were so deep but because their recovery is being hampered as global markets experience new pain from a number of sources. Events in the Middle East and North Africa, the tragic events in Japan and New Zealand combined with lingering doubts over the global financial outlook is causing renewed volatility in the markets.

What does all this mean for investors with an eye on retirement? Well, the majority of Sipp portfolios are held in equities and other assets whose values are tied to the performance of financial markets. As the feeling of uncertainty spreads, negatively affecting the value of their Sipp holdings, the question for many Sipp investors will be, what is the cure?

The answer for some could lie in alternative investments, asset classes uncorrelated to traditional financial markets. PDL International recently conducted research which found that 55 per cent of pension advisers would consider rec-ommending alternative assets that are uncorrelated to financial markets within a Sipp portfolio.

Interestingly, the research also found that around the same proportion of advisers (48 per cent) would look to move clients towards these assets as they approach retirement.

Clearly, there is a strong body of opinion that believes diversifying Sipp portfolios with alternative asset classes could be the medicine to remedy the effects of the jitters in the markets.

While the financial crisis and recent global events are affecting the markets in the short term, many investors planning for retirement will look at the long term. If they look at the FTSE, for example, it is still below its level 10 years ago.

As JM Keynes once said, the difficulty lies not so much in developing new ideas as in escaping from old ones. It is not surprising, therefore, that many adopt equities and bonds as default but a number of investors are seeking new ideas and asset classes that can give returns but are not linked to traditional financial markets. In alternatives, many are finding just that.

So, what does this mean for pension advisers? Clearly, there is a significant opportunity to present clients with a range of alternative investment options. However, this means there is also a significant need for advisers to understand what the options available are.

In developing a full understanding of the products and how they work, advisers will then be able to decide which clients suit which products and, just as crucially, which ones do not.

There are indeed a wide range of options that fall under the banner of alternative investment although some are perhaps better known than others. What is certain is that the risks posed by these investments are different from traditional options, which is why a full understanding of them is needed.

Take insurance-linked investments, for example. In 2010, FSA head of investment policy Peter Smith warned advisers and investors against investing in life settlements without understanding the risks involved. These are not the risks of prices fluctuating but instead risks regarding longevity or possible counterparty risks.

Smith’s comments were absolutely right. A different asset class will carry different risks. No one should ever consider advising on or inv-esting in an emerging asset class such as life settlements without properly understanding them. Sticking with the example of life settlements, the full facts will reveal that new products have been developed that mitigate many of the risks levelled at them. Many advisers are indeed coming to the conclusion that for sophisticated Sipp investors, they will make an excell-ent addition to a diversified portfolio.

There are other alternative investment options that have low correlation to traditional financial markets such as forestry funds, some types of hedge funds or even art and fine wine. These work very well within Sipps because they are typically a long-term investment. In buying a piece of forest land to preserve, for example, investors can generate uncorrelated return year on year over a 25-year period.

With the ongoing sovereign debt crisis in the eurozone, the uncertainty in the global financial markets does not look likely to disappear any time soon. As a result, many Sipp advisers are keener than ever to learn more about uncorrelated asset classes. Their objective is clear – to secure the best retirement possible for their clients. That is why advisers are increasingly of the opinion that alternative asset classes make such good sense for Sipps. They can offer a beacon of security when other equity investments may be suffering, ultimately securing a better return for a retirement portfolio. Alternative investments could be just what the doctor ordered.

Diversify: ’There are other alternative investment options that have low correlation to traditional financial markets such as forestry funds, some types of hedge funds or even art and fine wine’

Should a Sipp investor be considering alternative investments for their Sipp portfolio?

Five questions to ask:
What proportion of their portfolio is suffering as the jitters in the markets continue?
2: What level of protection and real diversifi-cation does their portfolio have from the financial markets?
3: Are they comfortable diversifying their port-folio with a few new and different investments? And, importantly, do they know what the alter-native options are?
4: Does their long-term plan for retirement rely on the performance of the financial markets alone?
5: How comfortable are they investing in forestry funds, life settlements, art or wine?