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Exploring the "Alternatives" - Eureka Report Article

September 4, 2006
Exploring the "alternatives".
By Scott Francis

PORTFOLIO POINT: Professional investors are allocating a small proportion of their portfolios to alternative investments, a good recipe for smaller investors.

What is the key determinant of investment success? Whether we like it or not, the answer is asset allocation. The apparently simple business of allotting amounts of money into various segments such as cash, shares or property will ultimately be the most important move you make. But in the past decade, the choices within asset allocation have changed. The rise of "alternative assets" such as private equity, hedge funds and direct investment in infrastructure projects has redrawn the landscape for all investors.

Some of the most successful institutional funds are run by managers pushing the boundaries of traditional asset allocation. MTAA Super (the Motor Trades Association of Australia Superannuation Fund) has topped the rankings of industry funds for several years by running a portfolio that has half the funds in alternative assets. More conventional corporate funds such as Qantas now have 16% of funds in alternatives.

Should private investors try to catch up with institutional fund managers who are pouring money into these new areas? Yes, they should but only if they clearly understand investing in "alternatives" because the terms can mean different things to different people. For example, many private investors believe investing in agricultural tax schemes is an alternative but fund managers rarely go near this area. Similarly, fund managers increasingly invest in private equity, an area that is virtually unknown to private investors. Before you get to grips with what's ¡§alternative¡¨ you have to understand the basics of asset allocation.

Asset allocation refers to the way an investment portfolio is split between various asset classes. These asset classes include growth assets and defensive assets. Common growth asset classes include Australian shares, international shares, listed property investments and direct property investments. Defensive asset classes include fixed interest and cash investments.

In the Financial Analysts Journal in 1991, Gary Brinson, Brian Singer and Gilbert Beebower updated their 1986 article Determinants of Portfolio Performance. This study examined 91 US pension funds during the period 1974 to 1983. The study looked at three factors to see which made the biggest difference to portfolio returns. The first was asset allocation; the second was security selection, which were the investments within each asset class that the managers actually chose. The third factor was market timing ¡X the ability of the portfolio manager to move from underperforming asset classes to better performing ones. That is, choosing the best time to invest in each asset class.

The results were conclusive, with more than 90% of the variation in returns explained by asset allocation; 4.6% of the variation in returns was explained by security selection and 1.8% by market timing.

Two more articles explore this further: Does Asset Allocation Policy Explain 40, 90, 100 Per Cent of Performance? by Roger Ibbotson and Paul Kaplan in the Financial Analysts Journal in 2001, and Another Look at the Determinants of Portfolio Performance by Craig French for the Social Science Research Network in 2003. They found that asset allocation policy explains more than 90% of the variation in total portfolio return. This supports the original study by Brinson, Singer and Beebower.

Intuitively, it is reasonable to consider that asset allocation is the significant driver of portfolio performance. We can expect that most well diversified investors will get an investment return within 2%, plus or minus, of the index return. However, the difference in returns from the underlying asset classes will vary more substantially.

In 2004-05, the index return for international shares was 0.1%, the index return for Australian shares was 24.7% and the index return for listed property trusts was 18.1%. The average return on a cash management trust was 4.5%. Regardless of whether an active manager was able to beat the index by 2% or trail it by 2% because of costs, the results would have been determined primarily by the asset classes in which the investments were held.

Over the five years to June 2005, Australian shares returned an average 10.1% a year. International shares returned negative 5.7% a year and listed property trusts 15.4% a year. Clearly, the percentage of a portfolio exposed to each asset class is crucial in driving the overall portfolio return.

For private investors, the key issue in asset allocation is the widening gap between investment allocation as practised by professional fund managers and asset allocation at the retail investor level.

Just how different have the two forms of asset allocation become? As a proxy for the average, self-directed investor, I have used the asset allocation for superannuation found on page 24 of the Eureka Report book Making Money: Alan Kohler's guide for the independent investor (Random House 2005). The asset allocation proposed in the book is:

mMaking Money  Asset allocation for self-directed investors

As a proxy for the average professional investor, I have used the June 2005 APRA report on superannuation funds, which nominates the average asset allocation of the ¡§default¡¨ superannuation option for each fund. The default option is the segment of the fund in which funds are placed if members do not provide further instructions to the fund. The majority of money in superannuation funds is within default options.

So most investors in most funds have their money in default options, which are usually a ¡§balanced¡¨ investment option. Across the superannuation industry, asset allocation for the default option is as follows:

mAPRA 2005 Annual Superannuation Bulletin
mAsset allocation, professional investors

The interesting aspect of comparing these two graphs, asset class by asset class, is not how different they are but how similar they are. There is a 2% or less difference in the asset classes of Australian shares, international shares, property and cash investments.

The primary difference between the two graphs is in the asset class "other". In the individual, self-directed investor's asset allocation there are no investments recommended in the "other" investment category. The professional investors have allocated 10% of their fund to this asset class. The asset class referred here to "other", being the non-traditional assets, is more commonly known as "alternative assets".

If this is the biggest difference between the two groups of investors, self-directed and professional, then we need to drill down further into it.

To look further at the "alternative assets" used by professional money managers, I have done a very random sample of superannuation funds. I have looked at a mix of government funds, industry funds and retail funds; and within each I looked at the investment option that has the highest proportion of alternative assets to determine the maximum exposure these funds are comfortable with, and which alternative assets are held, or potentially held by the fund.

Because of the difficulty of finding exact data, I have based some funds exposure to alternative assets according to their target allocation; in other cases it is their actual exposure.

mFunds' portfolio allocation
Fund % of alternative assets Alternative assets used
Government funds
Q Super
Infrastructure and private equity
Hedge funds and commodities
Vic Super
Australian private equity
NSW State Super
Unlisted equity (private equity)
Mature infrastructure
Industry funds
Qantas Super
Hedge funds
Infrastructure and private equity
Emerging markets equity
Uni Super
Infrastructure and private equity
Infrastructure and private equity
Hedge funds
Opportunistic property
Retail funds
BT Multi Manager Growth
AMP Flexible Lifetime Super
Hedge fund strategies
Private equity
  Venture capital
  Mezzanine finance
  Private debt

As a financial planner, the clients that I see will most commonly use two investing categories as alternatives: hedge funds and agricultural investments. Although hedge funds are commonly represented amongst the professional money managers, only Q Super has any scope for agricultural investments, and that is limited to timber. It seems the professionals have little time for truffles, olives, abalone or any other agricultural investments so enthusiastically promoted to self-directed and retail investors.

The major alternative investment classes held by professional investors are private equity and hedge funds. The range of portfolios exposed to these alternative asset classes in the sample we looked at ranged from 0% through to a maximum of 16.7%. This is a significant minority of the overall portfolio assets.

Let¡¦s quickly look at the definition of each of the alternate asset classes used by the professional investors:
  • Hedge Funds: These "trading funds" use aggressive strategies including gearing, short selling (a technique that will see them profit from falling investments) and trading derivatives.
  • Private Equity: A company that is not publicly listed on a stock exchange.
  • Venture Capital: Investments in the very early stages of a company's life cycle.
  • Emerging Markets: Investments in countries that are still developing; for example, China and Indonesia.
  • Infrastucture: Investments in assets such as toll roads, airports, communication towers and ports.

What does this all mean for the individual, self-directed investor? Professional fund managers clearly see alternative investing in a different light to private investors: there are five key lessons to be learnt.

Lesson 1: Asset allocation matters

If asset allocation is the primary driver of investment returns, and the research is unequivocally clear that it is, then you need to think about the asset allocation of your portfolio. Too much time is spent thinking about investment activity at an individual level with not enough spent thinking about investment activity at an asset allocation or portfolio level.

Lesson 2: The professionals don't get excited by agricultural investments

Agricultural investments are among the most actively promoted investments. Yet the professionals don't see enough value to invest in them. This is a sound strategy for individual, self-directed investors as well.

Lesson 3: Alternative investments are small part of professional portfolios

Let's do the maths on this. If the average professional portfolio has an exposure of 10% to alternative investments, and they expected the returns to be 4% ahead of the returns from a sharemarket investment, the expected increased return for the overall portfolio is only 0.4%.

Now, getting an extra 0.4% return is better than not getting a 0.4% return; however, we can see that alternative investments are only being used to put some "cream" on the top of the investment returns.

For an individual, self-directed investor, it is not as though they are forgoing significant investment returns by ignoring these alternative asset classes. Importantly, should they wish to invest in alternative investments, they should learn from the professional investors and only do so with a small amount of their capital.

Lesson 4: Hedge funds, infrastructure and private equity are the most common alternative asset classes amongst professional investors

All three of these asset classes are available to individual, self-directed investors. There are any number of hedge funds available through most fund managers. There are any number of listed hedge funds, infrastructure funds and listed private equity funds on the Australian Stock Exchange. Details of these can be found on the ASX website under the heading Listed Managed Investments.

Lesson 5: Alternative investments are when mezzanine finance belongs

Only one of the funds we looked at, AMP Flexible Lifetime Super, had a place in its portfolio for mezzanine finance, and it was in the alternative asset class section. This is where mezzanine finance, such as the Westpoint investments, belong. In fact, I would say there is a powerful argument that unsecured notes and debentures should only be used in this area of your portfolio.


Asset allocation is the primary driver of investment returns: this should be at the forefront of every investor's mind. When we take a look into what is happening in the portfolios of professional investors, we see that in many ways they follow a conservative approach to building a portfolio, allocating the majority of their funds to the traditional asset classes of Australian shares, international shares, property, fixed interest and cash investments. They only venture outside this with a small amount of their portfolio, seeking a small amount of additional return from alternative asset classes. It's a good recipe and one that also makes great sense for independent, self-directed investors.