Investment is one of the purest art forms left in the professional world. It is intensely subjective and judgmental, even though some of the...

Investment is one of the purest art forms left in the professional world. It is intensely subjective and judgmental, even though some of the best quantitative minds have been directed towards the discipline.

Success in the business has major determinants well outside the influence of the manager himself. Markets remain stable for several years and then change dramatically; rather like the progressive movement to failure of the San Andreas fault. It has been said that there are no professional investors — only gifted amateurs. It is a profession where only the mediocre believe they are good. After all, professionals built the Titanic — not the Ark!

Once in a while, the investment world throws up an individual who does well in a particular environment. These are the great fund managers: John Templeton, George Soros and Warren Buffett to name a few. They have all written and spoken about the above sentiments.

There are, of course, many highly experienced investors in the market who are very good at making a satisfactory return for their clients. If they are in it for the long term they have almost invariably learned the basic rule of money management.

This is primarily risk mitigation. All of the "greats" above have taken big selected bets only where they felt that they had a real insight. Their analysis of the risks involved had been primarily assessed from first principles. The investment by a standard Robert Fleming Investment Trust was more global and invested in more emerging markets in the 1930s than it does today, let alone 20 years ago. It was truly diversified.

Seeking diversified returns
Templeton started by picking up industrial stocks at the end of the Great Depression, seeing World War II would hedge his risks. Soros bet against sterling in 1992 assessing that the UK government could not hold the market. Buffett has been willing to take billion dollar stakes in large companies down on their luck – with hindsight, we know that his risk was hedged against the interest rate collapse of the nineties. In each case, their decisions were driven by a perception of the risk that was different from that of the markets. They were decisions, founded on their own judgement and analysis, which could have gone wrong.

The longer a fund manager stays in the business, the more he/she realises that managing money is about risk reduction — NOT taking extra risks. Investment risks are a given — if you invest you have to take the risks. Hedging that risk is key.

Equity investment in small, unlisted companies has always been one of the nettles that fund managers have hesitated to grasp. Over the last two decades, even the Swiss, traditionally more methodical and conservative with new investment classes than more aggressive "Anglo" investors, have moved their clients' money from cash and bonds into equities.

They have progressed from holding few equities even in Switzerland, into Germany, the UK and the US. They then added some Asia, and from there into the emerging markets and currently into alternative investments such as hedge funds and private equity. Investment by even UK pension funds in Siemens, Deutsche and Daimler were regarded as being ambitious in the early 1980s, but is seen now as being too mainstream for the mainstream.

Emerging alternatives
Emerging markets were useful for portfolio managers seeking extra returns in the late 1980s and the 1990s. This sub-asset class comprised markets relatively untouched by international investment as much as by fast growing, less developed economies.

Emerging market investment ranged from India to Indonesia (not Hong Kong, which is sometimes confused as being emerging!) to Austria, Norway, Poland and Hungary, Israel, Egypt and even Jordan. Anywhere where fast economic growth, international demand, low liquidity and low market maturity are combined.

Emerging markets allowed investors — especially in the early 1990s when the US market seemed as if it would never grow again — to pick up excess performance by diversifying their portfolios away from more correlated main markets. Even when Japan at last faded in the early 1990s, there was always performance to be found in the rampant growth of the Asian Tigers, India and South America —and often with US$ ADR's to soften the currency blow. It was easy to diversify by geography.

But by the Asian crisis of 1997 and the NASDAQ crash of 2000, investors were beginning to appreciate that no longer were they able to get successful diversification through geography alone. By 2000, almost all global stock markets, including India, Brazil and Thailand (although significantly excluding China in this cycle) were strongly correlated to the global cycle through US economic growth. As the US market was suffering from "irrational exuberance", it has subsequently recycled market falls around the world much faster. We can additionally blame sector theme investing for dramatically increasing global correlations in key sectors of the economy such as telcoms, financials, construction, oil, semiconductors or pharmaceuticals.

Hedging becomes proactive
The latest fashion in the investment markets is that for hedge funds. There are four or five major hedge fund styles but in essence they hedge out broad market movements to benefit more closely from movements in underlying securities. They use the growing ability of investors to sell equities short or to use derivatives to otherwise hedge portfolio holdings. The use of debt to leverage the portfolio can give an element of spice to the underlying equity-linked performance.

Sometimes hedge funds can disappear up their own analysis, by re-hedging the hedges, and ending up with a risk profile that is difficult to understand, let alone manage. The simple argument might then be to stay in long equity.

One of the most famous examples of this led to the 1998 collapse of the hedge fund LTCM which boasted a board comprising multiple Nobel Laureates plus some of the most experienced, able and richest brains of Wall Street.

The long bull market run in technology in the 1990s allowed an obvious sectoral mismatch of performance. Hedge funds could prosper by simply going long technology and short industrials. This "no-brainer", momentum-driven investment strategy lasted long enough for hedge funds to build up an enviable reputation for performance. They also spawned a plethora of technology sector funds that were seriously caught out in the technology crash of 2000/2001 by lacking the protection of both real hedging and diversification.

Latest figures once again prove the law of the ancients that it is not possible to make a nice purse out of a pig's ear and that risk is unalterably related to return. There is no free lunch. The hedge fund investment process is not easy to explain to clients, and returns cannot always match consistent benchmarks as long-only funds can do. The comfort of having fund returns differ from globally correlated equity returns comes at the price of higher fees and lower liquidity.

What can be said for the hedge fund technique is that investors can expect to receive long-term, long-only equity returns with the added advantage of lower volatility than with a naked long-only fund. The use of a weighting of hedge funds in a multiple asset-class portfolio is likely to contribute positive returns.

Hedge fund returns are less correlated to major market movements. When working to hedge a multiple asset-class portfolio, they can be classed as alternative investments.

Alternative investments
The advantage of being able to hedge away global market correlation, and to do it with some liquidity, has enabled hedge funds to become the primary investment vehicle for the primary alternative investment class for institutional investors and for their retail and private clients.

Interestingly, they currently have little competition in the alternative investment asset class except perhaps from their cousins, the guaranteed investment fund, where a certain asset is capital protected at some level by a hedge.

Alternative investments as such have been around for a long time, especially in private banking. Property is of course the biggest and the most dominant, although not easy to access in financial investment form at the private end of the market. Art, fine wines, horses and venture capital have been touted by many a private banker to high net-worth individuals as alternative investments.

What is clear is that alternative investments are here to stay and will increasingly form a key part of multi-asset portfolios.