Alternative Investments The Trend Toward many people viewed foreign markets Incorporating Alternative Investments with a high degree of skepticism. Exotic Hedge Funds and Many individual and institutional investors and risky are two terms that come to have been introducing or increasing their mind. And yet, since that time, many Managed Futures allocations to “alternative” or non- astute investors have embraced traditional investments in their portfolios. international investing as a key element in a Portfolio Why? Because, in short, the poor market of building a diverse portfolio. In the performance of 2000 – 2002—the same way, investors today are intrigued weakest period for the stock market by the benefits that early adopters of UBS Financial Services is pleased since the 1970s—drove investors to seek alternative investments have been seeing to provide you with information investment strategies that were more since the 1990s—chief among them about alternative investments. independent of market movements. diversification. These investors want There are a few points we would They sought portfolio performance that insightful guidance on how best to like to raise with you at the outset. wouldn’t hinge on the traditional asset understand and evaluate the classes of stocks, bonds, and cash—and opportunities provided by alternative This article is for educational and this led them to alternative investments.1 investments, in both a general and a informational purposes only. It detailed sense, that accounts for their does not constitute investment Alternative investments—defined here as own investment goals and portfolio. advice. Among other things, it hedge funds, managed futures, private does not take into account your equity and real estate—can play an This brief introduction to alternative personal financial situation, or important role in creating a complete investments provides an overview of the your investment goals or strategies. portfolio solution. With their diverse role hedge funds and managed futures You should not construe any sources of return and relatively low can play in a portfolio. Since hedge information provided here to be correlation with traditional asset classes funds and managed futures share several an investment recommendation such as stocks and bonds, alternative similarities—both investment approaches for you to follow. You should investments have the potential to reduce are based primarily on tradable securities contact your Financial Advisor for risk and/or enhance returns when such as stocks, bonds, options and information or recommendations included in a diversified portfolio. futures—for our purposes here we are that may be useful specifically including managed futures within the to you. Alternative investments often are broader hedge fund category. We’ll misperceived, much as international include private equity and real estate investing was a generation ago when in subsequent pieces. UBS is the world’s largest wealth manager 2 and is one of the largest participants in the alternative investments industry, managing and distributing more than $100 billion3 in client assets. Our global team has relationships with many of the world’s leading hedge fund, managed futures, private equity and real estate firms. We bring this elite talent to eligible individual and institutional investors. 1 Hedge Fund Research, Inc. (HFR) September 10, 2007, www.hedgefundresearch.com 2 Source: Scorpio Partnership, June 20, 2007, www.scorpiopartnership.com ab 3 Source: UBS. Figure as of June 30, 2007 1 Alternative Investments We realize that our clients’ financial Hedge Fund Strategies Some of the more common sources goals and needs differ. You may be The alternative investments category of return are alpha generation, beta particularly focused on growing or has evolved rapidly over the past ten exposure, risk premium and leverage. maintaining family business interests, years and with it the number of funds, multi-generational planning or strategies and styles available to Alpha and Beta philanthropic funding. We’ve found that individual investors. The term “hedge Alpha is defined as the manager’s when individuals or families begin to fund” is often used as a catch-all phrase added value on a risk-adjusted basis. think about how their assets will benefit to imply that all funds are the same. An example is the extra return a portfolio future generations or worthy causes, A hedge fund is really the packaging, earns by superior stock selection after an important shift takes place: These or the investment structure. The key is comparing the beta of an appropriate investors begin to think and act more like to examine the underlying investment benchmark. Beta expresses the variance institutional investors than as individual strategy and the techniques that the between an investment’s return and its investors. The types of strategies that fund is pursuing. Some examples include benchmark. A stock with a “high beta” may be appropriate for a “lifecycle” funds that pursue event-driven strategies, has been more volatile than its portfolio—more stocks at a young age, such as investing in a company that benchmark index, while a stock with more bonds toward retirement—become has been or will be influenced by a a low beta has been less volatile than less so. Multi-generational investing merger or regulatory changes; global that benchmark. requires a total return approach that macro strategies that hinge on will surpass inflation, taxes and fees, fluctuating economic situations and Alpha and beta often are tossed around while preserving and growing wealth. currencies, such as currency trading. as “good” and “bad” indiscriminately. Alternative investments have the Even within one strategy—equity hedge We say “indiscriminately” because potential to achieve these goals. (long/short) —one hedge fund manager the roles of alpha and beta must be might employ “low net” exposure (more understood within the context of Whether one’s investment objective hedged) while another might favor one’s overall investment objective. is wealth preservation or capital long-biased exposure (closer to 100% Beta exposure is not necessarily bad; appreciation, there are many different net long). Hence the term “hedge fund” if markets trend higher over time, types of strategies within alternative is simply the start of a much more it is beneficial to have some beta investments from which to choose. detailed conversation. exposure in a portfolio. Our goal here is to provide valuable initial guidance on how these strategies Sources of Return can be introduced into a traditional Every strategy should be examined portfolio. We hope that this information and employed within the context of will prompt helpful conversations about its potential for return. Because hedge alternative investments between you funds generate returns that are less and your Financial Advisor. dependent upon market performance, it is important to understand the underlying return drivers for hedge fund strategies. 2 Alternative Investments Risk Premium Some strategies, such as directional Risk premium can be defined as the ones including equity hedge, can be amount of return earned by bearing viewed as managing market exposure risk that others may seek to avoid. (beta) plus security selection (alpha). For instance, high-yield bonds pay a Many non-directional strategies, such as higher rate of interest to investors to fixed-income arbitrage, earn their returns compensate for the risk their lower by exploiting a spread (risk premium) credit ratings carry. Option sellers earn based on duration or credit rating and premiums when they provide other magnifying this spread with leverage. market participants with puts or calls for hedging or speculating purposes. Risk Factors The most common risk factors for Leverage alternative strategies include the direction Leverage—using financial instruments or of the stock market and its volatility, borrowed capital—is often used to interest rates and credit spreads. By increase the potential return of an examining the sources of return for a investment. A simple example is buying strategy, specific variables or risk factors securities on margin to benefit from an can be identified as having a tendency to expected increase in the price of a stock. influence the returns of these strategies. As long as the gains from price returns Evaluating risk factors is an important exceed the cost of borrowing, the trade step in building a portfolio. is profitable. Other forms of leverage include options, futures or swaps that The sources of return and risk across have embedded leverage because of the alternative strategies are based on relatively small initial capital required to the components of the strategy hold these positions. These types of employed and the style of the manager. trades can be used to increase returns Evaluating these strategies requires both or provide downside protection and can a qualitative and quantitative approach. magnify all of the return drivers present Before looking at specific risk statistics in hedge funds and managed futures. that may be helpful to compare investments, it is important to have an in-depth knowledge of the strategy and the manager’s style. 3 Alternative Investments Pursuing Asymmetric Return In short, many investors place a high • Supplying risk management/ Opportunities: The Goal value on consistent, positive returns that “selling insurance” to other market of Alternative Investments minimize participation in down markets. participants (risk premium