Last year alone, alternative assets under management surged by 20 per cent to US$1.26trillion worldwide last year, according to a survey released last month by Watson Wyatt.

Sally Wong, executive director of the Hong Kong Investment Funds Association, notes that here in Hong Kong 15 authorised hedge funds have been launched since 2001, along with four real estate investment trusts and numerous equity funds, which provide a proxy to commodity markets and real estate.

The popularity of alternative investments, which has been spreading from private banking downstream to the core affluent market, has its roots in the meltdown of financial markets at the turn of the century, when many investors found themselves over-exposed

to equity markets and scrambling for new places to park their money. Hedge funds, real estate and commodities caught the eye as attractive investment options during the period between 2001 and 2003, when stock markets languished.

'Investors saw the value of adding these asset classes to the portfolio in terms of the possibility of providing higher risk-adjusted returns,' said Ms Wong.

Get diversified

Stephen Gollop, chief executive of independent investment adviser Bridgewater, says investors have never had a wider range of alternative investment options and should seek to leverage the opportunities to create a truly diversified investment portfolio.

'Holding different shares in different sectors in different geographical locations does not produce any meaningful diversification,' he says. 'You have to find assets with little or no correlation and then hold them at the right time.

'I still do not understand why bonds are retained long term to reduce volatility. Historically, bonds have struggled to return anything above inflation, and in their bad years, such as 1995, many lost as much as 25 per cent.

'Bringing in alternative strategies provides the potential for most asset classes in a portfolio to be positive each month. And if you have weighted the various asset classes to provide real diversification, then the portfolio should be positive most months.

'A low percentage of negative months, minimising losses and compounding positive returns are the key factors in good long-term results. Genuine diversification [through alternative investment strategies] is the surest way of achieving these objectives,' Mr Gollop says.

Storm clouds in the United States

One of the chief arguments for introducing more alternative investments into portfolios currently centres on the US economy, according to Mr Gollop. If upward pressure on interest rates were to tip the US economy into recession, as some economists fear, no equity market would be left undisturbed.

'Take a look at what happened in May, because of fears over inflation rising in the US. The S&P 500 Index dropped by 12 per cent and every market followed. The far better-priced emerging markets lost an average of 20 per cent. India, which has strong price-earnings ratios, gave up 36 per cent, and even China - who in February of this year was still sitting on a minus position for the Shanghai index over five years - lost 5 per cent.'

Mr Gollop says he would not generally recommend holding more than 25 to 30 per cent in 'selected equity sectors', and not more than 10 per cent in bonds

'So you could say we are holding around 60 per cent of our portfolios in alternative assets, but then our definition of alternative is very broad,' he says.

Hedge funds

There are many hedge funds strategies that could provide a portfolio with diversification. Some worth considering, Mr Gollop says, include: multi-manager funds, which will give investors exposure to diverse strategies and access to carefully chosen funds; mergers and acquisitions arbitrage strategies, which anticipate corporate deals and make bets on price movements in the stocks involved; and distressed securities strategies, which generate value by breaking up and selling the assets of the expiring company, or putting together a new business plan and initiating new management.

A careful fund selection is critical, and this is especially true of hedge funds, says Derek Young, chief executive of ipac Asia, which do not have the transparency, good governance and continuous valuation of mainstream funds. Unlike conventional funds, unauthorised hedge funds are not bound by regulations regarding governance and how they manage money. The situation lends itself to malpractice, he says.

'There is a high failure rate associated with hedge funds, and most of these disasters have related to organisational malpractice, such as fraud or the inability to quantify risk,' Mr Young says.

Hedge funds also tend to depend entirely on the skills of the individual investment manager to make the right bets, which leaves investors vulnerable if the manager they have entrusted money to decides to leave.

Another challenge for investors interested in hedge funds is that the risks associated with such funds are difficult to quantify.

'There are a number of hedge fund indices, but they all suffer from survivor bias. They do not record data from failed managers. This is a particular concern because hedge funds have a much higher exit rate than conventional funds. The attrition rate of hedge funds is now around 15 per cent, and this results in their returns being overstated by 2 per cent per year, which is a very significant discrepancy,' Mr Young says.

Ipac's research concludes that only the top 5 per cent of hedge funds are worth investing in, Mr Young says. And they are accessible only to wholesale investors, such as the multi-manager fund run by his company.

'We do not recommend any of the current crop of retail hedge funds, which are too small and lack transparency and liquidity. These are all characteristics of hedge funds that fail,' Mr Young says.

Commodities and other options

Thankfully, there is more to alternative investing than hedge funds. Mr Gollop says some of the other alternative strategies Bridgewater has identified for clients includes traded futures funds, which often concentrate on the commodity sector, looking to exploit market pricing inefficiencies; income-driven strategies, which focus on investing in secure sources of income, such as commercial property funds and real estate investment trusts; and special situation funds, which aim to identify investment opportunity where the risk of losses are minimal.

Mr Gollop says commodities that have benefited from a bull run stretching back to 1999 have also served investors well in the past three years, as energy prices have skyrocketed.

Although commodity prices are often associated with high price volatility, the commodity futures index provides almost the same return as stock markets in the past 45 years, but with significantly less volatility, he notes.

'If investors are contemplating investment now, we suggest caution to energy sectors where huge gains have been made in recent years. However, long term still looks good. Likewise, many base metals are in a similar position and if the US were to slow down quicker than the US Federal reserve is hoping, this would have a short-term effect on global demand and therefore negative to prices.

'For us, there is a much stronger argument for holding precious metals and agricultural [soft] commodities. Gold and silver are still cheap, and underground stocks are likely to be exhausted within 15 years.

'These are the great inflation-proof assets, which make silver ridiculously cheap when you consider that it now stands at around the US$12 p/ounce level against US$48 back in 1980,' Mr Gollop says.

He also notes that the price of wheat, adjusted for inflation, is trading close to its

100-year low.

Gaining entry

Investing in alternative investment strategies traditionally carries minimum capital hurdles that only the super rich and the institutional investor can clear. Minimum purchases may start from US$100,000, which means an investor's portfolio would need in excess of US$1 million to attain an appropriate level of diversification.

However, by using a custodial dealing platform provided by an independent financial adviser, access is often lowered to US$10,000, which would not result in overexposure for a portfolio of just US$40,000 (HK$312,000), Mr Gollop suggests.

With respect to commodities, investors can attain exposure through authorised equity funds, which primarily invest in listed companies with business exposure along a commodity's value chain, says the HKIFA's Ms Wong. Gold funds, for example, may invest in companies as diverse as gold mines and jewellers. US-listed exchange traded funds linked to commodities indices are also available to investors who have US stock trading accounts. Another way for retail investors to gain entry to alternative investments is through multi-manager funds, which comprise a diversified portfolio of best-in-class specialist funds, Mr Young says. Minimum capital requirements for such funds of funds come as low as US$10,000, making them ideal for the retail investor.

Five ways to diversify

Bridgewater chief executive Stephen Gollop identifies ways to branch out from stocks and bonds

Hedge funds

The traditional 'non traditional asset'. Hedge funds use a variety of strategies, but success is ultimately down to the fund manager, and the really good ones are few and far between.

Commodities

In the middle of a bull market and providing very little correlation with equities. Ways to gain exposure in commodities include direct purchases, mutual funds and US-listed exchange-traded funds.

Traded futures funds

These funds usually concentrate on the commodity sector, looking to profit from instances of price anomaly that the market will eventually correct.

Income-driven funds

Commercial property funds are among these schemes, generating a solid income stream by selecting only the best tenants.

Special situation funds

These funds have a broad investment scope - such as activist funds in Japan, which buy into and reform badly run companies, whose shares may be trading at 75 per cent or less of the value of their assets.