Investors should be careful when picking alternative UCITS funds, even though they may appear the right choice in this low interest rate climate.
Even though the U.S. Federal Reserve has begun to tighten monetary policy, markets remain firmly in a low interest rate environment.
In Europe, it is likely that these conditions will stay around longer, particularly with the European Central Bank still unsure about when to start tapering the pace of its quantitative easing scheme.
Low interest rates mean that investors will continue to look for alternatives, especially if they need income from their portfolios or want to bulletproof against the eventual prospect of rising rates.
In the past, investors were often willing to accept higher risk, meaning they invested in high-yield bonds or bonds with a very long duration to generate higher returns.
However, even these strategies don’t pay off fully anymore as spreads have in some cases come down so far that they no longer reflect the risk from the issuer.
And given the initial rate hikes by the Fed, the long duration approach does not seem to be the right answer either.
Therefore, it is not surprising that investors are focusing on alternative UCITS funds, since these products seem to be the product of choice in an environment like this, as they often promise to generate returns in all market environments.
Alternative UCITS offer retail investors a regulated approach to the alternative fund industry. This stems from the European directive UCITS (Undertakings for Collective Investment in Transferable Securities), which ensures that funds can be sold to any investor under a harmonized regulatory regime.
Alternative UCITS are often considered as “hedge funds light”.
This is obviously wrong, as even though a number of products in this sector do imply hedge fund strategies — such as long/short equities or global macro approaches and/or modern portfolio management techniques — these are often exposed to market beta.
In rising markets this is not bad for the funds since the tide lifts all boats, but they have to prove their ability to avoid losses during rough market conditions.
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The year 2016 showed that not all funds deliver on their promises.
This means investors have to look very carefully at the strategies and techniques used by managers of alternative UCITS funds if they want this kind of fund as a bond surrogate or to bulletproof their portfolios against market disruptions.
That said, it is not bad for an alternative UCITS fund to have some market exposure, since this can help to improve the return of a strategy. But investors have to take this into consideration when they build their portfolios.
They must estimate the overall downside risk to their portfolio.
On the other hand, there are also funds available that have only limited market exposure and might therefore be a better choice, even though they show lower returns in rising markets.
From my point of view, alternative UCITS funds can be a good option for investors who want to use this kind of product as a bond surrogate or as an alternative source of return in their portfolios.
But they have to select the products very carefully; not all funds — even those within the same peer group — have the same investment objective and may follow different investment strategies.
These even small differences can, especially during rough market conditions, lead to totally different results.
Investors need to use a proper fund selection process to pick those that really fit their needs and expectations and should not simply buy an alternative UCITS fund just because of its past performance.
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The views expressed are the views of the author, not necessarily those of Thomson Reuters.