OPPORTUNITIES OR THREATS TO THE UNIT TRUST INDUSTRY?

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1 BY DINESH VIRIK, Executive Director & PRETTA MEHROTRA, Head of Research, Perkasa Mormandy Advisers Sdn Bhd THE PROLIFERATION OF ALTERNATIVE INVESTMENT PRODUCTS - Dinesh Virik Pretta Mehrotra OPPORTUNITIES OR THREATS TO THE UNIT TRUST INDUSTRY? Alternative investments are generally hybrids of existing asset classes, but include physical assets specifically created to meet basic investor needs for high returns with an appreciation in value over time. Hedge funds are among the first Alternative Investment Products (AIPs) to tie fund manager fees with return levels - a major sweetener allowing fund managers to be rewarded for specialised risk-taking. Subsequent AIP development led to the emergence of privately negotiated investments in private equity; e.g. corporate buyouts and venture capital not usually found in publiclytraded markets requiring high outlays that excluded a wide spectrum of the investment community. Financial derivatives with embedded hedging 2008 Issue No.1 UT TODAY 31

2 strategies, including structured products targeted at the mid-to high-net-worth investor, were also formed to fill the needs of a growing investor spectrum. AIPs are not limited to market instruments. Among the latest AIPs establishing footholds in the investment realm are real estate (and its investment trusts) and commodities (including precious metals), collectibles such as art and antiques, fine wines, rare stamps and coins. The global product leader Globally, hedge funds have become a significant force in investing and wealth management. Today, there are over 9,000 hedge funds with approximately $1.4 trillion in assets under management. A recent report from the Hedge Fund Research Inc. shows that hedge funds gained $45.2 billion in assets during the third quarter of One major reason for this phenomenal growth is a recent study by the Institute for Private Investors showing that the ultra-wealthy are increasingly allocating more of their portfolios to hedge funds. Ultra-wealthy investors are those who are typically defined as having over $50.0 million in investible assets. Whilst generally classified as an AIP, hedge funds are technically skill-based investment strategies and offer the opportunity to participate in a wide variety of new financial products and markets not available in traditional investor products. Skill-based strategies obtain returns from the unique skill or strategy of the trader. As a result, hedge funds have also been described as absolute return strategies, as these returns do not depend on the long-term return in underlying traditional stock and bond markets. Aside from choice, AIPs offer wider diversification benefits compared to conventional investment products (CIPs), which fall into two major asset classes: equities and fixed income instruments (predominantly bonds). Put simply, portfolio management that includes AIPs offer greater diversification value to investors owing to a low correlation with CIPs and returns independent of market conditions. Hedge funds reduce portfolio volatility risk and enhance portfolio returns in economic environments in which traditional stock and bonds. Similarly, real estate investment trusts (REITS) are exemplary portfolio diversifiers, providing the added benefit of insurance against inflation/deflation. In determining appropriate investment portfolios and combinations of CIPs and AIPs, risk profiles are key. CIPs, while market dependent, are able to generate returns on a specific short-term basis offering consistent albeit range- Figure 1: Evidence of Low Correlation between AIPs and Equities 100% 80% 60% 40% 20% 0% -20% 32 UT TODAY 2008 Issue No.1 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 MSCI World NAREIT RICI Bursa Malaysia Gold May-07 Jul-07 Sep-07 Nov-07

3 bound yields. In contrast, AIPs are long-term, some potentially high-risk high-return products better outfitted to the aggressive industry participant. Consequently, the rebalancing of portfolios to include both CIPs and AIPs must involve a consideration of risk profiles; the higher the propensity to undertake risk, the higher the allocation of funds to equity and alternative investment instruments. The question is, are AIPs available to everyone or are they limited to a select few? When first introduced, retail investors found the high entry-level costs of AIPs out of their purview, preferring the flexibility offered by CIPs. Hence, AIPs investments were confined to institutional investors and a few highnet-worth individuals. This changed with the advent of REITs, ETFs and lower costs - in Malaysia, entry-level Education of the different types of asset classes in AIPs, its investment strategies, benefits and disadvantages as compared to other asset classes and more importantly, its risk characteristics and how it fits into an investment portfolio for one s client are the core competencies to be developed in the goal of being a good adviser. costs for AIPs such as structured products have been lowered from RM1.0 million to RM250,000 broadening target market segments to include retail investors. Statistics indicate that an average of 8% of investments in the Asia-Pacific region is in AIPs - but the Malaysian market is still a long way from a globally comparable level of development. Experts attribute a small market cap to risk-averse domestic investors beleaguered by a lack of adequate technical expertise and market knowledge. This, however, does not mean alternative investing is at a standstill; it is merely that the local market is restricted to the few with necessary capital and regulative understanding of the characteristics and complexities of AIPs. AIPs: Regional Preferences and Local Flavour Figure 2: Asia Pacific REITs statistics Listed REITs - Regional Concentration Malaysia Australia Singapore Hong Kong Value (in US$bil) No. of REITs 2008 Issue No.1 UT TODAY 33

4 Globally, ETFs are now one of the fastest growing global investment products. Last year saw 100 ETF launches across Europe and there are now in excess of 120 ETFs listed on the London Stock Exchange. Buoyed by projected 6% GDP growth, rapid expansion of the retail and commercial sectors, and high local and foreign demand, the market for Malaysian REITs is benefiting from keen investor interest. However, as indicated in Figure 2, the market cap of US$1.4 billion (RM4.6 billion) pales in comparison to regional figures. In other Asian countries like Japan, the market capitalisation of listed REITs rises by about US$1.0 billion per month. In fact, potential returns on Malaysian real estate are promising, ranging from 6% to 12% depending on location, demand and type. Capital gains of approximately 20% to 80% can be realised on new properties within two to three years, according to industry professionals. This industry growth provides the underlying strength for a successful REIT structure. REITs are among the best portfolio diversifiers for an investor wishing to reduce correlative risks and seek capital-protection in both bear and bullish markets. Promising returns seem likely given the positive stimuli the local market is forecasted to enjoy in coming quarters. Other AIP potentials like structured products are also gaining local recognition for their investment potential. Last year, the structured products industry exceeded $100.0 billion in total annual sales, compared with $64.0 billion in 2006 and $40.0 billion in Standard Chartered and CIMB-Principal have enjoyed a measure of success with both conventional and Syariah-compliant SPs, noting that the offer of superior returns at very attractive risk-reward ratios compared to traditional IPs provoked the unprecedented growth of the train-i and Greater China Equity/Global Income funds. At present, additional efforts are being made to overcome issues investors balk at. For instance, the asset class for structured products will be further developed with an emphasis on liquidity, enabling the investor to exit the fund at the prevailing market value. Returns are not guaranteed, however, and capital can only be recovered at the end of the fund s tenure. Conversely, with absolute return funds (ARF), investors know what to expect. ARFs are popular alternative investment options for their capacity to employ hedging strategies at lower risk and at guaranteed return levels. Investors are offered asset-protection, assured yields and the potential for substantial capital expansion when markets are on the upswing. Yet, as with all funds, failures abound in the event of off-the-mark strategies and dicey speculative techniques (e.g. Soros Quantum Fund, Amaranth, and LTCM). ETFs join the list of alternative investment innovations, tracking funds from a basket of indices with gains reliant on active trading, short-selling and options. Said to be cost-effective in terms of lower expense ratios and load fees (index funds do not require active management, eliminating high engagement costs), ETF investors also stand to benefit from specialised sectortracking - in recent years, oil, gold and other commodities have yielded strong returns. The Hong Kong Tracker Fund (HKTF), the first Asian ETF with sector allocation based on economic outlook, grew to a high of HK$20.18 in 2006 from an initial low of HK$12.02 in However, positive yields are dependent on good timing and accurate [Hedge funds are] generally classified as an AIP are technically skill-based investment strategies and offer the opportunity to participate in a wide variety of new financial products and markets not available in traditional investor products. 34 UT TODAY 2008 Issue No.1

5 AIPs are not limited to market instruments. Among the latest AIPs establishing footholds in the investment realm are real estate and commodities collectibles such as art and antiques, fine wines, rare stamps and coins. identification of potential booms, and the more specific the focus, the higher the risks. Hidden costs may also present themselves in the form of accumulating broker commissions. Globally, ETFs are now one of the fastest growing global investment products. Last year saw 100 ETF launches across Europe and there are now in excess of 120 ETFs listed on the London Stock Exchange. Whilst the US has 533 listed ETFs with a value of US$533.5 billion, Europe currently has 386 ETFs with a value of US$125.9 billion under management with more launches planned for Still in its embryonic stage, the most recent addition to the local capital market is MyETF, a government initiative tracking the Dow Jones Islamic Malaysia 25 Index, offering exposure to the top 25 companies on Bursa through a Syariahcompliant fund. Released shares held by government-linked companies will stimulate retail participation, increasing market liquidity and lending a much-needed boost to capital expansion. Apart from these instruments, art and antiques, fine wine and rare stamps - commodities that appreciate in value over time - are becoming increasingly popular among discerning investors. Blue-chip wine investors are seeing returns of between 12% - 30% p.a. in a market that hasn t seen depreciation in 25 years and is purportedly susceptible only to global depression. Investors are able to enjoy increments in value of between 50% - 200% within a 5-10 year period, an appreciation that can be attributed to finite production, high worldwide demand and an improvement in quality over time. Wine investing is also tax-free. According to Premium Liquid Assets Ltd., the Malaysian market is still in its infancy and is limited to a small number of high-net-worth individuals, but a new wine brokerage is in the works in response to budding interest. While returns are largely guaranteed, the long holding period (as with other AIPs) could prove to be a disincentive; also, the purchasing of wine is still reliant on demand, which is affected by market conditions and inflation and the whims of wine collectors. But challenges remain, and while AIPs provide the potential for economic expansion and for wealth to be unlocked, the employment of speculative investment techniques, including leverage, short sales, and derivatives, involves substantial risks. Investing in these products can also result in the loss of capital. It is therefore necessary to undertake comprehensive due diligence processes prior to investing in AIPs. Investors will need to consider external auditing reports and historical performances of investment managers/general partners, obtain information on procedures, strategies and policies (as one would when getting background info for a traditional portfolio), and identify exit strategies and hidden fee structures. AIPs and Unit trusts advisers How do unit trust advisers benefit from the proliferation of AIPs available in both local and global arenas? As it stands, not very much. Most of the AIPs are not readily accessible to unit trust advisers in Malaysia save for structured funds, structured treasury and derivative linked products which are sold by banks or treasury related entities as well as REITs and ETFs which are transacted via Bursa Malaysia as listed entities. Will this change? Normandy believes that it will be a matter of time before regulatory liberalisation, market demand and product expertise make AIPs part of a unit trust fund offering. Derivative-linked strategies in structured products and property management models are not part of a typical equity/bond fund manager s skill hence the need to either develop local skill or import foreign expertise. The former requires a longer term to maturity, whilst the latter may prove inefficient in a local environment or unfeasibly costly. In any case, market forces and investor demand will be the major push factors for the growth of AIPs as a unit trust offering. Local investors are increasingly aware of the benefits of alternative investments in the wake of slower global growth and cost-push inflation where income and value portfolios appear more attractive than fixed deposits and CIPs. Industry professionals report that an increasing number of Malaysians are channelling funds overseas to meet their needs for diversification and enhancement of gains. Recent government initiatives and fund launches are equally strong indications of upcoming trends hence managers will have to raise their core competency aside from just expanding product knowledge to respond to the growing demand. In a bid to prepare for the inevitable, unit trust advisers should equip themselves with the most important advisory based principle - understand the product that you are advising on. Education of the different types of asset classes in AIPs, its investment strategies, benefits and disadvantages as compared to other asset classes and more importantly, its risk characteristics and how it fits into an investment portfolio for one s client are the core competencies to be developed in the goal of being a good adviser. With a plethora of investment products in economic markets today, advisers business differentiation lies in the specific areas of competency, trust and service. Remember, your best salespeople are happy clients! 2008 Issue No.1 UT TODAY 35