Exploring the alternatives in investment

In the alphabet soup of the funds world, there are two acronyms that all investors need to be aware of – UCITS (Undertakings for Collective Investment in Transferable Securities) and AIFs (Alternative Investment Funds).

UCITS funds are aimed at retail investors, are tightly regulated and restricted to what they can invest in – usually conventional asset types such as equities, bonds and cash. AIFs, on the other hand, are generally targeted at professional investors and have no such restrictions on the type of assets they hold. They can offer greater asset diversification and the prospect of higher returns, but they also come with downsides including higher risk and a lack of liquidity.

“They sit in a different regulatory regime,” says Niamh Ryan, partner and head of the funds group with international law firm Simmons & Simmons. “It is much more disclosure based. That’s an appropriate regulatory regime on the basis that they are sold to professional rather than retail investors.”

In other words, professional investors know what they are getting into, and the risks involved and make their decisions accordingly.

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“AIFs typically provide exposure to alternative private market assets which you can’t invest in publicly, for example, through a stock exchange,” says Tom O’Gorman head of distribution, Ireland at Legal & General Investment Management. “These assets have limited liquidity, meaning they can’t readily be bought and sold. AIFs are different from UCITS funds, which can invest only in liquid transferable securities.”

“AIFs have scope to invest in a much broader and more complex range of investments including anything from direct lending to property and infrastructure, derivatives and renewable energy assets such as wind farms,” says KPMG partner in financial services tax Philip Murphy. “On another level, investment funds provide funding to companies and projects, such as infrastructure, renewable energy and real estate and so on which helps facilitate an efficient and healthy economy.”

Their limited liquidity tends to relate to the nature of the assets involved. “AIFs cover everything from real estate to private equity,” Ryan says. “They tend to be a little less liquid. You can’t go in and out quickly. Investors in AIFs do not expect to be able to come in and out daily in the same you as you are able to with UCUTs. You may have to wait a long time to get your money back or to get a return on it.”

Many AIFs take the form of closed-end funds with fixed start and end dates. “AIFs often target a longer-term time horizon than other investment vehicles, seven to 12 years, depending on the specific asset and strategy, because private market assets are typically less liquid than comparable public assets,” O’Gorman says. “As such, AIFs are normally closed-ended funds, meaning they raise a fixed amount of money and invest over a specific period.”

That structure is as much for practical reasons as anything else. A private equity fund will need time to build a portfolio of investments and more time again to exit them. Those funds couldn’t operate if investors were able to take their money out any time they wished, says Ryan.

The attractions tend to outweigh those downsides, however. “Alternative investments typically have a low correlation with those in standard asset classes,” says Mazars asset management audit director Andrew Brennan. “This low correlation means they often move counter to the stock and bond markets. This feature makes them a suitable tool for portfolio diversification. Investments in hard assets, such as gold, oil, and real property, also provide an effective hedge against inflation, which hurts the purchasing power of paper money.”

Because of this, many large institutional funds such as pension funds and private endowments often allocate a small portion of their portfolios – typically less than 10 per cent – to alternative investments such as hedge funds, he says.

“Hedging is another big attraction,” says Brennan. “Derivatives and commodities offer an opportunity for investors to hedge against market and inflation risk.”

There are other attractions as well, of course. “Alternative asset classes such as property and infrastructure normally provide investors with access to a long-term flow of relatively stable returns, which is one of the reasons why alternative funds can be of particular appeal to pension funds,” says Murphy. “Furthermore, the growing level of interest from investors in the environmental, social and governance (ESG) agenda, has increased the level of interest in AIFs which invest in renewable energy and related green assets. Outside of an alternative fund, many investors would not have the level of capital to obtain investment exposure to such assets.”

There are regulatory attractions as well. “An alternative fund is also required to appoint a regulated alternative investment manager, meaning the investor gets indirect access to investment professionals who have specific expertise in managing risk and investment exposure in the relevant asset class,” Murphy says. “From an investor perspective, this greatly removes the risk associated with investing on an individual basis in similar assets.”

Investors should also be aware of some of the drawbacks associated with AIFs. “As with any potentially high return, the risk is higher with AIFs than UCITs,” says Brennan. “The underlying assets of AIFs are more volatile than traditional investments such as equities and bonds, and the investors are therefore taking more risk by investing in these fund types. Given the nature of underlying assets, such as real estate and unlisted equities, the valuation of AIFs can also be challenging. Whilst many see the reduced regulatory requirements associated with AIFs as a positive, some investors find comfort in increased regulation and are deterred from AIFs for that reason.”

“When considering an AIF, investors should be prepared to commit their money over the longer term,” O’Gorman says. “AIFs provide exposure to assets which would otherwise be inaccessible, but it’s important that investors do their due diligence to understand exactly what the fund will be investing in.”