There's more to investing than equities, bonds, and property

There's a world of investments outside the traditional categories of equities, bonds and property, says Lucerne Investment Partners Executive Director Michael Houghton.

"There's a lot more to investing than those three markets," he says. Lucerne looks globally for opportunities, such as regions, currencies and themes, plus alternative ways to participate in markets.

An example of a lesser-known alternative investment is volatility itself, which Houghton says can be seen as an asset class.

Lucerne uses derivatives over the CBOE Volatility Index (VIX), as a kind of natural hedge against the ups and downs in other parts of a portfolio.

"As uncertainty increases, the price of that improves. It doesn't have to be that markets have fallen or asset prices are falling," Houghton says.

The recent travails of the Chinese property developer Evergrande and its impact on markets is a case in point.

"Even the fall and then the rally just creates uncertainty and that drives the price in something like the VIX," he says.

In the following interview, Houghton explains what he calls natural hedging, and how portfolio construction and the use of instruments like the volatility index can smooth returns.

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Edited transcript

Where are you finding opportunities outside of traditional markets?

It's a good question and also it's an observation that we do make often. The herd mentality we're referring to is basically people investing in those traditional markets that you alluded to.

Equities, bonds, and property, I suppose would be considered the three areas that most Australian investors would participate in but there's a lot more to investing than those three markets and what we're looking for is well globally we're looking at regions, we're looking at currencies, themes.

You look at different types of aspects to what investors are seeking as well and also from our perspective, different ways to participate in those markets.

So we may be investing in an equities market but at the same time we're doing it differently or we're focusing on a particular segment or thematic to do with that equities market.

And, for example, and as we've said several times, there are ways of doing that through some funds that invest long and invest short, there are ways of looking at ESG, there are ways of looking at particularly emerging markets as well and what they're able to offer investors outside of those more traditional markets.

What’s an alternative class most investors are not familiar with?

Well certainly I would say volatility in itself is an asset class. It's one that we are using as a way of hedging and that's a non-traditional way of approaching how you would invest to hedge because most people would see your hedges as buying protection.

This is another form of doing that volatility itself is an asset class that's getting a lot more fund managers focusing on it and investing in it to provide investors with that protection and or to make money out of it by trading it.

Beyond diversification, what other ways can investors hedge their returns?

For us, we don't typically hedge by taking out more traditional put protection or buy futures or whatever the case may be.

We're looking at how we asset allocate and the portfolios that we build and the hedging that we get from those is what I would call more natural hedge — something that you actually participate in a market or an asset class because it's giving you protection against another event or asset class or a market moving adversely.

And by that, I've mentioned volatility, the way that we participate in that and we've been using it recently for our fund of funds is to purchase an index or an ETF over an index that's the VIX which most people may have heard of.

As uncertainty increases is when the price of that improves. So it doesn't have to be that markets have fallen or that asset prices are falling.

You just have to say uncertainty and investor behaviour or attitudes and the market starting to worry about potential events and one example of that recently in the last few weeks was the Evergrande concerns; where was that company going to meet its debt obligations at the end of September?

And people started to worry, markets themselves didn't necessarily tank, I mean they did fall a little bit but they rallied off the back of it but even the fall and then the rally just creates uncertainty and that drives the price in something like the VIX. And for us that's been a good position already in the time that we've held it.

What percentage of your portfolio is dedicated to hedging?

It's a good question because it's not something that I think you can typically say, 'oh I'm going to price it this way and then therefore I'm going to weight it that way'. It's more a case of what it is that you're trying to protect now, for example of our fund of funds.

We already believe we've got a lot of natural hedging built into it just through the way that the portfolio is structured and the assets that we've allocated to.

So if we were to look at the VIX, that's for us at the moment about 1% of the fund, but you also look at the price behaviour of the index or the ETF that we've bought over that index.

And it typically lags the behaviour of the VIX so it does give us a little bit of an opportunity to enter and exit ahead of and or behind what's happening in the VIX which is also good.

And also it gives us enough protection that it smooths any transition if you like for the portfolio itself from getting caught in whatever's happening in the market.

In the way that I would elaborate on that is that for some of our long-short funds for example, they might have a bit more of a long bias as the markets going along well and it's bubbly at the moment, very bubbly at the moment.

They've still got their shorts on but as they see the market start to change and they think that there's going to be more uncertainty and that some of those shorts might start to get punished a bit more, then they will maybe increase their exposures but there's a transition that goes on and we might see our portfolio returns subtly full.

Not so much so that investors would notice but enough for us to pay attention to and that's why something like the volatility hedge comes into play just to smooth those returns for us.