Portfolio diversification is crucial. The academic evidence is overwhelming. Gary P Brinson's study into 91 large pension funds over a 10-year period found that a staggering 94 per cent of the variability in a fund's investment return was due to the choice of asset classes. By contrast, it showed that stock-picking and market timing accounted for just 4 per cent and 2 per cent of returns, respectively.
Smart asset allocation can be easier said than done, however. For example, adding foreign shares to your domestic equity holdings can result in fewer diversification benefits than one might imagine. Since 2001, the average correlation between annual returns on the UK and the US stock markets has been almost 0.94. For the UK and Europe, the figure is 0.88, and for emerging markets 0.62. In all three cases, the correlation has risen over the period and is now over 0.9.
The solution, then, is to look beyond equities in order to lay off our equity risks. Real estate, commodities, hedge funds, and private equity all offer potentially promising risk and return benefits. So we consider here how well they do their job - and how a Sipp investor might invest in them.
The spirit of the rules governing what sort of real estate can go into Sipps is very clear: residential property bad, commercial property good. And although it may be disappointing not to be able to put villas in Valencia and maisonettes in Maida Vale into our pension pots, commercial property offers plenty of opportunities and increasingly easy access. As well as the proliferation of UK real-estate investment trusts (Reits), you can also hold business bricks-and-mortar directly. However, most advisers reckon that you should avoid syndicates or direct holdings unless your fund is worth at least £100,000, if not £300,000.
A cheaper and more efficient way of getting broad exposure to real estate is tracking property indices. Barclay's iShares unit has launched a range of products in the past year that track the FTSE EPRA/NAREIT indices, covering everywhere from Asia to Europe to the US. These exchange-traded funds (ETFs) also have no initial management charge and the annual management charge is usually between 0.4 and 0.59 per cent.
Several large fund management groups - such as Standard Life and Henderson - have launched global Reit unit and investment trusts, too. But while these are interesting products, they have some major flaws. The first and biggest is cost - trackers are simply cheaper. The Reit funds-of-funds are also in effect stock-pickers, which means that many are likely to underperform their relevant benchmarks.
As well as the potential for strong returns, commercial property is generally thought to provide a good hedge against inflation, and a low correlation with equities. However, William Bernstein, author of The Efficient Frontier, has analysed these supposed characteristics. He reckons that "the jury is still out" when it comes to real estate's inflation-hedging abilities, and he is suspicious of the claims of low correlation with equities. US Reits are found to have performed similarly to common stocks over the past three decades and have done poorly during inflationary periods.
A cursory analysis of the FTSE EPRA/NAREIT indices seems to support Mr Bernstein's view. The evidence that global property markets are lowly correlated with equity markets just doesn't stack up. The UK commercial property tracker, for example, has the highest correlation with the FTSE All Share over the past five years of just above 0.6. That's not far off many FTSE 100 stocks. However, Asian property markets are less correlated to the All-Share, at just over 0.4, as is the US, at just 0.273.
Along with property, commodities represent one of the hottest alternative asset classes of today. Raw materials prices raced ahead last year, with those of copper, nickel and lead reaching new record highs. Soft commodities are also buoyant, with orange juice making a 10-year high, and large gains for corn and soyabeans. So, despite recent market turbulence, plenty of investors believe that we're in a commodities 'super-cycle' that will continue for several years yet.
For Sipp investors, there are many possibilities. For short-term, highly-geared returns, you could buy options or SG's covered warrants on individual commodities or broader indices. Taking a longer-term perspective, closed-end funds such as Merrill Lynch's Gold & Mining Trust provide good exposure to certain areas within the asset class. But perhaps the most cost-effective way of gaining a presence here is through exchange-traded commodities, a variety of ETFs.
ETCs are extremely liquid and have low expense ratios of just 0.49 per cent a year. Those available include 20 single commodities, including favourites, such as copper, oil, coffee and gold, as well as more arcane ones, such as lean hogs, zinc and live cattle. There are also a dozen commodity index ETCs, which track indices of all commodities, as well as sub-categories, such as agriculture, precious metals and energy.
More complex structured products are another way to get into commodities. These usually take the form of a closed-end investment trust, with a fixed five- to six- year term. These track a basket of commodities - usually oil, gold plus a spread of industrial commodities - and offer to pay out a percentage of the final return on redemption. Two providers dominate here: Close's Enhanced Commodities fund offers a 200 per cent return, while the two BNP Secure funds offer returns of between 250 per cent and 340 per cent of a basket of spot commodity prices. The advantage of these types of fund is that they gear the upside across a spread of commodities, albeit with the risk of magnified losses should they fall.
So you need to remember that commodities' long-term performance has not always been good. Their capital appreciation has been vastly inferior to that of equities over the past few decades. And, since they pay no dividends, the total return comparison is even less flattering. Still, commodities markets may have changed fundamentally over the last 10 years. Hedge funds and other institutional investors are believed to have altered the demand-profile for these materials.
The influx of new investors into the area could be a curse as well as a blessing, though. Take the example of the streetTRACKS Gold Shares, a US-traded gold ETF. Launched just 15 months ago, it's already attracted funds of more than $6 bn. To put it another way, the trust is sitting on 343 metric tons of the stuff - more than the Bank of England. Some believe it is having a distorting effect on the overall gold price. So, across commodity markets generally, the heavy influence of hedge funds could prove a recipe for disaster if a crisis of confidence occurs.
Nevertheless, hedge funds continue to boom. There are now 6,500 vehicles in existence - between the years 2000 and 2004, the number of new managers grew at a rate of up to 25 per cent a year. That huge expansion has resulted in assets under management in the hedge-fund industry growing from $39bn in 1990 to $1.2 trillion in 2006. High returns, low correlation with equity indices and increasingly easy access for non-super-rich investors are the industry's main selling points.
Nevertheless, one problem for private investors wanting to tap into these funds is that the huge variety of fund-management styles can be confusing and is forever changing. In 1990, for example, macro-hedge funds made up 70 per cent of the hedge-fund universe, yet they now account for only about 10 per cent.
As for making an investment, there are a small number of hedge funds that will accept direct contributions from private investors. So a more sensible way to access the sector is through a fund-of-funds or multi-manager, although these can be expensive. The average hedge fund may charge a minimum of 2 per cent of assets a year, plus an extra performance fee if returns exceed 20 per cent. Add to that the costs of a multi-manager and internal researchers, and your total expense ratio can easily exceed 2.5 per cent or more. At these levels, a hedge fund would have to return 7.5 per cent or more a year just to exceed cash savings rates.
Luckily, there is potentially a cheaper and more effective way into the market, via a tracker recently launched by New Star fund management group. It's called the Hedge ETS, and it's a London-listed daily tradable security that gives you a similar level of outperformance as that enjoyed by hedge funds through exposure to a hedge-fund index called the RBC Hedge 250 Index.
The Hedge ETS is a unique product in that it's a fairly typical ETF, but there's also the option of buying shares that track the RBC index with a three times gearing exposure to the performance of the index.
New Star launched this fund because even the bigger institutions were demanding a more cost-effective way of tracking the main hedge-fund indices. They wanted access to the sector without the risk of picking individual managers and incurring huge management costs. And since its inception in July 2005, the RBC index has produced 11.1 per cent annualised returns with impressively low volatility of 3.9 per cent.
Another route into hedge-fund investing open to the Sipp investor is via the closed-ended investment trusts from providers such as Close, Man and Dexion that invest in a wide range of strategies. Average returns from across this sub-sector have been a rather undistinguished 7 to 8 per cent - barely 2 to 3 percentage points above cash. This small differential falls well short of the absolute returns of 10 to 15 per cent that many hedge funds trumpet in their marketing material. Then, of course, returns will be further eroded by annual fund charges, which are rarely below 2 per cent. On the other hand, these funds do at least prove that correlation with the FTSE All-Share is fairly weak and in some cases negative - although two funds are correlated mildly at between 0.34 and 0.38.
However, alongside private equity, hedge funds are rapidly turning into everyone's favourite bogeyman, partly thanks to a series of scandals. The Amaranth debacle, for example, and the difficulties of Red Kite, have prompted regulatory crackdowns, especially in the US. But a much more harmful attack has come from professional economists. They've been crunching the numbers and are asking some awkward questions. In particular, they point out that glowing historical return data for the hedge-fund universe is flawed. It frequently excludes failed funds and performance data that funds choose not to report.
As well as dodgy numbers, a second academic critique suggests that the whole business model of hedge funds might be in trouble. Increasingly efficient markets are making it harder for hedge fund managers to find mis-pricings. Data from the 2000-2006 period shows there has been a compression of hedge-fund returns, making construction of a truly diversified portfolio more problematic. Recent estimates put the amount of money currently chasing alleged market inefficiencies at $600bn. It follows that the profit potential from exploiting these inefficiencies should shrivel. So, if returns from 2007 are anything to go by, the hedge funds' days of making even average returns may be numbered.
Private equity: the boom
The private-equity sector is fast emerging as the alternative asset fund of choice among sophisticated investors. Smart, wealthy private investors are pouring huge amounts of cash into the sector. According to the 2006 Merrill Lynch Cap Gemini World Wealth Report, wealthy clients' exposure to alternative investments in 2005 was 20 per cent, and is forecast to rise to 22 per cent in 2007.
Private equity's performance appears to merit this enthusiasm. The British Venture Capital Association (BVCA) says that private equity's net annual returns amounted to 16.4 per cent over a 10-year period, 11.9 per cent over five years, and 21.1 per cent over three years. Returns on private-equity investment trusts - which are very accessible to Sipp investors - have been even more explosive.
These private-equity investment trusts may have some other major advantages moving forward. Many of the funds are operating at a substantial discount to their underlying net asset value. For example, seven of the 15 venture capital trusts in our downloadable table are on discounts of 10 per cent or more. So, as arbitrageurs move in on the sector, these discounts should narrow even if the wider market falls. Many of the funds now hold huge amounts of cash on their balance sheet, too. These cash reserves should provide a useful hedge against any market downturn while also dampening volatility.
Click here to download a table of private-equity funds' performance (as a PDF file)
It's also becoming increasingly easy to invest in a wide range of quoted private-equity funds through products, such as SG's structured tracker product. The SG Private Equity Index Protected Note tracks the Privex index of the largest global listed private-equity players, whose constituents include 3i, Candover and SVG. What''s more, the £1,000 certificate is capital-protected - based on the 20 March 2007 issue date for the index - which should mean that even if the constituent companies fall in price, you'll still receive all your money back if you hold on until redemption in March 2013.
As it's a tracker, you get 100 per cent of the upside of the index, although you won't receive any of the dividends that you would have gained from holding the underlying shares. The lack of dividends shouldn't be too huge a problem, though, as most private-equity players don't pay a huge dividend. That said, some pay special dividends following particularly successful deals.
Remember, too, that in spite of the astonishing success of some private-equity houses, such as 3i and SVG, the correlation between private-equity players and the FTSE All-Share has been rising in recent years. In 3i's case, correlation is now routinely above 0.5, making it fairly vulnerable to any stock-market sell-off. This closer relationship with stock-markets' movements makes sense, though. Most buyouts are motivated by low interest rates along with low volatility. Also, more and more deals involve a company being taken private and then being re-floated a few years later.