The Australian institutional investment industry is underinvested in hedge funds in comparison with its international peers, according to MLC senior investment strategist Michael Karagianis.
"We have probably been underinvested as an industry in hedge funds in Australia for a long period of time," Karagianis said in an interview with Investor Weekly.
"I think the issue with hedge funds is not that they can't provide diversification, it is just that you have to be very selective in the exposures that you have in that space.
"Not all hedge funds are the same, not all multi-manager structures are the same, so it comes down to understanding the investment structure that they have and the volatility pay-off dynamics."
He said the current debate about the high exposure to equities in superannuation portfolios, fuelled by former Super System Review chair Jeremy Cooper and former Treasury secretary Ken Henry, ignored the idea that there was a third dimension.
"There are a number of genuine diversification strategies in Australia, but generally we underemploy them," he said.
"There are a number of reasons: they are generally more costly, they are less understood and probably there has not been a need for them in the past.
"If you are invested in equities and they go up all the time, then why look for a diversification? Well, that might have been true up until 2008, now the situation has fundamentally changed."
Apart from hedge funds, he said there were a number of genuine diversifiers, including insurance-related assets, such as catastrophe bonds and long-term private equity investments.
"When people say 'diversification didn't work' . well, the building blocks [of portfolios] have changed over time," he said.
For example, he pointed to listed property trusts, which initially were income-oriented investments and became stapled securities targeting high growth.
"Property trusts were turned into high beta plays. Their investment model changed, but generally our understanding of their role in portfolios did not change," he said.
MLC has continuously increased the allocation to alternatives in its Horizon series over the years.
"In our balanced approach we now have about 11 or 12 per cent in alternative asset classes, which is a significant rise," Karagianis said.
But he said there was ultimately a limit to how much in terms of alternative assets could be put into what was generally perceived as a balanced fund.
"Once you start getting up to 20 per cent and beyond, it starts to become problematic in terms of the costs and in terms of what the portfolio looks like versus what a portfolio should look like when people perceive a balanced fund," he said.
"Once you get beyond that, you skip to a new paradigm and that is where an absolute return product is suitable.
"But then you are not talking about 10, 15 per cent alternatives, but 50 per cent.
"You are now talking about a much greater flexibility in changing your asset allocation depending on the market. If you think bonds are expensive, you can have virtually nothing in bonds."
But absolute return products are still a hard sell, largely because they do not fit into established practices.
"It certainly is attracting a lot more interest, and also generally you see an increasing number of these funds in the industry, although they are still in the minority," Karagianis said.
"But I think one of the problems is that a lot of investors don't know how to use them.
"They don't fit in the risk profiling model in Australia."
