By Ryan Bisch

Every so often the Financial Times or Wall Street Journal runs a story along the lines of "The art market defies economic gloom." Is this so? If so, why? Should investors be considering an allocation to art as part of their alternatives portfolio?

Over the last five years, Mercer's Alternatives Boutique has researched an assortment of "exotic" alternative investment strategies. In doing so, Mercer has also endeavored to provide answers to these questions for its clients.

Exotic alternatives are particularly interesting in volatile markets and in considering the fallout of the global financial crisis. One lesson learned was the realization that many of the
more traditional alternatives, such as certain hedge fund strategies, failed to deliver as a diversification strategy and exhibited higher correlations to broader equity and credit markets in a period of extreme market distress.

Exotic alternatives provide exposure to non-traditional return drivers. These unique return drivers are an excellent source of diversification from the risks that dominate the traditional portfolio. While there is no explicit definition of what is an exotic alternative, Mercer uses a broad definition which includes alternative investments that are not traditional hedge fund strategies, private equity, private debt or infrastructure. Exotic investments are perhaps best described by articulating some of the investments they comprise, including insurance-linked investments, shipping, drugĀ  royalties, aircraft leasing, litigation finance, intellectual property and just about any rare or exotic assets such as antiques, stamps, paintings, wine and/or ostriches.

The aim of Mercer's research into exotic alternatives has been to first and foremost understand the key risk and return drivers and detail the history of each relevant market. This has allowed us to: understand the risks of the relevant strategies; identify the successful managers focused on these assets; and finally, to form an opinion on the merits and appropriateness for investment consideration by our clients. This research has been underpinned by a vast number of meetings with exotic alternatives fund managers and extensive work to understand the markets for the underlying assets. Some of the key points which we address when looking at exotic alternatives are:

What is the investment thesis and economic rationale?
Why does the opportunity exist?
What has changed to make this opportunity attractive at this moment in time?
What are the return drivers behind the opportunity?
Under what economic conditions is the opportunity likely to be successful?
What conditions are likely to result in an investment faring poorly?

Not everything exotic has passed muster under the Mercer research process. In fact, on more than one occasion we have proactively recommended that clients avoid investment in certain assets.

Perhaps, the best way to provide some insight into exotic alternatives is to highlight a selection of investment opportunities in that asset grouping.

An investment opportunity in the shipping sector is based on a strategy of acquisition and redeployment of shipping assets. This opportunity exists as a result of:

A slowdown in global trade that has caused a collapse in character rates and an associated reduction in vessel values
Aggressive use of leverage for new ship building that led to bloated order books
Dysfunctional maritime lending markets

Historically, shipping has not been a particularly attractive opportunity for investors seeking portfolio diversification, particularly diversification from equity risk. This is because one of the key risks in the shipping industry is exposure to the global trade supply/demand cycle, which is highly sensitive to global GDP.

While the underlying risk involved in shipping has not changed, we believe the potential returns available today - anticipated by investment managers to be in the high teens to mid-twenties - are appealing. The investment thesis is supported by a macro thematic of return to global growth expected over the medium term.

Potential Investment Opportunities
This is an opportunistic investment strategy that is expected to have a private equity-style return profile, albeit with a yield component.

Purchased distressed shipping assets from motivated, even distressed, sellers; capacity can be sold opportunistically or hedged with long-term charters/freight forwards
Private equity such as investments in troubled operating companies with valuable assets that need to be recapitalized

Catastrophe reinsurance is an insurance-linked investment (ILS) which involves transferring risk from the insurance markets to institutional investors.

Returns are generated via exposure to catastrophe insurance which relates to severe but infrequent events such as earthquakes or hurricanes.
Insurance risk represents a true alternative risk premia which is not linked to the traditional capital markets.
Current market conditions have had an impact on the availability of reinsurance capacity for the 2012 calendar year, due the capital scarcity among traditional risk capital providers leading to attractive yields.

Investors need to have an appreciation of the risks and complexity of ILS. Therefore at a portfolio level, the allocation to insurance-linked investments should represent a small portion of a diversified asset portfolio.

Potential Investment Opportunities
This asset class has attractive diversification characteristics and is worth further consideration for investors who are able to tolerate the tail risk associated with this exotic alternative asset class.

Investment in the catastrophe reinsurance market via allocations to catastrophe bonds and collateralized reinsurance contracts managed by specialist investment managers.

The opportunity in aircraft leasing is based on an investment into a portfolio of aircraft leased to commercial airlines. The investment case is underpinned by long-term factors linked to the expected growth in the aviation market and the supply-constrained aircraft industry.

The key risk exposures involved in aircraft leasing are credit risk (event of default or bankruptcies) and asset risk (residual value of the under lying craft). The return factors exposures in this type of investment primarily reflect macro-economic market conditions and the availability of capital.

Potential Investment Opportunities
This is an alternative investment strategy which is expected to produce a mid-teen return, with a significant component of the return generated via income.

Investment in a portfolio of aircraft, with leases to "top tier" airlines; those with strong credit quality, good operating history and status of national flag carrier.

Exotic alternatives present investors with opportunities to achieve more robust diversification through the introduction of non-traditional return drivers. This is an attribute that stands out as particularlya attractive in the current economic environment. As always, well-considered implementation is critical, and access to high quality managers and careful due diligence is of paramount importance. Mercer's Alternatives Boutique continues to explore the exotic alternatives asset classes and will review select investment opportunities as part of the ongoing research agenda.

Ryan Bisch is a Sydney, Australia-based Principal in Mercer's Alternatives Boutique. This report appeared in Mercer's Perspectives On Alternative Investments report from April 2012. As the Director of Exotic Alternatives, he is responsible for generation of intellectual capital and research of esoteric/niche alternative investments. His areas of specialization include insurance-linked investments, asset-based lending strategies, timberland, agriculture and other non-traditional alternative strategies. He is also global lead researcher for insurance-linked investments.