Thinking alternatively
Part fourWe are strong believers in the value of diversification in investment portfolios. Historically, fixed income has been viewed as an effective portfolio counterweight to more growth-oriented equity allocations.
We are strong believers in the value of diversification in investment portfolios. Historically, fixed income has been viewed as an effective portfolio counterweight to more growth-oriented equity allocations.
The rationale for investing in alternatives is to deliver investors a differentiated return which in turn serves to enhance overall portfolio outcomes. Different types of alternative investments can be utilised to achieve a range of portfolio objectives, including:
We identify five broad categories of alternatives:
Understanding the characteristics of each category can be just as important as assessing the investment acumen or performance history of the investment manager. Uncorrelated return histories may nevertheless mask common risk factors driving the returns of both the alternative investment and the rest of an investor’s portfolio. This can undermine the diversification benefits of an investment, or otherwise inhibit its ability to deliver on an investor’s broader portfolio objectives.
Within a given category of alternative investments, approaches can differ substantially. Hedge funds and privates, for example, will almost necessarily be active, or skill-based, investments. Therefore, investment styles may drive return profiles just as much as the 'type' of alternative investments. Other investments - where for example the alternative characteristics derive from fundamentally uncorrelated asset class returns - may be available in either active or more passive forms (for example, gold).
Here, we provide an overview of the broad types of alternative investments and some of the considerations investors may need to take into account when including them in their portfolios.
Hedge fund strategies are diverse, and different styles of hedge fund – and indeed individual managers – can deliver very different return profiles. The popularity of hedge funds derives from this diversity. Whatever an investor’s portfolio objective, there is likely a range of hedge funds designed to meet that objective.
For example, tail-risk funds are designed to be explicitly defensive and can be expected to post their strongest returns when equity markets are performing the worst. CTAs and macro hedge funds have some defensive characteristics but are not quite as explicitly defensive as tail-risk funds. Multi-strategy and relative value might be considered more 'all-weather', providing more modest but more consistent and less correlated returns, and might provide valuable diversifying qualities for a portfolio. Equity long-short and even market neutral funds might be more suited to boosting overall portfolio returns, but may have a slightly higher correlation with equities.
Individual funds within each category may deliver different results, and an appropriate hedge fund investment will depend on the investor’s objectives, the hedge fund style, and the particular traits of the manager in question. Manager-skill plays a large part in determining whether a hedge fund investment ultimately delivers on an investor’s expectations.
In terms of liquidity, hedge funds tend to range from monthly to quarterly redemptions. More recently some funds have begun to offer daily liquidity while at the other end of the spectrum others have started to seek 'permanent capital' and lock-up investments for several years.
Private equity (PE) strategies can vary, but they share a common trait of being highly illiquid, with investor capital often locked-up for ten years or more. Similarly, private credit strategies tend to be illiquid, with long lock-ups and little secondary market liquidity. However, a subset of private credit strategies increasingly offer more favourable liquidity terms, for example monthly or quarterly redemptions.
Investors generally hope to capture an illiquidity premium as compensation for being locked-in to a private investment, in addition to manager alpha. As such, many investors use privates to boost overall returns. An additional benefit is that often the volatility of returns is very low, although arguably this is due to conservative portfolio valuations and also infrequent valuations. Valuations are often only updated quarterly or perhaps monthly, so day-to-day volatility is essentially zero. This gives rise to an additional benefit, namely, correlation to public market (equities and fixed income), which go up and down every day, looks very low.
On face value, privates make an appealing investment proposition, offering higher returns, lower volatility and low correlation in exchange for less favourable liquidity terms. There is, however, an important caveat. Fundamentally, the value of the portfolio is largely driven by the same factors driving similar publicly listed securities. Therefore, even where day-to-day returns appear uncorrelated, the long-term returns investors make from a private investment can reasonably be expected to be strongly linked to the public market equivalent.
Nevertheless, higher expected returns and lower realised volatility can benefit an investor’s portfolio immensely, and we think privates can be a good literal 'alternative' to public investments. Similarly, private strategies can be tailored to exploit a specific opportunity and can therefore help investors manager exposure to specific macro factors. However, we think caution needs to be exercised in relying too heavily on those features if the objective of the alternative investment is to diversify overall portfolios away from equity or credit risk.
Physical, non-financial investments such as property and infrastructure are often grouped together as real assets. Such investments can be held directly, where an investor takes a direct ownership stake in a specific asset, or in fund owning a portfolio of assets. These can be either public or private, and investors can gain exposure via highly customised active strategies or more passive index-like exposure.
The returns from assets such as buildings, toll-roads, airports and power plants are somewhat related to the real economy, but often the contractual nature of the revenue for such assets means asset class returns are less correlated to equities and fixed income. Moreover, real assets can be inflation-proof investments capable of delivering positive real returns even during periods of high inflation. The value of real assets comprises partly from the tangible value of the asset (for example the cost to rebuild etc) and partly from their ability to generate an income stream (for example rental income for property), and both of these can be a source of inflation protection, especially where the income stream is linked to inflation.
On the other hand, because the value of the asset is a kind of present value of the future income stream, real assets can nevertheless be susceptible to rises in real interest rates. Real rates can therefore be a common factor driving returns of real assets, equities and fixed income, especially during an inflationary shock where a central bank, for example, may have a policy objective to raise real rates in order to combat inflation.
Liquidity can be another consideration for real assets – after all, it’s more difficult to sell an entire office building than to liquidate a share portfolio. Even for more liquid investment vehicles, investors need to be careful where there is a mismatch between the liquidity offered to investors and the liquidity on the underlying assets (e.g. buildings). The potential for a fund to be 'gated' where investor redemptions get halted during period of above-normal withdrawals is a real consideration in this instance.
Commodities investments can take many forms. Traditionally, many investors gained exposure to commodities via equity investments in mining companies. However, the performance of mining companies is often more highly correlated with equity market factors and can diverge from the performance of the commodities they are mining due to overall equity market sentiment, price/earnings re-ratings, company management or long-term vs short-term outlook for commodity prices.
Another way of gaining commodity exposure is via a broad commodity index such as the Bloomberg Commodity Index or S&P GSCI. These indices track the prices of a broad range of financial commodity contract prices ranging from precious metals to energy to agricultural exposures. The exposures in these indices can be so diversified that sometimes positive price movements in one sector can be offset by negative moves elsewhere.
Additionally, while long term correlation of the commodity market 'as a whole' can be low versus equities and fixed income (making commodities a candidate for a portfolio diversifier), overall commodity returns have been somewhat underwhelming over longer periods, with periods of boom followed by periods of bust such that timing in commodity markets is extremely important (but also quite difficult).
Some commodities, such as gold, have almost become their own asset class. Gold has long been considered a store of value, dating back to its use as a medium of exchange, up to and including its use as a gold standard backing the value of individual currencies.
Commodities in general have been shown to be an effective investment for investors seeking to build inflation protection into their portfolio. Empirically, periods of high inflation have coincided with strong commodity returns, and interest in commodities invariably increases whenever investors have concerns about higher future inflation.
Collectibles such as art, wine, cars, jewellery and watches are beginning to establish themselves as a new alternative investment type, with the potential for long term growth with low correlation to other asset classes.
Scarcity combined with increased demand are viewed as the return drivers for the asset class, while transparency, liquidity and scalability are some considerations for investors. Unlike most other investments, in many instances there are few reliable pricing sources for collectibles, with infrequent transactions, highly fragmented marketplaces and very high transaction costs making price discovery difficult.
One might expect to see an overall relationship with the economic cycle, however, the scarcity of collectibles and the fact that the ultra-wealthy – the main investors in the asset class – are less susceptible to the economic cycle means any relationship might be sufficiently loose so as not to undermine the diversifying qualities of this type of investment.
Alternatives is a highly diverse investment segment. Different types of alternative investment can be used to achieve different portfolio objectives, and that can be true even amongst alternatives of the same 'type'. It is therefore essential that investors understand the nature of different alternative investments and how they can be best utilised to achieve those objectives.
It is unlikely that any single alternative investment will be able to deliver on all an investor’s portfolio objectives. Private equity may be well placed to boost overall portfolio returns, but less able to diversify the portfolio. A truly uncorrelated hedge fund may deliver only modest (but consistent) returns, but the diversification benefits might be substantial. Real assets and commodities may provide inflation protection, but that might not always be needed. Our view is that investors should include a range of alternative investments in their portfolios and have different expectations for each. This will enable investors to more appropriately assess the benefits and risks associated with any particular investment and help build more robust portfolios over the long-term.
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