Fixed IncomeMar 30 2015

The no-nonsense guide to alternative investments

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Alternatives is a catch-all term that is open to interpretation.

Recently, this term has applied to non-traditional investments in asset classes in which investors are wary of taking exposure or cautious in their positioning.

This is evident in opportunities flagged as ‘equity alternative’, ‘bond alternative’ or ‘property alternative’ investments. Essentially, these opportunities are not seeking to provide the same sensitivity (or beta) of being a long-only investor in the traditional asset class.

Alternatives can also relate to investments where the fundamental drivers to performance remain largely insensitive to movements in traditional asset classes. Consequently, these ‘genuine alternatives’ can be used to diversify a portfolio as they provide low correlation to wider markets.

When investing in any type of alternative asset, consideration must be given to its underlying liquidity as well as the investment structure by which it is accessed.

On the whole, underlying liquidity is limited by the specialist nature and confined participation of the investment opportunity. In these cases, committed closed-end vehicles are generally the optimum way to access these opportunities.

So, what are these obscure investments, and how can they be used? Convertibles best illustrate equity alternatives.

In spite of the essence of this asset being rooted in a corporate bond, convertibles provide investors with equity participation through a future conversion option. In this way, there is the asymmetric attraction of equity upside with bond floors for protection.

Convertible valuations became increasingly attractive in 2014, largely as a result of an increase of new issuances, many of which have been issued with higher yields at lower premiums.

Bond alternatives seek to provide attractive credit returns against the backdrop of lending retrenchment seen in the banking sectors since 2008.

For example, an abnormally high return from senior loans secured against property assets can be achieved in property debt funds.

Investing more directly in commercial property assets can lead to a more specialist approach offering less sensitivity to the property cycle.

With the structural change in the retail sector away from the high street towards click and collect, mobile and e-commerce, there is currently an acute shortage of big-box logistics units in the UK.

Tenants are having to commit to long-term leases due to the supply/demand imbalance caused by indexed rent reviews due to the high barrier to entry for site acquisition and development.

This is resulting in a robust 6 per cent yield.

Genuine alternatives are, by nature, more esoteric investments.

They require a proactive research approach to gain sufficient understanding of the risk and reward opportunity.

The inherent advantage of putting in this effort is to benefit from the idiosyncratic risks of the specialism in providing real diversification, whilst exploiting any compelling risk-adjusted returns that may be presented.

Ian Rees is head of research, multi-asset funds at Premier Asset Management

Expert view

Peter Hobbs, managing director of IPD, which provides real estate indices and data, says:

“The strong momentum over recent quarters suggests that 2014 will be another stellar year for real estate, the fifth consecutive year of above-average performance since the financial crisis. Although there tends to be a delay before most national markets report their year-end performance, the early results from the UK, the US and particularly Ireland confirm the continued strong performance. The results for Ireland, at 40 per cent for the year as a whole, are staggering and represent the best ever annual performance since the series began 30 years ago.

“Despite this strong performance, increasing concerns are being raised over its sustainability. On the one hand, income returns, that tend to account for the largest component of real estate performance, have fallen sharply, from an annualised 7.7 per cent in the UK at the end of 2009 to 5.9 per cent at the end of 2014, and from 7 per cent to 5.3 per cent in the US between mid-2010 and end 2014. On the other, these yields are down to levels not seen since 2007-08, the prior cyclical peak and a powerful signal of market pricing.

“Many investors take comfort in the relatively low levels of new supply and the still attractive spreads with bond yields, and continue to aggressively bid for real estate assets. But many others are becoming more cautious, exploring opportunities to invest in less favoured and often overseas markets, or deciding to hold back until real estate itself becomes less frenzied.”

KEY POINTS

Property prices

• The national real estate pricing indicator tracks the pricing of national markets based on two simple measures of ‘income return’ and ‘income-bond yield’ spread over each of the past 10 years.

• Most markets became aggressively priced during the 2007-08 peak and corrected in the years of the crisis.

• Over recent years, pricing has become more aggressive, particularly in Canada and the US.

• In spite of the surge in pricing of the UK (values up by 12 per cent in 2014) and, particularly, Ireland (30.7 per cent in 2014), these markets do not seem as aggressively priced as Canada and the US.

Source: IPD