Finding right balance is key for alternatives

The combination of these assets depends on a number of things, from the volatility and risk targets of the portfolios, to correlation between assets and the liquidity of certain sectors. The average multi-asset portfolio has come a long way from the ‘balanced’ or ‘distribution’ funds that held equities and bonds but little else.

A review of the Investment Association Mixed Investment 40-85% Shares sector shows roughly 85 funds with some kind of allocation to alternative assets, whether it is property, private equity, infrastructure or hedge funds. Alternative assets seem to be a staple in many funds, but with so much choice, is there anything that doesn’t work in a multi-asset portfolio?

Paul Flood, lead manager of the Newton Multi-Asset Diversified Return fund, says: “There are some places within alternatives where [investing] can be useful because of the relative value to equities and bonds.”

As an example he points to renewables, which are expected to deliver relatively good returns of 7 per cent during the cycle compared with the low yields on bonds. In addition, some renewable projects, such as solar or wind farms, have already been established and have benefited from government subsidies and so have a sustainable income.

But he adds: “It is important to understand what you own and why you own it. We think [renewables] are mispriced because a lot of investors don’t look at that space as it is small. But it will become closer to what we see in the infrastructure space, where the market has caught up with what [is being] invested in and how sustainable the business models are.”

Andrew Ford, absolute return specialist at Standard Life Investments, notes that for funds such as the global absolute return strategies (Gars), the asset allocation is a “pretty broad church”.

“[In Gars, we are] looking to allocate to a whole host of different asset classes, but they have to be liquid. We don’t have exposure to real estate at the moment, but it is another option. It is about looking at as broad a range of different asset classes as possible and finding the optimal combination for the medium term.”

Asset allocation has changed over time as the sources of diversification and the opportunities and valuations have altered with the macroeconomic environment. For example, Mr Ford points out that in 2008 the main diversification benefits came from areas such as duration in fixed income. Thus Gars had large holdings in Japanese government bonds, gilts and US Treasuries, and so there was a large defensive ballast.

But he adds: “Given what has happened with interest rates in recent years and the future path of rates, we definitely don’t feel comfortable holding a big allocation of treasuries, for example.”

Instead, he notes currency strategies have performed well, including positions that were long the US dollar and short the Canadian dollar. “There is a strong, negative correlation between this strategy and everything else. So something like this will act as a diversifier when the equity and credit positions behave in a certain way.”

Mr Flood says that alternatives have historically been under researched. Most fund managers run either equities or bonds, while traditional multi-asset investors have tended to shy away from the sector as it is not in the benchmarks.

He points to the fact alternatives in a multi-asset portfolio also need to be differentiated in terms of the sustainability of the yield, with a focus on businesses that can grow through a recessionary period and come out stronger.

Alternative strategies can include convertible bonds, catastrophe bonds, hedge funds and even aviation finance – buying an aircraft and effectively leasing it out. But while these are all diversifying assets, the key thing investors should ask is whether they are getting paid for the risk.

“These asset classes benefit at different points in the cycle,” Mr Flood says. “For example, I don’t believe you’re getting paid for the risk you’re taking with catastrophe bonds, but those types of securities are going to be uncorrelated with risk assets so they do provide diversification. If you’re not getting paid for the risks you’re taking, you shouldn’t be holding [those assets] just for the sake of diversification.”

Mr Ford agrees: “Clearly [you] need good ideas, but it is trying to find a combination of ideas that will generate returns on different time frames. It’s not just the number of strategies, it’s the negative correlation and having strategies that behave in different ways. So you have a portfolio that is robust and can perform well whatever happens.”

Nyree Stewart is features editor at Investment Adviser