Why alternatives have come of age

This leaves investors and advisers in something of a quandary. Should you increase your risk tolerance to try to maintain returns, or instead accept lower growth prospects? The available options may not be as binary as they first appear, if we consider the possibility of including alternative investments within a diversified portfolio.

The range of alternatives has become more diverse over past decades, as many industries have sought to become more accessible to external investment. Some alternative investments are more niche than others, but their detachment from the peaks and troughs of market cycles is part of what makes them intriguing.

These financial innovations really began with the emergence of mortgage backed securities, which financed the construction of most of the US skyscrapers in the 1920s. We then saw the creation of hedge funds in the post-war period. Alfred Jones is considered the creator of the hedge fund concept. His fund avoided regulatory requirements by limiting itself to 99 investors. At the heart of his idea was to leverage short-selling to protect investors from downturns in the stockmarket. Mr Jones chose to charge no management fees and instead take 20 per cent of profits as compensation.

More recently, catastrophe bonds were first issued in the aftermath of Hurricane Andrew and the Northridge earthquake in America. This followed the need by insurance companies to alleviate some of the risks they would face if a major catastrophe occurred.

Perhaps the most talked about part of the alternative investment universe are absolute return funds or hedge funds. The past decade has seen many different terms used to fundamentally describe the same thing. After the lack of downside protection offered to investors during the global financial crisis, and a couple of subsequent high-profile frauds, the term hedge fund fell out of popularity in retail markets.

Absolute return became the common phrase for hedge fund strategies, although more recently investment banks have created “liquid alternatives” as the buzzword for referring to absolute return strategies in a daily dealing format. At the root, the same strategies are employed, but managers will align themselves to whatever the classification du jour is. When looking at these investment vehicles, it is important not to forget the vast range of different strategies on offer such as merger arbitrage and long/short equity.

Investors now also have greater options within specialist property funds, which can include health surgeries, warehouse distribution centres and student accommodation. These investments can provide inflation-linked returns as well as potential capital appreciation. Importantly, these types of alternatives often help to smooth returns in different parts of the business cycle and potentially offer more certainty in terms of future cashflow forecasts.

Other areas include renewable energy, which comprises wind farms, solar firms, biomass plants and waste processing plants that all pay an inflation-protected income. Aircraft leasing is another sector.

For a long time, alternatives were seen as the dark corner of financial markets because they were complex to understand and expensive to invest in. This is no longer strictly true.

Over the past 10 years, the addition of alternatives to a bond and equities portfolio has improved risk-adjusted returns and enhanced yield. Importantly, alternative assets are largely unaffected by fluctuations in capital markets and should offer an element of downside protection. This is especially important in the context of the current market conditionals, with traditional assets such as equities and bonds becoming increasingly correlated.

Advisers, and investors, should of course be aware of the different risks involved in using these alternative asset classes, the most obvious being the potentially reduced liquidity. It is important if investing directly into these assets, to understand not just the asset class itself, the strategy and manager, but also the structure that the investment is housed in.

Rigorous research in the alternatives space can uncover interesting investment opportunities which fit well within an overall diversified portfolio.

Solomon Nevins is an investment manager at Architas