There is an ever growing number of multi asset funds using alternative asset classes to construct their portfolios.
And with a regulatory expectation that advisers ‘look under the bonnet’ to understand the investment solutions they are recommending, for some with little experience in researching funds with alternative assets this can be a bit daunting.
It is not made any easier since ‘alternatives’ is such a large asset class with so many different areas making up the categorisation. Consequently, some areas may be harder to understand and research.
The case for alternatives
Many advisers know about the 1980s academic paper written by Brinson et al, showing that asset allocation is important. Following on from this is the notion that asset classes have a statistical relationship within one another – otherwise known as a correlation. How assets are correlated with one another is the basis of effective diversification. In building a portfolio, to reduce risk diversification is made through the combination of assets with low correlation.
This is the main reason for using alternatives: they are a good portfolio diversifier. They act also in many cases as another source of income generation and potential capital appreciation. In other words the returns can be good as well.
As a source of growth, alternatives are becoming more mainstream as investors look for more solutions. Following on from the financial crisis, a greater use of alternatives is being made within portfolios, not only to help dampen volatility but also to meet a growing interest in real, rather than financial, assets.
So what are alternatives and how do they differ from the traditional asset classes such as equities and fixed income?
A good and, importantly, simple definition of what makes up an alternative asset class is an investment that is not either a share that is listed on an exchange or a fixed income security.
Typically these complex investments share certain characteristics:
• Low liquidity – difficult to buy or sell at certain, possibly, critical times or on demand. It may be difficult or impossible to find a buy when you want to crystallise the investment.
• Difficult to value – sometimes the theoretical price is calculated by an algorithm which could be vastly different from the price offered by the market. Otherwise known as the difference between the ‘mark to model’ and ‘mark to market’ prices.
• Higher due diligence need – the regulatory environment for alternative investments is not as strong as traditional investments. Therefore, a deeper and wider range of enquiry is needed as to the who, how and where the investment is being managed. Transparency is not something the alternative space is usually known for.
Alternative investments include highly specialised areas such as wine, stamps, antiques and art. However, this is outside scope because very few multi-asset funds invest in these areas.
The alternative asset classes we are interested in that are typically and increasingly found in funds are: