Choose wisely amid volatility

This article is part of
Multi-Asset Investing - December 2015

The ending of extraordinarily easy monetary policy in the US will for many be the trigger for a period of increased market volatility as interest rates are hiked.

Money printing has effectively underwritten asset prices and suppressed Treasury yields for a number of years, fuelling an equity bull market and a chase for income. Many asset classes are at or nearing expensive territory valuations.

The expected inflationary pressure from a global economy awash with liquidity hasn’t happened and rates remain far below central bank inflation targets. This will change in time as unemployment continues to fall and wages start to rise.

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With an outlook of increasing volatility, interest rates and inflation, it is time for investors to review the role of traditional asset classes in portfolio construction. While stockmarkets can continue to offer long-term capital growth, stock selection will surely be more crucial.

Bond yields and cash deposits are closer to historic lows than highs, challenging future real returns. Many investors are therefore turning to alternative assets in portfolio construction to provide capital growth, income and diversification.

An investment can be defined as alternative if it is either a non-traditional asset class, such as commodities, or a non-traditional strategy, such as long/short equities. A good alternative investment is one that produces a competent risk-adjusted return over a reasonable period and displays low correlation to traditional asset classes.

Ten years ago there were few alternative investments available for UK retail investors as the funds industry was mainly made up of a variety of equity and bond products. There were some managers targeting long-term absolute return, though hedging tools were very limited.

Alternative investments were mainly reserved for institutions and offshore for high net worth investors. After the financial crisis many investors were looking for tools to help limit downside risks in portfolios.

The industry responded by launching innovative products, with some strategies migrating from offshore to onshore. Early launches were absolute return funds focusing on hedging risk.

These vehicles, such as market neutral or absolute bond funds, were positioned as risk diversifiers for a portfolio.

Product development has since accelerated, resulting in more availability of alternative funds. The most established hedge fund strategy, long/short equity, can offer investors capital growth and diversification, with the potential to enhance overall returns.

Alternative funds are also proving popular with investors in spite of the strong equity bull market since March 2009, as monthly inflow data from the Investment Association clearly shows. A variety of hedge funds and absolute return funds are becoming commonplace in portfolios as investors look to reduce bond weightings ahead of the pending US interest rate rise and with cash offering no real yield.

So the right alternative investment can improve both the diversification and risk-adjusted return of a portfolio as market conditions change.

But this is not a homogenous asset class and no two alternative funds are created the same. Fund selection is critical, both in the initial assessment of a portfolio, as well as the ongoing monitoring of risk and returns.