The rise of alternatives

Since the global financial crisis, the loosening of monetary policy by central banks around the world has had consequences for income investors. 

The introduction of quantitative easing (QE), which included central banks buying financial assets such as government and corporate bonds, boosted the prices of assets such as equities, bonds, property, commodities and currencies, while at the same time yields – particularly on government bonds – fell. 

This environment has made it trickier for investors to find sustainable income streams, and while some move up the risk ladder, for example from government or corporate bonds into high yield fixed income strategies, another option is to look at alternative investments. 

For many years, alternative investments meant property, but as this has become a more mainstream investment the description now encompasses a wide range of asset classes, from infrastructure to renewables to alternative fixed income to macro, event-driven or long/short investment strategies. 

Opening up new avenues

Once seen as a niche area, figures show the alternative investment industry has grown steadily in the last decade, rising from $3.1trn assets under management (AUM) in 2008 to $8.8trn in 2017, and is predicted to grow to around $14trn by 2023. 

While global monetary policy has been a key driver of this trend, other factors that have helped the rise of alternatives include better accessibility to more niche investment areas, particularly through the use of investment trusts. 

These closed-ended investment vehicles allow a broad range of investors access to otherwise inaccessible investments, such as renewables, infrastructure or private equity, which are generally quite illiquid asset classes. Investment trusts offer a reasonably liquid fund structure that can be traded on the stock market, while the fixed capital nature of investment trusts helps protect against unexpected surges of inflows or outflows, as witnessed in some open-ended property funds in the wake of the EU referendum in 2016.

In addition, from an income point of view, the structure of an investment trust allows it the flexibility to build up income reserves that can help smooth income distributions.  This feature has allowed more than 40 investment trusts to increase their dividends for 10 or more consecutive years. 

Two infrastructure vehicles – HICL Infrastructure and International Public Partnerships (IPP) – have benefited from this feature, increasing their dividend payout every year for more than a decade.

Infrastructure is a growing area of interest for income investors, mainly because of the long-term sustainable income streams from projects that are often backed by governments. This can include hospitals, schools or transport networks, all of which can be considered quite defensive, ‘real assets’ that are often inflation-linked in some way.  

Solar powered returns

In a similar vein, renewables is also becoming a strong candidate for those seeking sustainable income streams. Most often associated with wind power or solar energy, these investments can share a number of characteristics with traditional utility investments, such as predictable revenue streams, and defensive and non-cyclical traits. In addition, the global move towards tackling climate change – including the recent actions by Extinction Rebellion – and the fall in prices as technology becomes cheaper and more sophisticated, makes the case for renewable energy being a long term trend instead of the short-term fad some once considered it.   

In the current market environment, the demand for both infrastructure and renewables has been particularly strong given their exposure to relatively stable, economically insensitive, inflation-protected cash flows. These assets have the potential to generate low volatility, consistent growth of cash flows and returns that are uncorrelated with other asset classes, resulting in very attractive diversification benefits for investors. 

Creating the right balance

However, while alternative investments offer many advantages to the income investor, there are also risks to be aware of. For many of these, particularly infrastructure, renewables and property, the fact they are ‘real assets’ also makes them relatively illiquid, meaning it is harder to sell the assets quickly without losing some value.  Whilst the investment trust wrapper can provide access in a more liquid form, they come with their own complexities with share prices able to diverge from underlying asset valuations, known as a discount or premium to the net asset value. It is therefore important to understand the drivers of this.

The continuing evolution of markets means new avenues are constantly opening up for the savvy investor to find new income opportunities, but as the saying goes, if it sounds too good to be true, it probably is, unless you’ve done your homework properly. 

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