Esoteric assets such as hedge funds, commodities and infrastructure are increasingly becoming a fixture in wealth manager’s toolkit. What do they offer and are they here to stay?
Alternative investments are the Quality Street of the asset class universe: a whole heap of different things bundled together under one label, including a lot of stuff no one really wants.
This seemingly haphazard assortment of products is perhaps better defined as anything that isn’t an equity or a bond. From property to private equity, absolute return funds to gold ETFs – in fact, even music royalties have found their way into the mix in recent years.
Despite their idiosyncrasies, alternatives now play an important role in DFMs’ portfolio allocations, typically as a diversifier away from the noise of the mainstream. But average allocations have gone down recently.
So Asset Allocator decided to take a closer look at the ways in which allocators make use of such tools, because, well, what else would we do on a Wednesday morning.
First, it’s worth noting that the decision to even touch alternatives as part of MPS propositions varies by institution. Some allocators are more heavily placed here than others: for instance, 16 per cent of 7IM’s holdings are in alternatives and property, while on the other hand, Liontrust affords less than 1 per cent of its strategy here.
DFMs’ average exposure to the broad bucket of assets hovers around 11 per cent, and with this in mind we had a chat with some allocators to see what’s occurring on the ground.
Eggs in baskets
Achieving diversification within multi-asset portfolios seems to be the starting point for most fund selectors before dipping their toes into the waters.
Ben Seager-Scott, head of multi-asset funds at Evelyn Partners, said the appeal of alts was sparked by low interest rates but he doesn't expect that appeal to fade now rates are higher.
“Alternatives have grown in popularity over the last decade, probably because interest rates have been very low for quite a while which has made bonds in general quite unattractive, pushing investors to look for other assets and investments to populate the non-equity portion of their portfolios,” he said.
“That may have shifted more recently given ‘bonds are back’ but the driving factor has probably moved away from the low-yield element towards the unstable correlation between equities and bonds – so, really about diversification, which is the key thing I think alternatives offer to investors.”
It is perhaps this 'bonds are back' thinking which has led to both alternatives such as absolute return funds and hedge funds and property and infrastructure allocations to dip slightly in recent months.
Current average holdings for alts are 6.99 per cent while for property and infrastructure this is 3.72 per cent.
For Francis Chua, fund manager at LGIM, diversification is key and alternatives are a way to achieve a better risk-return profile over time.
“We have seen this time and time again where different assets perform differently under different circumstances,” he said. “Take for instance 2022, a year when both equities and fixed income were challenged, the best performing asset was commodities, an asset class within alternatives.”
He looks for alternatives which offer the right differentiating characteristics, such as inflation linkage or an illiquidity premium.
LGIM is invested across infrastructure, global real estate, commodities and absolute return strategies, with varying weightings depending on the product. Generally, according to Chua, the allocation to alternatives is lower for higher risk portfolios.
Know your stuff
One of the thornier issues when deciding to use alternatives is their relative complexity compared to traditional securities. Each offering will be run differently and several allocators have stressed to Asset Allocator the importance of knowing exactly what’s underneath the bonnet of a chosen fund.
Ian Rees, co-head of multi-manager funds at Premier Miton, advocates the cautious approach.
“Investors do need to appreciate that by looking to alternatives, there is a greater level of analysis required in understanding these more complex asset classes and strategies,” he said.
“In addition, to benefit from lower drawdowns that arise from diversification, investors have to determine their preference for improving risk adjusted returns at the likely expense of lower total returns of the portfolio.”
He added that the team is currently a fan of Atlantic House Uncorrelated Strategies.
“Although a complex fund, the strategy has the simple aim of providing diversification on generating good returns as volatility increases in financial markets, without suffering a significant drag when volatility remains depressed,” he said.
Premier Miton dishes out about 9 per cent to its alternatives bucket, slightly above the peer average in our database.
At the other end of the spectrum, we also conversed with Mark Preskett, senior portfolio manager of Morningstar. He has stayed out of alternatives entirely, and offered some reasons behind the decision.
“Some problems investors face are a lack of transparency: these are very sophisticated strategies, using derivatives extensively, so really understanding what the funds are doing at any point in time can be difficult,” he said.
“Many are expensive, with steep performance fees eating into the returns. Liquidity can also be an issue; not all funds offer daily dealing and there is often a limit in a vehicle’s capacity.
He added that the quality of strategies available in a Ucits structure is relatively skinny, though improving. But with low credit spreads and US equities fully valued, Preskett says Morningstar are looking closely at allocating some capital to alternatives again.
And perhaps Preskett's approach of waiting and seeing isn't far off from what his peers are doing.
When we checked DFM sentiment towards absolute return, property and infrastructure the overwhelming reaction of our respondents was that they are neutral.
This doesn't suggest allocators are being overwhelmed by animal spirits towards or away from these assets (we haven't asked allocators about commodities because exposure towards them tends to be quite small).
Uncorrelated options
In terms of specific funds, there has been a fairly concrete move away from some of the favourite alternative funds in our database.
At the start of 2022, this section of our database was dominated by NB Uncorrelated Strategies and TwentyFour Absolute Return Credit which were both held by eight allocators each.
But the former is now only held by five while the latter is held by seven.
Which funds have won out? Well, AQR Managed Futures is now held by four allocators - up from two.
Artemis Target Return Bond has seen a growth in its following and is now also held by four allocators.
Hedge fund headaches
Hedge funds pop up occasionally in portfolios: sometimes for diversification, other times for pure alpha. In this sense these funds test managers’ ability to add value through their skill alone, largely independent of broader market movements.
Cormac Nevin, fund manager at You Asset Management, says the typical drawback when investing here is the associated costs.
“Many absolute return strategies continue to charge fees from a different era – with a less compelling return profile,” he said. “This has become more pressing of an issue in the higher interest rate environment as many managers now struggle to outperform cash rates after fees.”
He pointed out that these vehicles will not keep up with markets in ‘rip-roaring’ beta rallies, nor are they designed to. Nevin also said it depends entirely on the managers employed, rather than about strategies in the abstract.
Similar concerns are shared by David Lewis, lead investment manager in the Jupiter Merlin team.
"We would like advisers to be able to confidently explain what is going on under the bonnet of all the strategies we invest in for the Jupiter Merlin Portfolios and it is far less easy to be confident of this for funds in the absolute return/hedge fund space," he said.
"Indeed there have been a number of high profile absolute return fund strategies which have raised significant assets only for things to turn sour. We see a lot of value in understanding what you are buying and keeping things simple."
The two have a point. We looked at the average OCF charged in the IA Targeted Absolute Return sector at it currently sits at 0.92 per cent.
But in the UK All Companies sector it is 0.69 per cent and in the North America sector it is 0.61 per cent.
Fees also appear smaller in the bond world with the average OCF in the sterling corporate bond sector 0.42 per cent.
You's absolute return manager blend consists of three very distinct approaches designed to generate returns with low volatility across all market environments, according to Nevin.
Owing to their complexity, he said: “We would only advocate their use by those with the research capabilities to properly analyse these managers.”
Meanwhile, Lewis sticks firmly to gold and direct commercial property at Jupiter, assets that he believes have stood the test of time. Of the precious metal, he said:
"A currency which no central bank can print, it flourishes during times of fiat currency debasement and is what one can refer to as an anti-fragile asset. When other assets are crumbling, the safe haven status of gold often attracts money in, helping the returns from gold to often be inversely correlated to other assets during times of stress.
We have successfully increased our weighting to gold during challenging periods in the past and that is the alternative asset class which we would most likely use again. It has endured millennia of challenges and remains a store of value, a pedigree that other alternative assets would long for."
