Both history and common sense would suggest that diversification – the act of spreading your investments across various different types of asset – is an intelligent way to manage long-term risk and returns within a portfolio.
Avoiding over exposure to a single asset class or investment means that portfolios can better withstand the vagaries of global markets – quite simply, adhering to the old adage of not putting all your eggs in one basket.
But what does genuine diversification really look like?
We stand at the end of a decade-long experiment in monetary policy, which has pushed up valuations across most traditional asset classes. Against the backdrop of a global economy arguably more interconnected than ever before, previously uncorrelated assets may well be more correlated than traditional models indicate.
Finding true diversification is, therefore, an increasingly important part of building stable portfolios and achieving attractive long-term risk and return objectives.
So-called 'alternative assets' have long been an important part of multi-asset portfolios for this very purpose, having been typically used for both return and diversification benefits, with the term itself serving as an umbrella term to include cyclical assets such as property, alternative trading strategies like hedge funds, or private assets, such as private equity and private debt.
According to a recent study by Preqin (a data tracker for the alternatives sector), this broad sector is set to enjoy rapid growth globally over the next five years, with alternative assets under management likely to reach $14trn in 2023, versus just $8.8bn in 2017.
While this is an impressive headline, though, investors should not view alternatives as a single asset class, and the study projects considerable variation within the space ahead.
Indeed, these assets and strategies form a distinctly heterogeneous group, often exhibiting very different risk and return characteristics from one another, and being driven by varying macroeconomic forces.
Alternative versus traditional assets: a scene of changing dynamics
As the name would suggest, alternative assets are generally used to provide alternative solutions to existing investment conundrums. For example, when looking to protect against inflation risk, property could theoretically serve as a useful solution given its potential for inflation-linked rental income streams.
However, due to the inherent cyclicality in property markets, short-term correlation between property and equities may be high, providing little short-term diversification benefit during sudden market sell-offs.
Similarly, hedge funds – often viewed as risky investments – can be perceived to add to the overall portfolio risk due to their use of complex instruments and leverage.
However, many hedge funds are able to ‘short’ assets such as equities (i.e. benefiting when equities fall in value) and can, therefore, provide important diversification properties to equity portfolios during periods of stress.
Risk, as these examples would suggest, comes in many forms: equity market risk, inflation risk, liquidity risk, market volatility, etc. It is important, therefore, to understand the key risks within the traditional parts of a portfolio and to allocate to alternatives potentially able to mitigate those risks.