Equities have been enjoying one of the longest bull runs in history (particularly in the US), dragging valuations away from attractive levels. This exposes the vulnerability of equities to the wider economic cycle, the behaviour of central banks, and the general threat of unexpected influences and events.
Meanwhile, with global bond yields suppressed, the relative attractiveness of fixed income has fallen too, especially as bonds may not be able to provide the same diversification benefits they have historically offered during risk-off periods.
Government bonds have traditionally been the ‘diversifiers-in-chief’ but today they have a major issue – valuations are expensive.
With many major bond yields already very low (partly as a result of years of global central bank easing) the true protection that bonds will be able to offer investors during the next crisis is being called into question.
We believe investors should view investments classified as ‘alternatives’ as more than just risk mitigation tools; amid a seemingly lacklustre set of opportunities in traditional markets, investors may be well served in seeking returns from less traditional markets.
Indeed, investors can hardly fail to notice that a large swathe of traditional return drivers have been treading water (or displaying outright weakness) so far this year, illustrating the importance of finding alternative sources of return within multi-asset portfolios.
Compounding this, investors are increasingly seeing signals that previously well established relationships between asset classes are breaking down. Investors should be paying close attention to these changing dynamics, as if traditional equity market volatility starts to rise as the cycle evolves, traditional asset classes may struggle.
What’s more, on the heels of a period of markedly low volatility when set in a longer-term context, investors must not become complacent.
Gaining alternative sources of returns and protection through alternative assets
Where, then, can investors find these alternative sources of returns over the long term, and what health warnings come with these assets?
Private markets (such as infrastructure and property debt) can provide an attractive yield premium over their public counterparts due to higher barriers to entry and more inefficient market structures.
Commercial property would also fit into the category of alternative return drivers, but investors must be mindful of valuations and exposure to rising yields. Infrastructure and social housing, where the drivers are a lot more idiosyncratic and uncorrelated to the broader business cycle, also tend to offer something different.
In the commodities space, energy and industrial metals (which can be driven by market-specific supply/demand factors) can provide an inflation hedge, though lately metals have behaved unhappily, similar to emerging markets.
Elsewhere, some hedge funds have a demonstrable history of generating uncorrelated active returns through trading more niche markets such as volatility futures and energy contracts. Investors could also consider a hedge fund cohort we can describe as ‘volatility winners’ – designed to swiftly change positioning as market trends change direction, potentially benefiting as market volatility rises.
Questions appear on the last page of this article.