2018 was a difficult year for investors in many alternative strategies.
The promise of uncorrelated investment returns is an appealing prospect, as evidenced by the growth in both the number of absolute return funds, and overall assets under management (AUM) in the sector.
Returns, however, have in aggregate, been disappointing and many investors and advisers are questioning their allocation to alternative strategies.
Case for alternatives
However, in our view, the case for an allocation to alternatives is still clear.
Global government bond yields remain low by historical standards and over $17tr of global debt trades at negative yields.
At such low yields, prospects for a continuation of the 38-year bond bull market appear slim.
BlackRock estimates the 10-year nominal return for UK Gilts to be 0.7 per cent pa, which falls to -1.3 per cent pa, adjusted for 2 per cent inflation pa, with an expected volatility of 6.8 per cent pa - hardly an attractive investment proposition.
In conjunction with poor future returns, our analysis indicates a reduction in diversification benefits due to an increasingly unstable relationship between government bonds and equity markets.
Given this poor outlook for a core element of investor portfolios, it is understandable that alternatives have witnessed ongoing investor interest.
Our approach at Waverton is to clearly separate the alternative universe between absolute return and real assets.
The former should seek to deliver positive returns on a 12 month rolling basis, display low volatility and importantly low correlation to the broad equity market.
By comparison, real assets should be considered long only, return seeking investment opportunities, delivering equity like returns with lower volatility, albeit with some correlation to risk assets.
Value in real assets
We have categorised the universe across five real asset classes; property, infrastructure, commodity, asset finance and specialist lending and we are particularly positive on the current opportunities across a number of the specific real asset sub sectors.
Our contention is that an allocation to real assets can help investors meet the challenge of the low interest rate environment and bring portfolio diversification benefits.
We believe that real assets deserve to be considered as a core allocation within investment portfolios over the long term.
The asset class has proven its value over time by providing reliable long-term total returns, inflation protection and the ability to offset the volatility of equity and fixed-income investments.
Investors are looking for what real assets offer: the potential for steady, predictable and growing income, potential gains and capital preservation in an uncertain global environment.
The Waverton Real Assets Fund seeks to achieve a UK CPI+4 per cent total return over the long term.
Many of the assets and cash flow streams accessed are either explicitly or implicitly linked to inflation.
Low interest environment
Should the global economy remain within a “lower for longer” inflation and interest rate environment, and as real assets themselves become increasingly well understood, there is room for yield compression in many of the underlying investments.
The five core real asset classes and investments within each underlying specific real asset class sector will each respond differently to varied economic environments.
Some are more tilted to the economic cycle than others, some are more correlated with inflation, while others specifically take on commodity and other risks.
Diversification
The rationale for a diversified portfolio of real assets is to reduce the risks inherent in individual real asset and sub-real asset classes and provide a solution offering a consistent real asset return profile over time.
The real asset universe is broad and varied, but does share a number of common characteristics.
Firstly the universe is linked, to varying degrees, with the global growth cycle.
It is therefore more likely to post good returns in a positive economic environment.
Secondly, much of the universe offers inflation-linked cash flows and thus protection from rising inflation.
Thirdly these cash flows, whether delivered via a coupon or a dividend, provide an attractive level of income.
And finally, to date, the universe has seen much lower mainstream investor participation than the traditional asset classes which we believe provides a relative value opportunity.
Structural trends
Underpinning each of the specific real asset opportunities there are a number of structural trends supporting long-term allocation of capital.
Infrastructure: Global demand for increased infrastructure spend, either through the broadening of China’s ‘One Belt One Road’ initiative or a large scale US led fiscal stimulus package aiming to boost economic growth.
Property: The shift to e-commerce provides opportunity within the logistics and retail warehousing sectors, while the demographic profile and limited government budgets provide a range of attractive investment opportunities in Healthcare, Social housing and Care Homes.
Commodity: The shifting energy mix to tackle climate change coupled with the geopolitical and multilateral agreements to reduce greenhouse gasses provides a fertile opportunity set to invest across renewable asset classes, while many ‘traditional’ natural resources, such as copper have compelling supply demand dynamics, while trading at attractive valuations.
Finally, the retrenchment of investment and corporate banks from traditional financing has created a rich opportunity set for many institutional investors to provide capital at attractive rates across the specialist lending and asset finance sectors.
In summary, the global interest rate policy environment enacted by central banks post the global financial crisis with associated low yields, accompanied by weak economic growth and benign inflation appear somewhat entrenched in developed economies.
As investors assessing the outlook, we believe an allocation to both absolute return to aid portfolio diversification and real assets to aid portfolio returns, should be considered alongside traditional asset class exposure to enhance long-term risk adjusted returns.
Luke Hyde-Smith is co-manager of Waverton Real Assets Fund
