InvestmentsJul 9 2020

The role of alternative assets in dampening volatility

Supported by
Rathbones
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Supported by
Rathbones
The role of alternative assets in dampening volatility

Peter Fitzgerald, multi-asset investor at Aviva Investors, defines the difference as follows: “Risk is about a permanent loss of capital, volatility is about the propensity of the price of an asset to move up or down frequently.” 

Dan Kemp, chief investment officer at Morningstar, notes that volatility is required to help investors generate a return.

He says: “The problem is when markets are volatile, lots of different assets, good and bad, fall in price sharply, and that scares investors.

"But actually, it is from that volatility that opportunities arise. Without volatility, prices wouldn’t fall, and there would be [better] investment opportunities. Investors who try to time the market or are short-term in outlook don’t get the benefit of volatility, and instead experience loss of capital.”

As a result, there is a difference between low volatility and low risk.

Low volatility

David Coombs, head of multi asset investing at Rathbones, says many assets appear to have little volatility but are in actual fact among the riskier assets on the market. 

He says: “Low volatility should not be confused with an assumption that assets are also low risk."

He points to alternative assets, in particular as an area where the two terms can be mixed up.

"As we have seen recently in some sectors such as student housing, aircraft leading, infrastructure and property - all often found in multi-asset portfolios to act as a volatility dampener – what seemed a low volatility way to secure income has seen huge hits to value.

The problem is when markets are volatile, lots of different assets, good and bad, fall in price sharply, and that scares investors.--Dan Kemp

"However, investors should not get into the habit of focusing on the volatility of each line item in their portfolio – this is totally irrelevant. What matters to us, if we build a portfolio that offers real diversification, is that the correlation of the assets will drive the appropriate portfolio volatility.” 

He said an investor that focuses excessively on having a low volatility portfolio might find themselves in a position where the assets have little volatility, but also deliver low returns. 

Robin Geffen, global equity fund manager at Liontrust, sums this up a different way. He notes the lowest volatility investment on earth is to simply put money into a drawer. Doing this, of course, means sacrificing any possibility of making a return from an investment. 

In alternatives, products such as student property funds, which own assets that are not priced on a daily basis, can seem to have little volatility - because without movement of the underlying assets, there may be little reason for the fund price to move.

That creates the impression that there is little volatility in the asset class - until a major event happens and the market news the value of the underlying investment to fall in value, causing a swift, and sharp drop in the value of the fund. 

Another example is open-ended commercial property funds. These are strategies which can appear to have low volatility. 

But when Brexit and then the Covid crisis forced those funds to shut to investors wishing to withdraw their cash, the risks became all too apparent. 

Investors should avoid alternative investments which do not provide enough diversification.--Dean Cheeseman

The alternative asset class preferred by Mr Coombs is gold, as he believes investors will have to deal with deflation in the years to come, and gold is an effective investment in that climate.

He has also used derivatives, specifically those that protect his funds from future falls in the US equity market in exchange for a small payment from current returns.

This works in a similar way to an insurance policy and helps smooth out returns over the longer-term. 

Not all agree. Stephen Hay, multi-asset fund manager at Baillie Gifford, prefers not to invest in derivatives as he believes they are instruments ultimately linked to the returns of a particular asset class, and so are not really diversifiers.  

Opportunities in alternatives

Dean Cheeseman, multi-asset investor at Janus Henderson, is keen on alternative assets, but believes investors can sometimes be too blasé. While volatility is usually short-term in nature, extreme volatility can quickly turn into a permanent loss of capital .

Mr Cheeseman says: “A “properly” diversified portfolio that includes alternative assets should help dampen volatility.  Alternatives represent a wide array of investments available, but not all of them share common characteristics or achieve a goal of dampening volatility.  What defines an asset as “alternative” is exhibiting different return drivers and income streams from traditional equities and bonds, while also offering lower correlation with the primary two asset classes.

"Gold is an example of a commonly used alternative asset, but it can itself experience elevated volatility at times which may not necessarily suit all types of investment mandates. However, it tends to be a good hedge and a diversifier and is often used in multi-asset portfolios; recently it has been supported by a weakening US dollar.

"Investors should avoid alternative investments which do not provide enough diversification, ie have high correlation  to stocks and bonds, as well as those strategies with exposure to low-quality assets, high leverage and insufficient liquidity.”

investors should not get into the habit of focusing on the volatility of each line item in their portfolio – this is totally irrelevant.--David Coombs

More esoteric options are also available. Gary Potter, who jointly runs about £2.5bn of assets across a range of ten multi-manager funds at BMO Asset Management, has investments in assets such as UK caravan parks, which he says perform in a way that is not reliant on the wider economy, and so are alternative assets.

He also always tends to have gold in the portfolio, saying its unique characteristics help it stand out from other holdings.

He says: “My job is to make a return for my clients that is greater than inflation and the cost of advice. Alternative assets definitely have a role to play in that. We also own gold, which as an asset class performs in an odd way.”