Since traditional asset classes have been increasingly volatile and aligned in their performance, investors have been trying to balance their portfolios with alternative assets.
Fund managers have had to adapt to challenging market conditions, more recently caused by the Covid-19 pandemic, but also ongoing challenges like the consolidation of hedge funds and falling activity in traditional private equity areas such as retail.
Forecasts, based on projections from the PwC Asset and Wealth Management Research Centre, suggest that alternative assets under management will almost double from 2017 to 2025, but it is worth understanding what alternative investments are and why they are important to incorporate into portfolios.
Alternative investments are those that do not naturally correlate with traditional listed markets due to the nature of the underlying assets, such as real estate, infrastructure, private equity or commodities, or the novel way in which they are managed or structured.
Put simply, alternative investments do not slot into the traditional categories of bonds, equities or cash. Generally, their prices have a low correlation to these main three categories and while they can invest in traditional asset classes, they can also adopt arbitrage or short selling to take advantage of price differentials.
Alternatives can broadly be split into two categories: private fund assets and open-ended fund assets. Private fund assets include private equity, real estate, infrastructure and private debt or credit, while open-ended fund assets are financial instruments, exchange-traded securities and related derivatives, which usually come in the form of hedge funds or long/short funds.
Diversify for protection
“The chief benefit of using alternative assets or investment strategies is diversification,” says Charles Younes, research manager at FE Investments.
“Clearly if all of an investment portfolio is positioned in traditional assets that are reliant on the market and the market falls, then that will impact on returns. Adopting positions in alternatives should act as a counterbalance to any negative market movements.”
He adds: “A traditional ‘balanced’ investment portfolio has a 60/40 balance for bonds to equities, but there is a high number of academic studies to suggest that having a 10-20 per cent holding in alternatives can significantly improve risk-adjusted performance ratios by reducing volatility.”
Crucially, such diversification can be useful in uncertain times – such as the current Covid-19 pandemic – for the right investor. Exposures like uncorrelated hedge funds can provide returns when you need them most, such as in a volatile sell-off, and help cushion the rest of the portfolio.
As alternative assets tend to have a much longer return horizon, they tend to be lower risk. For example, income streams from real estate and infrastructure assets are usually steady and predictable and can be used to offset long-tail liabilities such as those within pension, endowment and insurance companies.
Weighing up the risk