InvestmentsApr 15 2021

Incorporating alternative assets into your portfolio

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Incorporating alternative assets into your portfolio
Pexels/Lachlan Ross

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.

The chief benefit of using alternative assets or investment strategies is diversification Charles Younes, FE Investments

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

Alternative assets also contribute to portfolio returns when the markets are not moving upwards and many investors use alternative assets as a counterbalance to falling markets, as they are not reliant on market performance.

Tim West, UK alternatives leader at EY, says: "Professional investors use sophisticated tools to measure the risk-return profile of alternatives to get the right balance.

“When looking to alternative investments, the potential for higher returns must be weighed against the higher fees charged by the investment manager. In some structures, the manager may co-invest alongside the investor and be entitled to performance fees – this alignment is seen as an extra incentive for the manager to outperform.”

Alternatives are not just necessarily a ‘defensive play’ to balance investors’ portfolios. Instead, they seek out returns linked to a non-traditional asset or investment strategy and can provide strong returns, according to Lane Prenevost, global head of discretionary asset management and head of UK multi-asset at HSBC Global Asset Management.

“Alternatives can increase returns by offering access to an illiquidity premium, which is most common in private markets, such as real estate or private equity. These assets often embed leverage, increasing returns, but also of course potential losses,” he says.

“Alternative asset classes may benefit more than equivalent public markets from active management, where there is product complexity or information asymmetry, as is the case for private credit markets or unlisted infrastructure. Option writing also offers the ability to increase portfolio income, which is really useful for investors looking for yield in their portfolios.”

However, according to FE Investments’ Younes, investors should not be fooled into thinking of ‘alternative assets’ as a single asset class in their own right.

He argues that the view that assets are either ‘traditional’ or ‘alternative’ and that all alternatives perform and behave in the same way in all market conditions is a mistake. One year ago, when markets were falling, some alternative assets that were geared towards certain market conditions performed very well, while other alternatives performed very badly.

He says: “Looking at the IA Targeted Absolute Return sector we see huge disparities in performance. Although the sector has averaged a negative performance of -4.86 per cent (relative to a -30 per cent fall in equity markets), funds like Argonaut Absolute Return, AQR Managed Futures or Allianz Fixed Income Macro were positioned to benefit from a sell-off in credit and equity markets and generated strong positive returns.

“Conversely, funds like Natixis H2O MultiReturns or GAM Star Global Rates took too much directional risk and fell in line with traditional asset classes.”

Fraser Harding is a freelance journalist