If clients are reluctant to take up the full 40 percent allocation to bonds in a portfolio, but also reluctant to embrace equity markets at a time when many valuations are nudging record highs, the only other option is to embrace alternative assets.
The first challenge here is to determine what those are, says Charles Hovenden, portfolio manager at Square Mile Consulting.
He says many market participants view them as being “anything that isn’t bonds, equities or cash,” while for others, the search is for assets that are uncorrelated to wider economic conditions or to the performance of equity markets.
Ben Kumar, senior investment strategist at 7IM, says: “It is not particularly helpful to the client to just say that alternatives are anything which are not bonds or cash. That is far too wide a universe to be helpful.
"I think the way to divide it is to ask, what does the client want to achieve from their alternatives exposure? Alternatives can either be there as a form of insurance, to protect wealth, or they can be a return enhancer, designed to go up in value.
"So, the first step is to work that part out. We generally want our alternatives to be flat or going up when equities are falling – the role bonds used to play.”
He adds that there is no one alternative asset that can perform this function, and instead he allocates to a basket of currencies and long/short funds to achieve it.
One type of investment often described as alternative, and which has certainly been in demand with investors over the past decade, is the alternative income investment trust. These invest in areas such as music royalties and aircraft leasing.
Hovenden is sceptical that these are truly alternative investments, because, as investment trusts, they are listed on stock markets, and so will behave in the same way as equities.
He adds that one of the reasons they have proved so popular is that with bond yields very low, the income from these trusts is being used as an alternative to the income clients once received from their bond allocation.
But if this is the case, then a rise in bond yields would likely mean the income available from those trusts looks less attractive, and so they would sell off. This implies the returns of such trusts are actually quite correlated to bonds.
Kumar says: “Most clients overemphasise the importance of income. The alternatives bucket we had returned 35 percent in March and April last year, compared with a 30 percent decline in equities.”
Suzanne Hutchins, multi-asset investor at Newton, says that while those investment trusts do have equity risk, “this is volatility. Risk in investment markets is about the permanent loss of capital, but volatility is different to that; it is about temporary movements.
"So, a music-royalty investment trust, for example, would have the volatility of equity markets, but the underlying cash flows are uncorrelated to equity markets over the long term”.