The role of alternative assets in a multi-asset portfolio

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”. 

Hovenden’s favourite way of getting alternatives exposure currently is via long/short equity funds.

These are products that own some shares in the expectation they will rise in value, and others from which they profit from a fall in the share price, meaning the fund can rise even if wider markets are falling. 

James De Bunsen, who runs the Janus Henderson Diversified Alternatives fund, says: “We classify anything outside traditional, long-only equities and bonds as alternatives. Key asset classes would be private equity/debt, hedge funds, infrastructure, property and commodities.

"We also look at more specialist parts of the credit markets, such as asset-backed securities and structured debt, and niche areas such as reinsurance, commercial litigation and royalties, as part of the alternatives opportunity set.

"Not all these assets provide strong diversification from traditional equities or bonds. We view private equity not as a diversifier but as a higher-return asset class, while infrastructure can have a meaningful amount of duration.

"The genuine diversifiers can be found in the hedge fund/alt-Ucits space, as well as in reinsurance and some commodities, such as gold.”

He adds that from an income point of view, infrastructure funds are a useful way to generate an income that is uncorrelated. Quite often, the income from these assets comes directly from the government, and as a result, is not linked to the performance of the wider economy. 

Keith Balmer, director and multi-asset fund manager at BMO Asset Management, says one mistake clients often make is to confuse having a large number of investments with having a diversified portfolio.

He says: “There are plenty of alternative assets that have different 'monikers' and are not typically seen in portfolios. However, many have the same economic drivers and so just give a veneer of portfolio diversification during normal times.

"These assets disappoint during stressed times, though, as they tend to lose value at the same time as the traditional equities.

"A good example of this would be different forms of credit, ie high yield, mortgage-backed securities and preference shares etc. These would all generally perform poorly in a recessionary scenario.

"True alternatives tend to be more complex, carry higher costs and/or are less liquid, such as certain hedge-fund strategies, catastrophe bonds or direct investments in infrastructure projects.” 

Sunil Krishnan, multi-asset investor at Aviva Investors, says one mistake clients make when thinking about alternative assets is to focus too much on cost.

He says some of the real diversifiers, such as emerging-market debt, are relatively expensive to access, but that this should not put people off, as the specialist nature of the asset class is what makes it both a proper diversifier and also more expensive.