InvestmentsNov 17 2021

Alternatives present opportunity for stable income generation

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Alternatives present opportunity for stable income generation
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As current demographics push more of the population into retirement, there is a broader demand for income as traditional asset classes are not providing the same level of income they might have done in the past.

In many respects, some parts of the alternatives market are more stable and less complex than investing in equities and can provide that income buffer. Given the lacklustre returns and income from bond markets, some of the more stable cash-generative alternative sectors might provide an attractive substitute. They tend to have limited exposure to the wider economy and tend to provide long-term, stable returns. 

With increasing worries about the impact inflation is having on real returns, driven by expansionary fiscal and monetary policies, many of these alternative investments are protected with inflation-linked revenues, and so are far better protected than bonds against the ravages of inflation. 

Where to start? 

There are varying degrees of complexity in all markets, but listed infrastructure and renewables assets tend to be fairly straightforward business models generating stable cash flows and paying them out in the form of dependable dividends.

There is less risk of merger and acquisition activity or management teams moving into unrelated business areas and surprising investors as their business models tend to be very focused on a particular activity, for example, solar or wind farms, battery storage or PFI projects. As a result, investors know the underlying exposures they are investing in and the sensitivities to changes in inflation or costs. 

With more complex investments such as hedge funds, private equity or leveraged credit, we believe investors need to be more cautious as they can be more sensitive to the economic backdrop and financial market conditions, so a good understanding of what the portfolios are currently made up of is important as this can change quite quickly depending on the managers’ views. 

If we take the example of a renewables company, investors know they will be exposed to power generation output, subsidies the sector benefits from and, to some degree, the power price. All of this tends to be relatively stable over time and far less correlated to the economic backdrop, which equities are far more exposed to. 

While we saw a lot of dividend cuts through the pandemic, all listed renewable and infrastructure companies continued to pay their dividends, highlighting the strength and uncorrelated nature of the asset classes and great diversification benefits you can get from owning them as part of your portfolio, particularly for income investors. 

It is quite surprising we do not see more equity fund managers, particularly income managers, allocating investment to the sector as it is fairly defensive and dependable for income. It is also part of UK equity benchmarks, given they are listed securities and many of them have outperformed the FTSE 100 over the longer term and are far less volatile. 

Investment trusts

The alternatives sector has evolved significantly over the past decade. Before the global financial crisis, it was dominated by hedge funds and private equity funds. However, over the past few years the UK-listed Investment Trust sector is democratising private markets by allowing individuals to purchase shares in some of these more illiquid markets. 

Today, investors can own a stake in a wind or solar farm that costs tens of millions of pounds to build and gives investors access to stable, repeatable cash flows that are paid out in dividends.

In addition, having alternatives through a listed investment trust offers diversification benefits to what would have historically been an equity/bond dominated investment portfolio, without affecting the manager’s daily operations when you want to add or decrease your holding.

The investment trust universe allows investors to gain access to a wide degree of assets that would typically only be accessible to investors with large amounts of wealth. One can invest with as little as the cost of one share at £1 to £2. So, even if you only have savings of £1,000, we believe investors could easily have a 10 per cent or 20 per cent allocation to alternatives. 

Investors can also invest in a well-diversified multi-asset fund that has a meaningful allocation to alternatives and outsource the decision making on which alternatives to own and when to rotate between different assets and asset classes to the fund manager.

This can provide a wider degree of diversification within alternatives, between stable compounding ideas and more growth-orientated ideas, as well as providing exposure to emerging asset classes more quickly, such as music royalties or digital infrastructure. It allows for a core diversified portfolio where you can add on some other equity or bond exposures depending on an individual’s own views and risk tolerances. 

Alternatives are not risk-free, but their risk profile is well compensated given the strong contractual nature, inflation-linked revenues and limited economic sensitivity of their revenues that help provide the stable cash flows they are known for. For that reason, we believe they provide an attractive compliment to an investor’s portfolio. 

Paul Flood is portfolio manager of the BNY Mellon Multi-Asset Income Fund