Alternatives necessary to truly diversify and protect against inflation

Returns are typically measured using an internal rate of return for a specific vintage of fund over a given term. Some private market funds provide a 'public market equivalent' benchmark to enable comparison. 

Private market managers should use an index of their own shares.

However rather than using a mainstream index for this calculation, we would argue that private market managers should use an index of their own shares, as an alternative public market equivalent comparison. 

Given retail investors’ need for liquidity and the high minima for investing in private market funds, we consider the shares of private market managers to be a useful proxy to this exposure.

Illiquid alternatives and private markets

For those that expressly seek to potentially benefit from an illiquidity premium by investing in alternative assets such as land, forestry, wind farms, student accommodation or alternative income streams such as ground rents, aircraft leasing, or private markets (the equity and debt of unlisted business), this is best achieved using investment trusts, rather than unregulated funds. 

Investing across alternative assets broadens the pallet of a portfolio.

For these asset classes, OEICs' promise of daily liquidity does not match. Hence the investment trust format is better for investment with this liquidity profile. The debate around whether or not illiquid asset exposures actually earn an illiquidity premium, and whether reduced reported volatility of illiquid holdings understates risk is ongoing and merits an entirely separate study.

Investing across alternative assets broadens the pallet of a portfolio and provides opportunities for asset-based diversification.

While the alternative assets above offer asset-based diversification, many of them have equity-like risk, so sizing risk contribution is key within a multi-asset portfolio context.

While a 60/40 portfolio may look diversified, in practice it can be more than 90 per cent correlated with equities in terms of behaviour.

For example, while property securities and infrastructure securities both represent different asset classes, their risk contribution may be commensurate to equities, and their correlation to equities or to a 60/40 portfolio can be relatively high, hence the extent of diversification from a risk perspective is less impactful.

In order to achieve further diversification from a risk-contribution perspective, an understanding of risk-based diversification is key.

Risk-based diversification

Risk-based diversification means looking less at asset labels and more at what an asset or strategy does to risk contribution and diversification effect.  

At its simplest, while a 60/40 portfolio may look diversified, in practice it can be more than 90 per cent correlated with equities in terms of behaviour.

Risk-based diversification expressly targets de-correlation with other assets within the portfolio to achieve a diversification effect, and hence 'true' diversification.

Looking explicitly at correlation structure is a way of ensuring that a diversifier in theory is actually diversifying in practice.