By Diane Earnshaw, Research & Consulting Director, Square Mile Investment Consulting and Research
When is an alternative not an alternative? To answer this, it’s worth starting by defining what exactly constitutes an alternative investment. The UK asset management industry is responsible for some £2trn of alternative assets versus some £11trn in mainstream assets. The very size of this universe reflects that fact that the alternatives label encapsulates a broad range of different asset types and approaches.
For many, a simple definition may be something that isn’t categorised as equity, fixed income or cash which are considered the traditional components of portfolio construction. I’ve covered multi-asset funds as a fund analyst for many years and in this context, I’ve seen many different genres of funds banded and labelled under the broad alternatives banner.
Asset classes grouped into alternatives buckets include, among others, private equity and debt, digital assets, infrastructure, real estate and commodities such as gold. Within the hedge fund/absolute return sector alone there are further strategies that might fit under the alternatives label with long/short equity funds, global macro funds and CTAs (i.e. trend-followers) being some of the most familiar. While digital assets are a newer kid on the block, regulators and lawmakers are beginning to facilitate their more widespread use.
The growth of alternative allocations in multi-asset portfolios has been an observable trend for many years now. Popularity grew during the lengthy low inflation era when traditional bonds offered little in the way of yield and carried the risk of capital loss for those worried about a shift in the interest rate regime. In this environment, alternatives were a natural diversifier. More latterly, despite a regime change and a more attractive bond market, alternatives have maintained their appeal in portfolios.
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A recent look at well-known private client benchmarks showed that currently the ARC balanced benchmark has an allocation to alternatives of approximately 30%. Many DFMs and MPS managers are represented here. Within the PIMFA conservative allocation, around 17% was allocated to alternatives and a 10% allocation now appears to be commonplace in high-net-worth portfolios. However, at a headline level, it can be difficult to see what type of strategies constitute these allocations because of the breadth of the definition.
What is key when defining an alternative is a consideration of different risk and reward outcomes. Indeed, this is what makes alternative investment funds and strategies so useful for long-term investors and their portfolios. They should offer a different risk/reward profile to the traditional asset classes investors are more used to seeing in their portfolios, namely equities and bonds.
A well-managed allocation to alternatives can offer a low and even negative correlation to these other asset classes helping with overall portfolio diversification. As an example of a compelling portfolio diversifier, we would highlight the BlackRock European Absolute Alpha fund which holds a Square Mile AA rating. This is a long/short equity strategy which is managed with a low net market exposure and which aims to deliver a positive absolute return over a 12-month period regardless of market direction.
Another fund worth mentioning is the Square Mile A-rated WS Ruffer Diversified Return fund. This fund also aims to provide positive returns in all market conditions over any 12-month period with an emphasis on preserving capital. It adopts a multi-asset approach and its holdings will typically include a blend of growth (mainly global equities) and defensive assets such as cash, conventional bonds, index-linked bonds, precious metals and derivatives. This deployment of derivatives to hedge directional market risks is a particular feature of this strategy.
Portfolio diversifiers such as these aim to deliver strong performance (in absolute or relative terms versus markets) particularly during stressed market conditions, when volatility is high or rising. It is this key characteristic that makes such funds attractive when held in a portfolio.
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Which alternative to pick matters to ensure that an allocation to such assets and funds does indeed offer diversification. For example, a highly correlated equity focused absolute return fund will do little to offset the downside of equities during a sell off. Attitude to liquidity, risk and complexity are also pertinent to the selection decisions. Gold and infrastructure are relatively simple to understand while the black box perception of CTAs and global macro funds are more complex and often less transparent. This doesn’t necessarily make them bad but a higher level of due diligence will be needed.
In addition, those who also value non-financial objectives may find the broad church of alternatives appealing. For example, private markets and real assets can be one of the most impactful ways of gaining exposure to sustainable or responsible investment themes. It is worth noting that, while many alternatives strategies have daily liquidity structures under the UCITs framework, others such as private markets may be less liquid, but can be invested through closed-ended vehicles.
It is therefore important that portfolio managers and fund analysts are on top of allocations to alternatives and understand with granularity as well as in totality, the risks and rewards that an allocation to these strategies are contributing to portfolios. Most importantly, it is key to ensure that they are fulfilling their job of diversification alongside traditional assets, stocks or funds that are held in the portfolio… otherwise an alternative may not end up being one.