The era of very low interest rates led to the creation of a range of new investment strategies, many invested in esoteric assets but with attractive yields.
In the context of abundant liquidity and low bond yields, such products, in areas such as aircraft leasing and music royalties, gathered assets rapidly and performed very well.
What followed was a series of proclamations from product providers that such assets were 'structural growth stories', and that while lower bond yields undoubtedly helped, this was far more important.
And many portfolio managers wanted to find an alternative, as for a decade after the global financial crisis bond prices rose without much volatility, while equities generally rallied.
Diversification was hard to come by, then came 2022 and the anticipation of higher interest rates.
Suddenly assets previously badged as alternative to bonds and equities began to perform in line with bonds and equities, falling in value.
So, is there any alternative asset?
Simon King, chief investment officer at Vermeer Partners, ponders that such assets might rightfully be called “other”, rather than alternative.
He says the key to the question of the role of alternative assets is whether one regards the decade after the financial crisis, a period when all assets appeared to be correlated, as an anomaly that lifted all boats, or whether such funds really do represent an investment opportunity in the new economy, and a “new paradigm” representative of people’s changing habits and interests.
Simon Molica, senior investment manager at Parmenion, takes a more literal interpretation, saying: “Ultimately everything starts by being priced off a risk-free rate and I believe alternatives should be a structural position in most portfolios.
"There are many types of alternatives, these include physical property, physical infrastructure, hard commodities, soft commodities, hedge funds, private equity, private debt, managed futures, and absolute return.
"There can be real benefits to owning alternatives alongside bonds and equities but any one alternative on its own will not be enough, so at Parmenion we use a bucket of alternatives of which each alternative has low correlation to each other so that as a whole we can achieve the uncorrelated characteristics that we require.”
Mark Lane, head of active funds at Progeny, says alternatives which are genuinely uncorrelated to bonds and equities tend to require significant leverage be applied to generate any sort of material return, something which alters the risk profile of the assets in question, and risks misleading clients about the level of risk they are taking in portfolios.
Matthew Yeates, deputy chief investment officer at 7IM, believes alternatives have a role in some portfolios, but agrees that many assets may not be as badged.
He says: “These styles, often those that embed a structural degree of equity market beta, are unlikely to bring much additional benefit to multi-asset portfolios. However, for the strategies that embed the ability to go long or short markets, we think there is additional diversification on offer.
"One prime example is in 'trend following' strategies that identify opportunities based on rules whether markets are trending higher or lower and take positions (long or short) on the assumption these trends continue. These strategies were particularly well placed in 2022, when both bonds and equities fell at the same time."
Rory Maguire, chief investment officer at Fundhouse, a wealth management firm that has no exposure to alternatives, says an issue with some of the absolute return funds that became very popular in recent decades is that “the managers of these change their minds so often that it is hard to know what insurance policy you are actually buying. Is it an equity hedge? Is it a bond hedge? If it changes that frequently, it is hard to say".
"This places the investor in a predicament when doing portfolio construction, especially if they require each investment to play a precise role in the portfolio. They can invest on the hope that the asset is uncorrelated and works when they need it to. Or, they can avoid it. Historically, we have taken the latter approach."
Aaron Hussein, market strategist at JPMorgan Asset Management, says: “Alternatives encompass a wide range of asset classes, each with their own return and diversification properties.
"Broadly, they can be categorised as either return diversifying or return enhancing. Return diversifying alternatives typically generate returns from stable, predictable cash flows, resembling fixed income assets. Due to their low correlation with traditional assets, they can serve as effective diversifiers from both stocks and bonds.
"Examples include core real estate, infrastructure, transport, core private credit, timber, and certain macro hedge fund strategies.
"Conversely, return enhancing alternatives focus on capital appreciation. This category includes private equity, non-core real estate, and riskier private credit strategies, such as distressed or subordinated debt. These assets are incorporated into portfolios primarily for their potential to enhance returns, rather than to diversify risk."
Hussein adds: “In general, an allocation to alternatives tends to be outcome orientated. The goal of an individual investor will dictate the appropriate alternatives allocation. Ultimately, whether it’s return diversification or return enhancement, these assets, while termed 'alternative', are becoming increasingly essential for investors who are comfortable with the associated risks.”
David Thorpe is contributing editor at Asset Allocator
