Clearing the air around alternative investments

In a world where an investor’s default allocation is to the traditional asset classes of stocks, bonds and cash, alternative investments seem to get left in the lurch.  

Myths about high volatility muddy the alternatives waters and the very thought of hedge funds post the global financial crisis (GFC) still leaves a bad taste in investors’ mouths. 

The market tends to advise people to avoid investing if they’re not an ultra-high-net-worth individual, with the bottom line being if you want to make money, stay away from alternative investments. 

But, investors need not be scared of alternative investments, which can be defined as anything other than the traditional assets of stocks, bonds and cash, including direct assets, real assets, infrastructure, commodities, derivatives and hedge funds. 

The reality is, while there is some truth to the alternatives talk, these types of investments offer many benefits to investors.

ARCO co-founder and portfolio manager, George Colman, says the role of alternative investments is to seek to add value to a diversified portfolio by adding something that is uncorrelated to the other asset classes.

“If an investor was only invested in mainstream asset classes that are highly correlated, then that’s a pretty high-risk strategy, because they’ll all move broadly in the same return profile,” he says. “If they’re all going up that’s great, but the converse if they all go down is pretty bad.”

Portfolio manager of Wheelhouse Partners, Alastair MacLeod, says value can also be found in alternatives given their ability to target specific sources of risk, which isn’t as easy to isolate through the three traditional asset classes. 

And, while high-net-worth investors (HNWIs) can definitely benefit from these types of investments, mum and dad investors stand to gain just as much from including alternatives in their portfolios. 

MacLeod added that retirees in particular stand to gain the most from using alternatives, given their objectives are to generate a high level of income without suffering drawdowns or market corrections. 

“If you think about stocks, bonds and cash, there isn’t really one asset that gives you all those three characteristics,” he says. “That’s where we feel really strongly about delivering equity growth but are very income-driven, and having downside protection when markets are weak.”

The good, the bad and the alternative

While experts are hesitant to call out “good” and “bad” alternatives, the strong message is that alternatives are what you make them. 

The key, according to Colman, is the underlying characteristics of the strategy, and whether they add an uncorrelated aspect to the portfolio to reduce risk and reduce the likelihood of drawdowns in that portfolio. 

Colman says alternatives can offer investors “sleep at night money,” which is the type of investment that investors don’t have to worry about when they see periodic, ugly drawdowns in the market. 

“Where the Aussie stock market might be down five or six per cent, if we’re doing our job correctly, we won’t be losing money under those circumstances,” he says. “What you want is something that’s going to have hopefully a very different risk and volatility profile to the broader Aussie equity market.”

No managers seem to think alternatives are particularly volatile in and of themselves, but MacLeod says the Wheelhouse team works to harvest any elevated levels of volatility and convert it to an income stream. 

Colman suggests that the more leverage introduced into the portfolio or strategy, the more volatile returns would be, but this is entirely dependent on the particular strategy used by the manager, and not part and parcel of the broader spectrum of alternatives. 

Hitting the mainstream

Michael Frearson, director and portfolio manager at Real Asset Management, suggests Australia is somewhat behind in taking to alternatives, given global investors have well and truly embraced the asset class. 

As investors become increasingly more sophisticated and educate themselves about strategies, they are becoming more interested in alternatives that are fit for purpose. 

“Particularly, I think private investors that have been around for a while and think about maintaining wealth kind of get that,” says Colman.

Infrastructure has been defined as a “mainstream” alternative asset class, that, according to 4D Infrastructure, offers investors monopolistic market positions, an inflation hedge within a business, visibility, resilient earnings and strong cash generation. 

4D Infrastructure global portfolio manager, Sarah Shaw, and global equity strategist, Greg Goodsell, believe investing in infrastructure as an alternative asset class makes a lot of sense.

“Regulated utilities are the preferred option in a slowing economy, possibly with falling interest rates, while user pays are suited to growing economic environments, with potentially rising interest rates,” they say. 

“Therefore, within a broader equity portfolio, an allocation to a sensibly balanced infrastructure position makes a lot of sense as it offers both the traditional defensive characteristics of infrastructure, while also contributing to aligning the overall portfolio with prevailing economic conditions.”

Shaw and Goodsell think there is enough diversification in the asset class despite its growing popularity, given it offers both defensiveness and significant potential growth upside.

As well, offering global exposure with assets across Asia, Europe, North America and emerging markets has allowed investors to capitalise on country macro cycles, and gain exposure to domestic demand stories.

“This, coupled with the diverse nature of the available infrastructure investment opportunities, create the perfect environment for infrastructure outperformance.”

While there are some types of alternatives that have hit the mainstream, MacLeod doesn’t think they will ever become so mainstream as to displace stocks, bonds or cash.

“I genuinely think, going forward, that the value that they could potentially deliver in a low-growth environment is increasing,” he says. “So, looking forward, the environment for the selective use of alternatives to deliver is increasing, and, as a result, will probably gain traction.”

Risky business

The use of leverage in strategies is where alternatives tended to gain their risky reputation, and the more leverage introduced into a portfolio, the more volatile the returns will be. 

The other great driver of volatility is market exposure, according to Colman, and the greater the exposure of the funds to the equity market, the greater the volatility of returns in line with the underlying market. 

“Market beta is only one source of return, and we think it’s pretty volatile, so we prefer to focus on stock alpha, which we think is more predictable and less volatile,” says Colman. “We typically operate with market exposure in a band of -20 per cent to +30 per cent, so quite a narrow band.”

The consensus across the experts is that if investors are exposed to the market, in a portfolio or using a strategy with leverage and limited diversification, they’re putting themselves at risk of volatile returns.

The end of the bull market

Looking forward, the alternatives market is looking extremely competitive as more investors try to generate investment returns with low-risk characteristics. “Trying to generate stock alpha is very hard. Everyone’s trying to do it and there’s an awful lot of good quality IP chasing those returns and I don’t think that’s going to change,” says Colman. 

The 20-year bull market is coming to an end, and the biggest thematic across the industry is the normalisation of interest rates, which will impact asset prices in the future, according to Andrew Kaleel from Janus Henderson.

He says while a lot of the easy money was made in the bull market, it is officially over, and as the environment becomes more challenging, managers must find low-risk, sustainable opportunities. 

It’s ARCO’s mission to figure out which asset prices will be impacted by the changing environment, and which asset classes will withstand it.

MacLeod warns that beta returns will most likely be a lot lower than they have been, and the quest is to deliver a real return that isn’t solely dependent on beta.

“Whether it’s an income-driven return, so the market beta doesn’t need to go up, or a market-neutral, long-short strategy like some hedge funds, it will become harder to generate those real returns, and that’s where sophistication in discerning which strategy is going to work for you is necessary.”

The easy investing of the last ten years is coming to an end and given the risk that Australia could end up in an inflationary environment similar to the US, investors need to look at what assets would survive. 

“Most do poorly,” says MacLeod. “Particularly fixed income, and in an inflationary environment, commodities, real assets and infrastructure can hold their value better than others.”

Rodney Sebire, head of alternatives and global fixed income at Zenith Investment Partners, says it is important to highlight that the opportunity set for alternatives varies across the respective style. 

“For example, managed futures managers are reliant on the existence of price trends across financial markets, while global macro managers seek to exploit relative value differences between markets, that is, buying cheap assets and selling expensive assets,” he says.

Sebire says the current market conditions for alternatives is challenging given stretched valuations and suppressed volatility, and it has reduced the opportunities set for absolute return strategies. 

“Despite this, we have observed some recent late-cycle market volatility, which may precede a more favourable trading environment,” he says.

“The 10 per cent drawdown in the S&P 500 in early February 2018 and the recent sell-off in Italian bonds and subsequent focus on the solvency of the Italian banks are examples of market events that can be actively traded by alternative managers.”