For as far back as I can remember bonds have been deemed expensive by all but the most pessimistic of investors. Yet, arguably, bond prices remain supported primarily by the actions of price insensitive central bankers, with their unprecedented monetary policies and bond buying programmes. Now a consensus seems also to have formed that almost all equity markets look expensive. The argument is that, while unattractive on price terms, equities appear less expensive than bonds. It’s not the most robust argument for owning a lot of risky assets.
Consequently the appetite for alternative investments continues to grow, but by their nature alternatives are less familiar to many investors, leaving many under-exposed to these assets. And at a time when there is a major shift in global monetary policy underway, many portfolios look particularly vulnerable to the threat posed by elevated equity and bond prices.
I would primarily define an alternative investment as an asset or strategy that is not a mainstream listed equity or straightforward IOU-style bond. Alternatives are generally further styled as such because they might either be less liquid, more esoteric/complex, or simply just less well established than their centuries-old equity and bond peers. Examples would be hedge funds, private equity, infrastructure, specialist credit, property and commodities.
Beyond the fact that equities and bonds look fully valued, there are two key reasons for straying off the beaten track into the world of alternatives: diversification and attractive return potential. The former is often touted as the main reason for investing in alternatives; one of the key tenets of portfolio construction is that by combining securities or assets that have a relatively low correlation to each other generates more attractive risk-adjusted returns. (For example, equities and bonds, whose prices follow fairly independent paths due to the differing sensitivities they have to such factors as growth and interest rates, are often paired together.)
However, the potential returns on offer are often surprisingly viewed as a secondary attraction. Private equity in particular has historically outperformed publicly listed shares, and while hedge funds’ returns in recent years have been more muted they have been achieved with much lower risk than mainstream equity markets. Property likewise has been a great place to be invested, as has infrastructure and specialist areas of the credit markets. Only commodities have disappointed in recent memory, undermined by a marked slowdown in Chinese investment (but gold has proven to be a decent diversifier against various geopolitical and inflation risks).
In Henderson Alternative Strategies Trust, a fund I co-manage with Ian Barrass, we analyse alternative assets in a similar framework to how we look at mainstream assets. Macro-economic factors such as economic growth, the credit cycle – the changing availability of funds to borrowers over time - and the direction of interest rates are just as important to alternatives as they are to equities and bonds, therefore we need to take these into consideration and allocate capital to different asset classes accordingly.
Diversification characteristics are equally important as value when constructing a portfolio. Some alternatives are closely correlated to ‘risk’ assets and should be treated as pseudo-equities. You should only invest in them when the valuation is attractive and the right time in the cycle. A common mistake is to assume that because something is not an equity it will not behave like one during a bout of risk aversion.
Private equity would normally be expected to be fairly highly correlated to public equity markets. This is for two main reasons: valuations are derived to a large extent from public listed equivalents and underlying company performance is clearly highly influenced by general economic momentum, as with listed equities. While we have taken some profits in this area due to rising valuations – accounting ratios that indicate the relative value of a company to its history or peers - we retain holdings in funds that are doing more selling than buying, (in other words mature funds that are harvesting gains on investments made several years ago and selling into a market that is prepared to pay high relative prices).
Hedge funds on the other hand can vary between being highly correlated to stock markets and not at all. These strategies are both vilified and lauded. Some of the approbation is merited. To my mind a hedge fund should not be a more risky investment than the equity market, whereas this is not always the case. Meanwhile, limited regulatory oversight in some cases has also led to poor risk management and the occasional dodgy practice. These are the exceptions not the rule in what is now a USD3 trillion sector. The clue should be in the name; a hedge fund strategy should primarily be defined by its greater flexibility, particularly a focus on absolute not relative returns, and its ability to short securities (i.e. profit from falls in their prices). This flexibility and greater opportunity set (having both longs and shorts) enables hedge fund managers to generate more consistent returns than long only managers, especially in sell-offs, thereby providing a much-needed form of diversification in these lofty markets.
The key clearly, as with investing in general, is to understand what you are investing in and have a good idea of how valuations might change in differing market backdrops. (And if you don’t have the time or resources to do this, outsource to an expert in this area.) Mainstream equities and bonds have been around for centuries and hence are tried and tested throughout booms and busts, war and peace. The same cannot be said for all alternative asset classes or strategies, and their potential liquidity, complexity and unconstrained nature make analysis and assessment more onerous. However, the dual role of alternatives as both a diversifier and an attractive source of potential returns make them a vital part of every investor’s portfolio, particularly at this juncture.