At a time when both share and fixed interest volatility is heightened, it’s important to point out the importance of looking at the long term returns and riding out any short-term hiccups. It’s also worth noting that interest rates on cash are still very low, so while it’s a safer option compared to shares, it’s not necessarily a profitable one given the current inflationary environment. That’s where alternatives come in and why we often include them in our portfolios.
To put it simply, alternatives refer to a wide range of investment assets that don’t fit into the standard asset classes of equity, listed property, fixed interest and cash. They include;
- private equity in companies that are not listed on a securities exchange,
- unlisted private real estate,
- tangible assets including infrastructure, agriculture, timber and water, but can also include things like artwork and vintage cars, and
- hedge funds (that is, pooled investment funds that employ different strategies to earn active returns for their investors).
As an asset class, alternatives are often the most difficult for clients to grasp and for that reason, might be overlooked by clients who are self-advised. One of the biggest misconceptions is that they’re high-risk and illiquid. On the contrary, there are many liquid alternative investments now available that are accessible to retail clients via the various administration platforms.
Not all, but many alternative investment funds have a low correlation with shares and property, meaning they don’t perform in the same manner at the same time. Diversification is the most fundamental concept in investing. Investors can reduce their risk by diversifying across different asset classes, sectors and regions. Inclusion of alternatives can help lower the overall volatility of your portfolio, by reducing the severity of market downturns.
To use a simplistic example, if you were to invest $100 in the share market and the market dropped by 20%, you’d lose $20. If during that same time period, alternatives returned 5% and you invested $80 in the share market and $20 in an alternatives fund, you would have instead lost $15 overall. While it’s still a paper loss, it can help to soften the peaks and troughs.
The traditional asset allocation approach to portfolio construction consists of a balance between growth assets (equities and property) and defensive assets (fixed interest and cash), depending on factors such as your risk tolerance, time horizon and investment objectives. We believe alternatives fit in the ‘growth’ component of your asset allocation and serve to soften volatility at a total portfolio level and enhance long-term returns. Alternatives don’t provide inverse returns, but rather differentiated returns.
The three main alternatives positions we hold in our portfolios include:
Managed futures
Generally, a ‘futures contract’ is an agreement to buy or sell a specific amount of a commodity or a financial instrument at a specific price and on a specific date in the future. Managed futures strategies attempt to identify and exploit persisting trends in a diverse range of futures markets including commodity, stock indices, fixed income and foreign currency futures. Because managed futures can take long and short positions in futures contracts, they can benefit from rising and falling market conditions. This capacity to exploit varying trends in both up and downward moving markets in any economic environment underpins the strategy’s low correlation with traditional asset classes such as equities, bonds and property.
Global macro
Simply put, global macro is an investment strategy centred on interpreting and projecting global economic and political events and their impact on a wide range of investment markets. In doing so, the manager forms top-down views to profit from opportunities in equity, fixed income, foreign currency and commodity markets resulting from these events. Like managed futures, global macro managers have the flexibility to take long and short positions in global markets using a range of financial instruments, over long and short-term holding periods. The strategy can therefore generate returns in all market environments, including downward moving and volatile market periods.
Managed futures and global macro strategies can quickly adjust or reverse their positions as required. This level of flexibility isn’t always as available in traditional stock and bond investments and is particularly important during periods of heightened market volatility.
Market neutral
The basic premise of a market neutral strategy is taking long positions in stocks expected to rise in share price and short positions in stocks expected to fall in share price. Shorting stock involves selling “borrowed” shares to make a profit, then buying them back cheaply when the price goes down. For the overall strategy to be ‘market neutral’, the short positions offset the long positions so that the strategy is primarily exposed to stock specific risk rather than market movements and therefore the major ups and downs of the overall market. For example, the fund manager may assess that two bank stocks have materially different valuations, shorting the overvalued bank and ‘going long’ in the bank deemed undervalued. This confines the investor’s risk exposure to stock specific risk, while removing the sector risk. The diversification benefits are evident because the returns from market neutral strategies are largely independent of the broader equity market.
A modest allocation to alternatives adds the following benefits to portfolios:
- Sources of differentiated and competitive returns
- Improved diversification
- Lower volatility
- Minimising the severity of drawdowns
- Enhanced long-term returns
- Attractive liquidity
