Nobel Laureate Harry Markowitz described diversification as the only free lunch in investing. Classic portfolio construction applies this principle by trying to obtain the best return from taking a particular amount of risk, with equities doing the heavy lifting on the return side and bonds playing the defensive role.
That split served investors well over the past 40 years while interest rates were in long-term decline: share markets got into trouble, central banks cut interest rates and bonds would go up in response. The counter-correlation between equities and bonds acted as an effective airbag for a portfolio.
But the current downturn has been very different: with interest rates starting at close to zero and going up, global bonds have fallen 20 per cent since the start of the year, roughly the same as global shares. The benchmark 60 per cent equities, 40 per cent bonds portfolio has never had a worse start to a year.
This has sparked a search for a new form of portfolio protection, with much of the focus shifting to ‘alternative assets’, a catchall description of a collection of different investments that are intended to provide returns that are uncorrelated to the rest of a portfolio. In other words, a new kind of airbag.
However, since the only qualification required is that returns are not correlated to shares or bonds, there is a broad range of investments that fits under the alternatives banner, from the relatively straightforward to the seriously complex, cheap(ish) to expensive and liquid to illiquid.
There is a lot to learn about alternative investments, but there are two important points to start with. First, the range of ‘alts’ accessible to private investors is quite restricted compared to institutional, and second, because these investments are uncorrelated there is no assurance they will go up when shares go down, they could go up, down or sideways.
Private market assets
Alts can be either defensive or growth oriented. One of the most popular is private markets investing, which can be into equity, real estate, infrastructure or credit. Because these assets are privately owned, they don’t trade on something like a share market, so they are not subject to the same ‘mark to market’ risk as equities or bonds. That means they don’t tend to experience the same level of volatility as publicly traded assets, thus the reduced correlation.
The legendary manager of Yale University’s endowment fund, David Swenson, pioneered a portfolio model that invested heavily in unlisted assets, and produced returns that comfortably beat share markets with lower volatility. Since then, institutional investors, here and overseas, have thrown ever increasing amounts into unlisted assets: AustralianSuper reported 28 percent of its $260 billion portfolio is in unlisted assets, and the Future Fund has more than one-third.
Unlisted property funds are already popular with private investors, and fund managers like Charter Hall have delivered strong returns from a blend of yield and capital growth. Other assets like water rights have also provided attractive and totally uncorrelated returns.
Hedge funds
The title ‘hedge funds’ also covers a broad range of investments. Managers can deploy options-based strategies, sometimes combined with shorting, to target positive returns regardless of underlying share market movements.
An example is long-short funds, such as L1, which can short sell stocks it doesn’t like and so potentially make money when markets fall as well as rise. Another is market neutral funds, such as Sage Capital, which will offset every long position with a short, thereby trying to neutralise exposure to the underlying equity market but aiming to make money from its stock selection skills.
Macro funds, which aim to exploit global economic trends, and CTA funds, which try to capture momentum trades by transacting in futures contracts across almost any investable asset, are aptly described as ‘crisis alpha’. It’s not unusual they deliver great returns when markets are volatile, but don’t do much when markets are performing well.
Blended funds
Trying to sort through the range of alternative assets available to invest in can be not only time consuming, but thoroughly daunting if you don’t know what you’re looking for. There are funds that offer access to a curated, diversified portfolio of alts in one hit.
Partners Group is a specialist in private asset investing and offers four diversified funds compiled by the Global Investment Committee that makes the most of their deep industry experience. LGT offers a broader portfolio of alts that aims to deliver positive returns in all market conditions, and WAM Alternatives (WMA) is listed on the ASX, meaning it is also a highly liquid option, but it can trade at a discount or premium to its underlying value.
Before investing in any alternative asset, investors need to understand the liquidity provisions that apply to it. Whilst some products provide daily liquidity, meaning you’re able to redeem your investment on a daily basis, others may only be monthly or quarterly, and some can require you to lock your money up for years. Although that can be a pain, the ‘illiquidity premium’ will hopefully be reflected in the returns you receive.
At a time when financial markets are in upheaval and listed assets offer little diversification protection, smart investors should consider alternative assets, but should also be conscious that they are often complex, pricey and can sometimes take months to get your money out of. It’s the kind of asset class where a good adviser can be very helpful.
