BLOG: The increasingly important role of alternative investments
The rationale for balanced portfolios has long been understood and accepted. For most investors the attraction of an appropriate mix of equities and bonds centres on potential diversification benefits and the anticipated reduction in portfolio volatility.
Today, it is not uncommon for a ‘balanced fund’ to have up to 70% in equities. The bulk of the remaining 30% is typically allocated predominantly to bonds and cash with small allocations to property, commodities and hedge funds as a representative group of ‘alternative investments’.
Bonds help to reduce overall portfolio volatility. A further benefit derives from the behaviour of bonds during stock market declines or bear markets. In this regard, it is the safe-haven characteristics on offer that really make government bonds in particular, worthy additions to a balanced portfolio. However, at this juncture, it seems clear that the outlook for government bonds for the long term investor is now not particularly attractive.
Looking ahead therefore, while the correlation between bonds and equities may remain low enough for them to offer diversification benefits, their ability to contribute meaningfully to portfolio return, particularly during periods of equity market volatility or outright bear markets is very questionable.
A carefully selected basket of alternatives can fulfil the dual role of reducing portfolio volatility and enhancing portfolio returns. An alternative portfolio can provide exposure to a range of sectors that exhibit low correlation to traditional assets and provide opportunistic market exposure to different return profiles to equities and bonds.
The key here is to look beyond the standard asset class labels used to categorise investments and instead to look to the underlying characteristics of the assets themselves. So for instance, while listed infrastructure funds would be categorised as regular equity investments, their defensive characteristics including high degree of cashflow predictability, high income and lower price volatility during broader market declines make them prime candidates for a broadly diversified basket of alternatives.
In addition to property, hedge funds, commodities and infrastructure, the broad range of alternative investments, defined by the nature and characteristics of their return profile rather than typical asset class labels, could be extended to other low volatility, absolute-return seeking assets such as zero-dividend preference shares, some private equity funds, insurance-linked securities and some niche debt funds.
The rationale for balanced funds remains as valid as ever. However, today’s economic and financial market realities dictate that investors reassess the traditional approach to their implementation. A well designed multi-asset class investment strategy should not emphasise returns over risk management. On the contrary, it should focus on delivering superior risk-adjusted returns over the economic cycle.
Abi Oladimeji is head of investment strategy at Thomas Miller Investment