Alternative investments – are they still an essential holding in 2023?

Chris Salih 11/05/2023 in Equities, Multi-Asset

The rise of alternative assets has been one of the major investment themes of recent years, as investors diversify their search for yield and asset managers seek to help them achieve their goals.

The asset class includes a wide variety of investments including natural resources, infrastructure, and global real estate assets, as well as hedge funds, private capital and even cryptocurrencies.

While some are pretty mainstream and suitable for private investors, such as commodities, others such as the fledgling crypto universe are certainly not for everyone.

It has been estimated that there was more than $13 trillion allocated globally to alternative investment asset classes at the beginning of 2022, with the total expected to exceed $23 trillion by 2026*.

The growth was initially concentrated in the hands of the institutional cohort, with exposure to the retail market sometimes limited by complexity and the need for certain assets to offer daily liquidity in certain products – but the use of closed-ended structures (like investment trusts) and improved regulation has gradually made them more accessible as a pooled investment in the likes of multi-asset/fund of funds offerings.

Alternative investments tend to be less liquid than traditional asset classes. Some cannot be traded on a public exchange and the ‘hold period’ of the investment can be longer than traditional assets. Investors expect higher returns for this illiquidity. This is known as the illiquidity premium.

The big driver of demand

But there is no doubt the biggest driver in demand from retail investors has been the desire for alternative sources of income in a low interest rate world. For much of the past decade yields have been at low levels in the bond markets, while in the UK equity income market (the most mature in the world), income returns have been below the 4% mark while also being heavily concentrated in a handful of stocks.

But it feels like 2022 has seen a significant juxtaposition in the investment outlook. Last year, many were questioning the validity of a traditional “60/40” allocation to equities and bonds – and whether it was still capable of meeting long-term investment goals. This was built off the back of an increasing positive correlation in the performance of both asset classes (when equities performed so did bonds and importantly, vice-versa). In 2022, the traditional 60/40 portfolio suffered one of its worst years in history, as both experienced significant losses.

But we now appear to be in a different economic cycle – the response to which has been a sharp rise in interest rates, making it far easier to achieve meaningful dividend returns. Instant access cash ISAs are now offering well over 3%, while the likes of UK equity income and corporate bond funds are offering in excess of 4% and 5% respectively.

Is the lure of alternatives fading as a result?

The sharp rise in bond yields has resulted in a number of multi-asset managers beginning to dial down their alternatives exposure in favour of traditional fixed income. Which raises the question of whether they still remain an integral long-term holding when yields are so readily accessible?

A 2023 research note from BlackRock suggests that while yields are back in the bond market, these bonds may struggle to deliver the level of diversification that they once provided as inflation and policy uncertainty persist. It says: “This brings into focus the role of alternative strategies as an additional source of diversification and returns in portfolios. Alternatives can capture the same yield opportunities found in traditional fixed income, while unlocking new return streams and providing the ballast that’s needed in portfolios today.”**

BNY Mellon Global Multi-Asset Income manager Paul Flood has recently cut his alternative exposure from 40% to 20%, increasing his bond allocation as a result. He says it is hard to ignore the fact bonds are more attractively priced but believes the role of alternatives is still essential given the importance of inflation linkage.

He says: “Bonds are buyable again, but alternatives have a major role to play given we’re in a world of rising inflation and interest rates. If inflation is likely to be higher/more volatile you need something to work with bonds, because interest rates are the key determinant of asset prices – you need something with positive correlation with inflation and interest rates, as a number of alternatives do.”

A good example would be renewables or infrastructure. The latter is an asset class with roughly 70% inflation proofing built in***. By contrast, real estate is potentially less reliable.

Paul says: “The problem with real estate is yes they have upwards only rent reviews and fixed inflation linked. But it is only fixed inflation linked until the tenant can no longer afford the rent, and then you have to re-base the rent to something that’s affordable to a new tenant.”

Aegon Diversified Monthly Income co-manager Vincent McEntegart says targeting a 5% yield on his fund made alternatives a necessity for much of the past few years, but he and his team have now cut back exposure, increasing the bond allocation to almost 50%.

He says: “These alternative holdings are not as essential as they once were, but they are still needed as alternative income streams as you want some yield that is not driven from equities or bonds as it leaves you exposed. We have simply scaled back alternatives.”

CT MM Navigator Distribution fund manager Robert Burdett says: “We need to have some alternatives, but not at the higher levels we’ve had in the past. We need the diversification in income streams – which is a key part of our job as a multi-asset managers. We would love to have 25 different income streams in an ideal world.”

Yields are back for alternatives too

One aspect that may be overlooked by investors is that, similar to bonds, alternatives can also benefit from higher rates. Many alternatives have “cash plus” return targets, meaning that they may have the potential to capitalise on higher yields to generate higher returns.

Darius McDermott, managing director of FundCalibre, says: “You can get attractive yields across a host of alternative assets be it music royalties, shipping, infrastructure, and renewables to name a few. But it is the diversification when delivering a consistent monthly income which is the key factor.”

*Source: Capital Connection
**Source: BlackRock – Yields are back, and alternatives are here to stay
***Source: First Sentier



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