Alternative asset classes: what they add to a portfolio

The challenge is not just in knowing which alternative assets are genuinely uncorrelated with shares and bonds. Ceri Jones reports.  

While the earnings season for equities has been remarkable, it does nothing to change the fact that most investors should be adding to their alternative asset holdings to improve their portfolio diversification, particularly as the bull market in equities has entered its 11th consecutive year.

The challenge, though, is not just in knowing which alternative assets are genuinely uncorrelated with traditional assets. Investors also need to position portfolios for the likelihood of lower returns on traditional assets in the decade ahead, higher inflation, and for an environment where bonds as portfolio ballasts are ineffective.

“Alternatives is often an interesting catch-all, used to describe anything that doesn’t look like a traditional equity or bond,” says Will McIntosh-Whyte, fund manager, Rathbone Greenbank Multi-Asset Portfolios. “One of the risks in building a portfolio is assuming that anything branded an alternative is likely to provide diversification. Take private equity. There is no doubt private equity is an interesting asset class, providing access to early stage businesses and sometimes talented management teams. But is it a diversifier? Are businesses likely to hold up better in a downturn because they are not listed on the market?” 

He adds: “In all likelihood, these are businesses operating in the same end markets as their listed cousins. If you are holding a listed vehicle, in a downturn the price of the stock is likely to correlate significantly with the rest of the equity market as the market re-values those businesses lower without waiting for the official quarter-end valuation. In fact, it can be worse if the vehicle has employed leverage, accentuating those losses, or if the business model involves levering up the underlying businesses, and the market fears default.”

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McIntosh-Whyte further points out “the same goes for a number of alternative offerings touted as diversifiers, but which look more like thematic equity funds investing in public or private businesses, and will no doubt fail to provide protection when it matters, potentially accentuating drawdowns if the liquidity is poor, resulting in big price falls”.

Indeed, very narrow thematic funds can sometimes be dangerously flawed. For example, several funds have been launched in the robotics sector but there are only a handful of good robotics companies, not necessarily the 30 required to populate a fund.

Invest in a wide spectrum of real assets for diversification

Instead, investors should be thinking about investing across a wide spectrum of real assets – such as core infrastructure, renewables, specialist property and broad commodities – to sit alongside equities and bonds in their portfolios. These assets can offer genuine diversification and typically yield 3% to 5%, considerably more than gilts. Hedge funds can also be considered as an alternative to bonds.

“Not all real assets offer income, but sectors such as core infrastructure – which focuses on operating assets providing support for communities such as schools and hospitals and benefits from contractual inflation linked cash flows that are government backed – can provide long-term income needs,” says Mayank Markanday, senior investment manager on the multi-asset team at Liontrust. “Furthermore, having a strong counter-party the other side of a transaction ensures dividends will be distributed even in extreme market environments.”

Even then, some physical assets that share the same objectives as traditional assets may be exposed to similar risks and become correlated in certain environments. “For example, infrastructure may be seen as a bond proxy by some investors due to its long-duration income characteristics and government-backed cash flow profile,” says Markanday. “The sector therefore may do less well as sovereign yields move higher, however this is also partly dependent on whether yields move higher due to a change in inflation expectations or real yields.”

Round Hill plans to acquire works by artists including Katy Perry (pictured), The Beatles, The Rolling Stones and Marvin Gaye 

Music royalties prove a hit with investors

A few novel assets have recently piqued investor interest. Investment trusts Round Hill Music Royalty Fund (LSE:RHM) and Hipgnosis Songs Fund (LSE:SONG) receive payments generated from rights to musical works that are downloaded or played publicly. Both yield over 4%. Famously, Mariah Carey’s All I Want for Christmas Is You earns £400,000 in royalties every festive season, while Spotify’s top song last year was streamed 1.6 billion times.

Hipgnosis Songs Fund recently reported that income from shops, bars and restaurants is likely to fall further despite the re-opening, and its performance royalties fell by over a quarter in the second half of its financial year (which ran until the end of Marach 2021) because of the restrictions on leisure and live music. However, the pandemic had boosted subscriptions to streaming services, which account for 32% of revenue. New streaming opportunities are constantly popping up, and the company estimates that by 2030 two billion people will pay for streaming services, up from 450 million today.

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“This asset class hits the right notes on simple criteria such as scarce supply, growing demand and a lack of structural leverage,” says Tigran Manukyan, analyst within the Fidelity Multi-Asset team. “The fortunes of these cash flows should in theory be relatively agnostic to broad economic growth and the health of the corporate sector, making them a valuable diversifier. While the full impacts of the pandemic on royalty payments are yet to be ascertained, early signs are encouraging. Limited negative impacts such as bar closures could be offset - and then some - by the growth in streaming which has been supercharged by our newly formed stay-at-home habits.”

Space exploration: the final frontier for investors

The space travel sector is another exciting growth story that has fired investor interest, but its diversification benefits are less obvious. Seraphim Space Investment Trust (LSE:SSIT), which listed on the main market last month, invests in space-related companies, typically satellite companies and advanced tech used in navigation and timing signals. Two recent investments are Isotropic Systems’ flat panel antennas, which can connect to any satellite in any orbit, and Commodities AI, a firm that fuses artificial intelligence with satellite data to forecast commodity prices.

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The trust is effectively private equity investment with return expectations of 20% a year and a 15% performance fee to match. It is therefore highly correlated with mainstream markets, and the unquoted nature of the underlying investments also suggests some holdings will fail. However, several of the technologies are much cheaper than a few years ago and are already enjoying commercial success. The managers have selected 20 businesses internationally and at least a handful are set to list, including at least three unicorns with valuations of $1 billion plus, so it may be a worthy growth play.

Sustainable energy another alternative asset to size up

Sustainable energy, which is enjoying fiscal stimulus from the EU Green Deal, is sometimes touted as a diversifier but it consists of several buckets with different characteristics such as low-carbon transport, smart energy, agriculture and food, and natural resource preservation, which vary in their correlation to the main markets.

“Renewable energy costs for onshore wind and solar photovoltaics are currently at grid parity in certain markets and such power generation now represents the most economic technology choice, which is driving rapid adoption,” says Alastair Bishop, co-manager of the BGF (BlackRock) Sustainable Energy fund. “We see similar cost competitiveness trends in areas such as energy-efficient lighting and energy storage solutions in automotive electrification.”

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“In the auto industry, tighter CO2 emissions limits in Europe mean 2021 is set to be a key year of transition. New electric vehicle models from the major global auto manufacturers are entering showrooms with significantly improved range and design.”

Where alternatives sit in an investor’s portfolio

When sizing an allocation to alternatives, investors need to take into account their tolerance for illiquidity. “As a general rule, an allocation of up to 20% of the overall portfolio to less liquid alternative asset classes should enable most investors to avoid liquidity issues, even during market crunches,” says Karim Cherif, a strategist in UBS' Global Wealth Management's chief investment office.

He adds: “Building a successful allocation to alternatives requires diversification across strategies, managers and geographies. Strategy diversification reduces dependence on any single return or risk driver, manager diversification avoids risk of overexposure to the biases of any single fund manager, and geographic diversification reduces the risk of overexposure to individual political or economic regimes.”