Using alternative investments and using them together

Alternatives are a broad category of investments – many are as different as stocks and bonds. So, finding the right combination of alternatives to suit your goals and your portfolio is not an easy task. Our panel discussed the crucial aspects of picking the right mix of alternatives and the importance of understanding how your alternative investments provide diversification.

Our panel:

William Dinning – Chief investment officer at Waverton Investment Management
Tom Davies – Investment manager at Quartet Investment Managers
Shane Balkham – Chief investment officer at Beaufort Investment

There’s no one set of rules for investing in alternatives, but it is possible to make the whole process a lot smoother.

Today, alternative investments are sought by a broad range of investors, looking for experienced and skilled managers who can greatly improve the balance of risk and return in their portfolios. But, they must remain cognisant of the risks inherent in the non-traditional approach and structure of alternatives.

Every alternative investment should play a role

Many industry experts feel it’s essential that managers define the role their funds play in clients’ portfolios. Investors tend to have an ‘alternatives bucket’ that doesn’t always offer the diversification they think it does. (BlackRock, October 2019)

It’s important to combine a variety of different strategies involving combinations of alternatives in order to achieve a diversified portfolio, according to William Dinning, chief investment officer at Waverton Investment Management.

Risk. Diversification and asset allocation may not fully protect you from market risk.

At Waverton, managers combine absolute return funds and, hedge fund strategies, such as shorting with real assets (e.g. real estate and infrastructure) to make a return.

Absolute return funds: this is a fund that aims to provide a positive return regardless of an index return

Hedge Fund: this a privately pooled investment fund that uses various strategies to optimise returns

Shorting: “Borrowing” a stock (usually from a broker) that is projected to decline in value, selling it and then buying it back for a lower amount.

The absolute return fund offers the potential for diversification – lowering risk by opening up new sources of returns – while real assets may provide higher returns due to the risk premiums offered to investors as a result of the asset class’ illiquidity.

Risk premium: The expectation of greater returns in exchange for taking on more risk.

Many advisors will likely inform you that absolute return funds have struggled in recent years, which they have, while others will make the argument that they still have the potential to add considerable strategic value, which is also true. “I don’t think the people running these funds have suddenly become incompetent,” says William Dinning. “It’s probably more a change in market dynamics.”

Risk. Due to its investment strategy an 'Absolute Return' fund may not move in line with market trends or fully benefit from a positive market environment. A fund/strategy should not be considered low risk in absolute terms and may not be suitable for cautious investors.

Balance delivers diversification

William Dinning explains that his team pay close attention to the relationship between the equity market and government bond markets. From 2007 to 2013 this was always negative, with UK government bonds (gilts) in particular offsetting equity market wobbles. Since 2013, however, the simple correlation between equities and gilts have become very unstable. (Waverton Investment Management, April 2019)

“There have been periods where the correlation has become positive and that makes it very difficult if you’re running a fund predicated on the idea that you can buy assets with different sources of returns to traditional equities, put them together in a mix and produce an absolute return,” he says.

According to William Dinning, while it might not be true for every market, a sterling-based investor in the UK has found it harder to achieve a good level of diversification from an equity and bond portfolio with a 60/40 (equity/bond) ratio. “That is why I still think it’s worth thinking about absolute return and trying to find ways of doing it that provides diversification and a low correlation to traditional equity and bond markets.”

However, when it comes to identifying suitable absolute return funds, one of the challenges is that some of them may have been earning returns by following the equity and bond markets a little too closely. This may result in strong performance when markets are rising, but it won’t provide diversification, because the returns will follow a similar pattern to your traditional equity and bond investments.

“It’s been very tempting for a lot of managers to mimic equity markets, during what has been a long period of rising markets, but that is not the point of an absolute return fund. You need to be careful that you’re not buying a fund that is as sensitive to market movements as your traditional equity investments,” says Tom Davies, investment manager at Quartet Investment Managers.

Such absolute return funds that have a similar level of volatility to global equity and bond markets will perform well when those markets are rising and there’ll be very little to worry about. But, when markets are falling, your lack of diversification could leave you exposed. Balance is key to diversification, and that’s what alternative strategies should be delivering.

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It’s been very tempting for a lot of managers to mimic equity markets, during what has been a long period of rising markets, but that is not the point of an absolute return fund. You need to be careful that you’re not buying a fund that is as sensitive to market movements as your traditional equity investments.

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Tom Davies, investment manager at Quartet Investment Managers.

Risk. There can be no guarantee that the investment strategy can be successful, and the value of investments may go down as well as up.

Keep it simple

Experienced wealth managers often emphasise the importance of understanding and breaking down the risks involved in each individual alternative fund. Only then can they be confident that a fund can deliver the required outcomes in a robust and sustainable way.

“You need to understand what you’re buying. It’s best to stress test your investments in particular periods – when do you need managers to be dynamic or when do you need them to not be exposed to market beta?”, says Kelli Byrnes, a consultant within BlackRock’s portfolio analysis and solutions team.

Beta: the measure of a securities volatility in relation to the wider market.

“It is important to avoid alternatives that are too opaque or overly complex,” says Shane Balkham, chief investment officer at Beaufort Investment. “We prefer things that are simpler. The golden rule is that if we can understand it to a degree then we’ll use it. If it’s something we can’t really get our heads around, then we won’t touch it with a bargepole.”

Another very important factor for Shane is finding strategies that have been tested in different market environments. But, as he explains, “This is difficult at the moment, because we’ve only had one market environment for the past ten years. It makes trying to find something that has a track record more difficult.”