What role do alternatives currently play in investors’ portfolios?

Before we invest, we need to ask ourselves, what are alternatives? We spoke to wealth managers, who offered their views on alternatives and urged fund managers to help solve the ambiguity around the asset class.

Our panel:

William Dinning – Chief investment officer at Waverton Investment Management
Alex Orr – Managing Director within BlackRock’s Alternatives Specialists team
Shane Balkham – Chief investment officer at Beaufort Investment
Kelli Byrnes – Vice President within BlackRock’s Portfolio Analysis and Solutions team

Our panel invests in a diverse set of alternatives, with many preferences, ranging from absolute return funds ( a fund that aims to provide a positive return regardless of an index return) that use a number of alternative strategies, to real assets, such as infrastructure and commodities. Overall, the wealth managers we spoke to prioritised meeting clients’ goals and overall transparency, but they were also keen to get clearer definitions of alternatives categories.

Below, we ask, what do absolute return funds aim to achieve? And how does the role they play in a portfolio differ from privately traded real assets – physical assets such as private equity and real assets?

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.

Absolute return strategies and real assets play distinct roles

Panel members agreed that investors, in part, turn to alternatives to manage volatility, especially in equity markets, and find alternative sources of income, particularly when government bond markets are offering little in the way of yield.

Risk. The strategy should not be considered low risk in absolute terms and may not be suitable for cautious investors.

This dual dynamic is summed up by William Dinning, chief investment officer at Waverton Investment Management, a firm that clearly splits the universe into two. On one side, the absolute return allocation provides diversification with the aims to lower portfolio volatility, and also looks to provide returns when equity market may be falling in value. However, he strikes a cautious note, “Among absolute return strategies, it has been difficult to find ones that do what they say they’ll do on the tin. But we think it’s still worth trying.”

The other allocation Dinning’s firm lumps together is real assets. He defines these as investments other than equities or conventional property that can provide some kind of return. “Some of that return might come from income, some of it might come from capital gain,”’ he says. He does caution that this allocation might at times still be affected by the economic cycle but may provide access to potentially higher returns via risk premiums not available in more-liquid equities and corporate bonds.

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

It is a view corroborated by Alex Orr, Managing Director within BlackRock’s alternatives specialists team, who says the firm is seeing distinct trends in both liquid alternative strategies and less-liquid privately traded real assets, across a range of clients. “When it comes to liquid alternatives, and absolute return strategies in general, the focus is very much on returns with as little correlation to those of equity and bond markets as possible,” he says.

Alex identified two distinct requirements of liquid alternatives, the first being risk management, which is all about diversifying clients’ portfolios and lowering exposure to public equity and bond markets. This can offer protection when those markets perform poorly. The second aspect comes down to the skills of proven fund managers – can they generate returns from both their traditional investments and alternative strategies, such as shorting.

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.

Within privately traded alternative assets, he says, there is a broad church of investments ranging from private equity and private credit to real estate and infrastructure. “All of these classes bring different characteristics and different benefits. In the last few years, we’ve certainly seen an increase in real assets and private credit, as investors have been looking for greater income,” he says.

For Shane Balkham, chief investment officer at Beaufort Investment, alternatives are “something that gives a different outcome than equities, bonds or cash might deliver.” For his firm, this is achieved via a multi-strategy vehicle that uses derivatives to generate different exposures to different markets.

Derivatives: a security with a value that is reliant upon or derived from, an underlying asset

Such products offer different sources of returns to the equities and bonds that make up the bulk of most clients’ portfolios. Overall, he says, the golden rule is to be able to understand the underlying strategy: “We prefer things that are simpler. If it’s something we are not clear about, we won’t touch it,” he says.

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We prefer things that are simpler. If it’s something we are not clear about, we won’t touch it.

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Shane Balkham, chief investment officer at Beaufort Investment

Alternative risks

The ambiguity around different types of alternatives can lead to potential risks. Kelli Byrnes, VP, BlackRock’s portfolio analysis and solutions, points out the dangers of over-concentration, noting that in practice an alternatives bucket can sometimes consist of a single real asset fund.

“An alternatives bucket can be a catchall for anything that doesn’t fit neatly into traditional equity or fixed income categories,” she notes. “It is vital to understand exactly what the role of that alternatives bucket is supposed to be,” she emphasises.

Balkham suggests a helpful way of looking at the category is to consider the question in reverse. ‘I’d look at it backwards and say: “What are the managers trying to provide, and can I get that elsewhere in a more traditional manner? Can I deconstruct this alternative and bolt on an equity and a bond and property and come up with the same answer?” he says.

In general, he looks for things that can be outsourced to an alternatives manager. “Derivatives are an obvious example, but it is important to understand what drives a fund’s risk and returns. Once you have that clarity, you have to consider whether the process is robust, sustainable and repeatable. Do the managers have a track record in this? Is it ultimately going to keep me awake at night, or is it something I know is going to add diversification within clients’ portfolios?”