I’m an alternative – get me in here!

December 23, 2013 Categories: Investment Strategy

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When working with clients on their portfolios strategy, “alternatives” are a continual challenge. The desire to increase diversified portfolios is clear – but challenges large.

Even once alternatives are understood, their role in the portfolio, the allocation size, and how reliable “hedge funds” or “private equity” can undertake it is not clear. The key to building a more diversified portfolio comes from moving beyond what investments are called, to understanding what drives their returns.

We used to think of asset classes as well defined. We knew whether an asset belonged in a class or not, and how the class behaved. They were a bit like planets travelling along paths that could be reliably projected into the future.

Alternatives never really fit this pattern. Firstly, the name “alternatives” merely means “other”. Secondly, when we closely scrutinise examples of alternatives, we are often left with more questions than answers. In what way are equities, long/short equities and private equity fundamentally different? Likewise, should we classify private equity and private debt separately, and should we differentiate corporate private debt and real estate private debt?

The financial crisis underscored the fact that investments should not be thought of as clearly defined, predictable “planets”. A better analogy would be a swarm of butterflies, which overlap and interact with each other. Chaos Theory demonstrates the “butterfly effect”: how conceptually the wing-beat of a butterfly in the Amazon could through ever-magnified successive changes ultimately affect a hurricane in the Caribbean. Similarly, excessive loan writing in the United States fuelled a contagion that almost brought down the entire global financial system.

We value alternatives for their contributions to returns and their ability to diversify risk, but asset class labels do not indicate the common drivers of return within alternatives, nor do they point to which investments are truly diversifying.

We need a new lens to order this chaos—to understand the risks that drive investment returns, and to see where common risks aggregate. This can apply to any type of risk —exposure to credit spreads, inflation, oil prices or presidential elections. But initially we will consider the primary risk components of the main asset classes — real rates, inflation, credit, economic growth, political and regulatory risk, skill and illiquidity.

When viewed through a “risk factor” lens, a traditional balanced fund with a large equity allocation may look very different. It may have a high exposure to economic growth and low exposure to illiquidity, political risks, inflation or skill. russell-investmest-wire-blog-graph-one

Diversifying these risk exposures may be difficult with traditional assets. The returns of equities and bonds are dominated by the macro-economic risks: real rates, credit spreads and economic growth. Access to political factors (through emerging markets) and skill (through active managers) is typically a modest element of the overall return. Alternatives offer more access to the non-economic risk premia, especially skill, political and illiquidity.

Indeed, the broad alternative “classes” can be identified with access to these core risks, e.g., hedge funds with skill, private capital with illiquidity. Inflation is another element where investors often desire larger exposure than gained from traditional investments. Real assets (such as real estate, infrastructure and timber) can provide access to returns from inflation often alongside strong elements of illiquidity and skill. Of course, none of these alternatives represent a “pure” risk factor but come as combinations of these risks.

However, asset class analysis is not sufficient. It is important to look at each investment individually because opportunities that look similar on the surface can have very different risk profiles. In real estate, for example, two similar looking buildings can hide very different risks. Once these individual risk profiles are understood, investors can aggregate the risk profiles in order to better understand and thus better balance the drivers of return within a multi-asset portfolio.

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Looking at exposures using the lens of common risk factors rather than asset class labels helps build better diversified portfolios. While we may not wish to have an equal weighting to each risk factor, to increase the chance of successful outcomes, we need to be able to make a conscious, active decision about the balance of return drivers in our multi-asset portfolios. This new lens also provides a framework in which we can better understand how alternatives help diversify investments.

Nick Spencer, Regional Alternative Consulting Director, EMEA

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