Investors face an environment of lower economic growth, low interest rates and ultra-low bond yields. How can alternatives help?
Over the last 10 years, we have seen the longest ever US equity bull market run, with the S&P 500 generating an annualised return of 14% between January 2009 and August 2019. However, the global economy is showing signs of weakness, amplifying the case for appropriate portfolio diversification.
What are alternatives and why are investors looking to them?
The last decade has seen an easing of monetary policy and a fall in interest rates, bringing bond yields down to ultra-low levels. This has forced many investors looking to generate income to buy riskier bonds, tilt towards higher yield in their stock selection, or apply excessive leverage to their portfolios.
Fund managers have responded by launching a wide range of alternative investment vehicles. Some invest in non-traditional assets, such as commodities or infrastructure, while others invest in traditional assets through non-traditional channels, such as the use of complex trading techniques and products by hedge funds.
It is important to note that rather than being a single asset class, alternatives span a range of sub-assets, vehicles and markets. Investors should therefore be aware of the characteristics of each alternative investment and its role within their wider portfolio. With effective diversification, risk management, and fund selection, we continue to believe that investors can achieve consistent returns from alternatives. At Sarasin & Partners, we offer clients exposure to alternative investments through carefully selecting and monitoring third-party funds.
How we assess alternatives
The potential return and diversification benefits of alternatives may be appealing. But their potential complexity and variety means that investors need to consider their options carefully. We think there are five key characteristics that make success in alternatives more likely.
1. A robust selection process
One of the risks in alternative funds, most acute in hedge funds and private equity, is a high degree of dispersion in performance between investment managers. This makes it all the more important to have a rigorous research process when selecting a manager, as this will be a key driver of returns.
We consider a range of factors that determine our conviction in an alternatives fund and make investment decisions that align with our long-term, thematic investment views.
Table 1 shows a sample of the alternative investment funds that we hold.
2. An embedded stewardship process
Environmental, social and governance (ESG) factor analysis is embedded into our investment process. Before investing, we analyse alternative funds to understand their ESG performance and whether they comply with our ethical restrictions.
We also engage directly with investment managers where we see scope for improvements. We saw a recent example of this when our discussion with a prominent infrastructure investment manager led them to adopting a new ESG policy.
3. An awareness of the importance of liquidity
Liquidity has long been an area of focus with regard to alternative investment funds. While some investors are comfortable to ‘lock up’ their investment for over a decade, as is the case with some private equity funds, others would rather have the option to withdraw their money more frequently. With this in mind, we have reduced our allocations to less liquid investments, particularly given the risks that they would pose in the event of a market downturn.
4. Active management
We believe active management is the key to steady returns. When constructing a multi-asset portfolio, alternative investments need to be carefully managed. As well as selecting investments that have an attractive risk-return profile, we consider their correlation with other alternative holdings, as well as with the broader traditional assets. This ensures that we reach an optimal level of diversification at both an asset class and portfolio level.
5. A flexible approach to asset allocation
Rather than allocating a specific percentage to any one sub-asset class, we make allocation decisions to reflect market opportunities and our areas of conviction. For example, we chose not to hold any gold between 2011 and 2015 – a period when the price of gold fell by 21%. We currently invest in gold as it is an investment that is uncorrelated and offers protection in case of a market downturn. Year to date, we have seen its value in GBP rise by 25%.
Given that we are in the late stages of the economic cycle, we have this year reduced our exposure to alternative assets that are more sensitive to economic factors. Market rallies throughout 2019 presented good opportunities for us to sell these at attractive levels, generating a healthy return for our clients and reducing their portfolio risk.
While the performance of some alternative assets has been cyclical and challenged during certain periods, active management of the asset class can produce consistent returns over time.
Chart 2 illustrates how the alternatives asset allocation has evolved within the Sarasin Endowments Fund between 2005 and 2018.
What are the different types of alternative investment?
While there are many different types of alternative investment, we categorise them in two ways: those that use absolute return strategies to offer uncorrelated returns and downside protection, and those that offer diversified return streams through access to new markets and unique drivers of returns.
Uncorrelated returns and downside protection
While some alternatives operate with high risk and complexity, others can help to manage portfolio volatility.
Absolute return strategies have become increasingly popular among investors, as they offer investment opportunities that are uncorrelated with traditional bonds, equities or property. An example of this is the Neuberger Berman Uncorrelated Strategies Fund, which Sarasin helped to structure. It provides access to several underlying strategies and has the flexibility to allocate across sectors, geographies and asset classes. Funds such as this allow our clients to stay invested throughout the market cycle, rather than allocating to low-yielding fixed income assets. In the event of a broader market downturn, they should offer sources of positive returns and minimise portfolio volatility.
Gold serves as an illustration of this type of alternative investment. Throughout history, people have held gold for a range of reasons, particularly as a store of wealth. When there is doubt and uncertainty, people typically flock to gold. In the context of an investment portfolio, its status as a ‘safe haven’ asset translates to it being a source of protection against market downturns, geopolitical uncertainty, and the weakening of major currencies. Its defensive characteristics make gold a particularly valuable alternative investment in the current economic and market environment.
Nascent markets and unique drivers of growth
Alternative investments are broadly recognised as a source of diversification, with some funds offering access to nascent markets and unique drivers of returns.
Investors have increasingly allocated to private equity to gain access to investment opportunities that are not otherwise accessible on the public markets. Private equity managers cite a range of factors that might enable them to achieve strong returns, such as the alignment of their interests with those of corporate management teams and the opportunity to take an active approach to corporate governance by acquiring large stakes in underlying companies and improving their operations.
An interesting example can be seen in Oakley Capital, a company we invest in which provides exposure to businesses within the telecommunications, media, technology, consumer, and education sectors. It is focused on western European early-stage businesses that are undergoing structural change, and which it expects to be resilient to economic and political uncertainty. Oakley Capital adds value by building long-term partnerships with entrepreneurs, committing resources to understanding complex business areas, and by building out businesses that have scope for rapid growth.
Infrastructure funds have also become increasingly popular with investors seeking new sources of income. These can span the risk-return spectrum. They may be lower risk public private partnerships, with government guaranteed and inflation-linked income streams, or more private equity-like assets, such as merchant power plants. Investing in infrastructure may provide three key benefits: diversification away from other asset classes, a consistent income stream and a degree of inflation protection.
With the increasing focus on climate change and fossil fuels, we have identified a number of opportunities in the renewable energy sector. This year, we participated in the IPO of US Solar Fund Plc, which we now hold across client portfolios. Solar power generation is a rapidly growing investment opportunity – it is currently 8% of global energy generation, but this is expected to rise to 40% by 2050, making it the largest global source of energy generation1. Particularly in the US, states are accelerating their clean energy targets and there has been significant policy support, including subsidies and tax incentives. We believe the US Solar Fund is well positioned to benefit from the rapid growth in renewable energy and will continue to be a compelling source of investor returns.
How have our alternative investments performed?
Chart 3 shows the performance of the Sarasin Endowments Fund’s alternatives allocation (compared to UK CPI +4%).
Over this period, our alternatives allocation generated an annualised return of 9.3%, while the MSCI All Countries World (ex UK) and FTSE All Share indices generated 8.8% and 6.2%, respectively.
Although we expect the coming years to be challenging for both traditional and alternative assets, our alternatives investment process has consistently performed through a range of market scenarios, including in 2008, when it generated a return of 7.9%.
Looking over the horizon
The current economic backdrop suggests slowing global growth, lower inflation, and lower interest rates. Even in the case that central banks are successful in preventing a downturn, there is strong reason to believe that traditional asset classes, such as equities and bonds, will struggle to deliver the same levels of return as seen in recent years. In a low-rate, low-growth environment, how can investors continue to generate investment returns and income they need?
Looking ahead, we seek to increase our allocation to alternative investments. While we expect challenges in the years ahead, we believe that consistent returns can still be generated from an alternatives allocation that is appropriately diversified, actively managed, and provides access to unique investment opportunities.
1 Source: Bloomberg New Energy Finance New Energy Outlook 2019, International Renewable Energy Agency