RM's Pietro Nicholl's explains what actually makes up an alternative asset.
Ever since Harry Markowitz’s 1952 paper on Portfolio Selection was published in the Journal of Finance, asset allocators and portfolio managers alike have been constructing portfolios to optimise expected returns for a given level of risk. In the intervening years, the theory has been expanded to include not just a portfolio of equities but all manner of asset classes from high yield bonds to commodities such as gold.
Fast forward to 2019 and almost every allocator from institutional investors such as pension schemes and insurance companies to IFAs running model portfolios, allocate across a range of asset classes and strategies.
According to research by PwC’s Asset & Wealth Management Research Centre, alternative assets under management have grown from c.$2.5tn in 2004 to c.$11tn in 2017, and are forecast to exceed $21tn by 2025.
What exactly are “Alternative Assets”?
Alternatives are well-established as an essential diversifier in investors’ portfolios. The generally accepted definition of an alternative assets is that such assets demonstrate characteristics which differ from those of traditional equities and fixed income securities.
Now, of course there are a range of ways to access or invest in alternative assets, for example it is possible to purchase gold bullion and store it in a vault (or under the bed if one is so inclined), or commercial real estate. However, such assets are illiquid and can incur significant personal cost to the investor. Another way is to invest in liquid securities such an ETF, or an Investment trust with exposure to the underlying asset such as a commodity fund or commercial REIT. The latter can provide liquidity in a more convenient fashion and without the same level of administration and cost.
At RM Funds we broadly define the alternatives universe as per the below:
Hedge Fund (merger arbitrage, global macro, relative value)
Commodities (metals, agriculture, livestock, energy)
Real Estate (GP surgeries, distribution centres, offices, residential property)
Alternative Credit (private credit, asset finance, platforms)
Infrastructure (availability, volume (renewables), demand)
We can crudely mentally split the six segments into those focused on high risk/high reward type investments such as hedge fund strategies, private equity and commodity investing, and those with a lower risk/lower return profile focused on the infrastructure and alternative credit segment. In the middle is real estate with its diverse offering. Another way of looking at such assets are those focused on real assets (i.e. infrastructure, renewables for example), where the assets are isolated rather than investing in a utility company with considerable operational and regulatory risk.
Why do investors allocate to alternative assets?
There are numerous reasons, but a couple of the key reasons are:
Diversification: assets which demonstrate negative or weak correlation to traditional asset classes are an extremely useful tool in the construction of an investment portfolio.
Volatility: whilst some types of alternative asset (such as hedge funds or private equity) might have high volatility, areas such as alternative credit and infrastructure tend to have very low volatility due to the nature of the business models they operate.
Risk-Adjusted Return Profile: alternatives can offer attractive risk-adjusted returns, allowing investors to capture illiquidity premiums, enhanced investor protections (private credit vs high yield bonds for example), and limited duration risk.
Liquidity: the key advantage of investing into listed securities within the alternatives space is liquidity. If you feel like owning part of a solar park, buy a listed yieldCo or an alternative income fund (I am the manager of one FYI – shameless plug), it’s an infinitely better idea than trying to negotiate with a farmer to build one in his back garden!
Of course one should not think of alternatives as a magic bullet but there are over £125bn of alternative assets listed on the London Stock Exchange. Investors have a range of options, from investment trusts, to UCITS funds.
"To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little protection than the uncertain return of a single security."
-Harry Markowitz, Portfolio Selection: Efficient Diversification of Investments, 1968