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Do alternatives help dampen volatility?

Many market participants take the view that an alternative asset’s role in a portfolio is either to generate returns or to dampen the volatility produced by the equity allocation.

But with liquidity always a concern, and the yields offered by government bonds having risen, are alternative assets still useful as volatility dampeners?

Simon Molica, senior investment manager at Parmenion, certainly thinks so. He says: “Including alternatives into, for example, a 60-40 portfolio should reduce the overall volatility of the portfolio and in turn produce better long-term risk-adjusted returns.

"But some alternatives can be volatile, such as managed futures. Some alternatives can have a low volatile profile but only because they are not priced frequently and are less liquid than equities. Physical property is a good example of this because the valuation point where an independent valuer assess capital valuations is usually no less than monthly."

Mark Lane, head of active funds at Progeny, says it is possible to find alternative assets that are capable of dampening volatility, but says clients need to be conscious that such an approach inevitably comes at the expense of investment returns, with such assets contributing little to that side of the ledger. 

Dan Boardman-Weston, chief executive at BRI Wealth, says he typically retains one part of his alternatives allocation as a hedge, or volatility management function.

But he says it has become harder to justify owning many of the assets that would typically be in this bucket as bond yields have risen.

He says: “If you can own a government bond with a 4 per cent yield, it is very hard to justify paying a management fee for an absolute return or hedge fund type strategy.” 

Ross Crake, of Osprey Wealth, elaborated on the point, saying that many of the volatility dampening alternative assets have had returns that correlated with bond yields in 2022, and therefore failed to perform their function. 

But he says the correlation does not always apply: “Correlation can depend on the economic backdrop. For example, correlations will be different depending on whether inflation is low and rising or high and falling. 

"Obviously private equity and debt are also very closely correlated to listed versions of the same assets but they tend to offer a higher return for the additional risk and lower liquidity over the longer term." 

One alternative asset class he does feel justifies its role of dampening volatility is commodities, as they often perform well during periods of geopolitical instability.

Commodity prices also tend to rise when inflation rises, higher inflation tends to be negative for government bonds, and so commodity prices are often inversely correlated with the performance of bonds – something that is not always the case with other alternative assets.

Conversely if economies are performing extremely well, then it is likely that commodity prices will rise as a result of extra demand, while confidence-filled investors will shun bonds in favour of the higher potential returns available from equities, reinforcing the negative correlation between commodities and fixed income. 

Matthew Yeates, deputy chief investment officer at 7IM, says one can dampen portfolio volatility via the simple expedient of holding cash.

But he adds that if one wants to achieve slightly more than that, “if they seek an explicit diversification (ie a negative correlation) with equity markets, that’s where genuinely defensive alternatives can help, as per the example of trend following.

"Alternatives, like many other areas of markets are also seeing fee pressures. However, many of the strategies being deployed are more research or implementation intensive, given the goal is to be market neutral, which we think justify the associated fees.

"For strategies that are just recombination of traditional betas though (in bonds or equities), we would not be willing to pay higher fees, as investors would be better off owning the passive vehicles with the same exposures to those underlying betas, even if there is some element of ‘alpha’ on top.” 

Philip Waller, investment specialist for alternative solutions at JPMorgan Asset Management, says: “Bond yields can impact valuations and market sentiment of alternative assets in a variety of ways.

"Firstly, the discount rate, used when pricing many assets, is often derived from bond yields. Higher bond yields typically lead to higher discount rates, which can lower the present value of future cash flows from alternative assets and reduce valuations.

"Bond yields, particularly government bond yields, are often considered a proxy for the risk-free rate so higher bond yields may reduce the relative attractiveness of certain alternative asset classes, especially more income orientated ones.

"Higher bond yields may also impact market sentiment, risk perception and general views on opportunity cost – all of which may impact valuations."

He adds: "It’s also important to note that many alternative asset classes are levered. As bond yields rise so will the likely cost of debt, which can push down future expected returns and, consequently, prices.

"Bond yields are therefore a critical factor in the valuation of alternative assets as they influence the discount rate, cost of capital, and relative attractiveness of investments with the relative impact varying across asset classes and asset types."

David Thorpe is contributing editor at Asset Allocator

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