Some of these alternatives could provide protection if government bond yields rise, which may be appealing.
Equity return and risk will almost always dominate in a portfolio with it being nigh on impossible to meaningfully reduce correlation with equity markets when owning other risky assets. A portfolio of carefully selected alternative investments can help though, moderating equity exposure and protecting a portfolio in the event of equity drawdowns.
Responsible investing
Many of the global mega-trends in play today reflect ESG factors and provide investors with the opportunity to invest more sustainably. Facilitating advancements in areas such as the renewable energy transition can provide additional returns and reduce some risks – carbon price/tax exposure being one.
Many alternative investments have no benchmark, hence managers are not pushed to own sectors or companies in which they have no conviction over the long term, something which is a problem for many conventional equity and bond funds, which are not permitted to deviate too far from the benchmark. This makes it difficult for those managers to properly construct portfolios with sustainability as the focus.
To integrate responsible investing, a comprehensive assessment of how an asset manager considers these risks and opportunities needs to be constructed both from the top-down, scrutinising how the business approaches ESG and mandate design, right through to portfolio construction and bottom-up/asset class specific factors.
There is a considerable difference between alternative strategies – real estate and quantitative macro do not have much in common and any ESG assessment should reflect that. Unsurprisingly this divergence creates a wide spread of approaches to ESG integration, although some asset classes show higher average scores than others.
Detailed analysis illuminates some rapid improvements, however on the whole more investor engagement within alternatives is required. None more so than in hedge funds where many managers are not doing enough and investors need to push them harder. Every business should have an effective ESG policy, buy-in from C-suite management, and commit to becoming carbon neutral, for example.
Outlook
Monumental change is required to make the human race sustainable. The likelihood of inflation and a rising rate environment has also increased. Investors should look at their portfolio’s exposure to these areas. Alternatives can provide strong inflationary linkage while also reducing equity risk and increasing ESG alignment.
We have gathered some high-level examples across a number of asset classes in the table below:
Strategy | Inflation linkage | Expected returns* | Expected volatility | ESG risks | Costs |
Asian Convertibles | Uncorrelated | 2-4% Credit/equity premium | Moderate | Moderate | Moderate |
Commodities | Strong | Inflation | High | High | Low-moderate |
Cyclical equities | Moderate | 2-4% Equity premium | High | High | Moderate |
Direct PPI | Strong | 2-4% Credit/illiquidity premium | Low-moderate | Moderate | Moderate-high |
Direct renewables | Strong | 2-4% Credit/illiquidity premium | Low-moderate | Low | Moderate-high |
Direct timber/agriculture | Strong | 2-4% Credit/illiquidity premium | Low-moderate | Moderate | Moderate |
EM equities | Uncorrelated | 2-4% Equity premium | High | Moderate | Moderate |
Floating rate credit | Moderate | 1-3% Credit premium | Moderate | Moderate | Moderate |
Inflation-linked bonds | Strong | Inflation | Dependent on duration | Low | Low |
* These are long-term expectations, but in the short-term asset classes can go through meaningful periods of deviation. This does not constitute investment advice. Where necessary, please speak to a financial advisor. | |||||
Summary
To conclude, this decade will not be like the last, which was defined by easy monetary policy and low inflation. The pandemic-induced fiscal and monetary stimulus has pushed up the price of financial assets and this is now starting to translate into the prices of goods and services as the inflation that has driven Wall Street in recent years starts to impact Main Street.
