Taking an ‘alternative’ route

Posted by Liz Rees in Latest insights category on 17 Oct 19

Diversification is one of the most important factors to take into account when constructing a portfolio. Traditionally, investors split their portfolio between shares and bonds according to their attitude to risk. These days, alternatives are being added to the mix so what are the options, which are most popular and how accessible are they?

Types of alternatives

Alternatives encompass a diverse range of investments, including more esoteric assets such as art, fine wine or classic cars. However, the ones more likely to be found in investment portfolios include property, infrastructure, commodities, precious metals, absolute return funds and private equity.

Their unique characteristics mean they may have lower, or even negative, correlation with equities and bonds. As such they may help reduce portfolio volatility and potentially enhance returns. On the downside, they may be less liquid, harder to value, and require greater due diligence.

Property & infrastructure

Property funds usually focus on the commercial sectors - retail, offices and industrial rather than residential. Returns may comprise both capital growth and rental income with the latter often linked to inflation.

Funds in the IA ‘Property Other’ sector invest in property shares which are more liquid although in the short term perform similarly to equities. Those in the IA ‘UK Direct Property’ sector invest in physical property so may face trading constraints if redemptions are high. An investment trust structure avoids such liquidity issues and these are increasingly being used to provide access to niche areas such as student accommodation or doctor’s surgeries.

Infrastructure funds focus on the provision of essential buildings and services to society. These range from airports and roads, to power grids, mobile phone towers and ports. The attractions for investors are high barriers to entry and access to regulated, or contract-based, businesses.

Income flows have tended to be stable and predictable, with some incorporating inflation protection. Many countries, particularly in emerging markets, are either upgrading existing or building new infrastructure. There have been a number of fund launches to take advantage of these opportunities.

As with property, some funds invest in shares and others physical assets. Funds tend to concentrate on listed companies and one with a strong track record is First State Global Listed Infrastructure which has a current yield of around 2.8% and is bronze rated by Morningstar. Investments trusts, such as HICL Infrastructure Company, may invest directly into long-term infrastructure projects. It should be borne in mind that investing in large scale assets may involve high levels of debt.

Commodities & precious metals

Hard commodities are those which are mined or extracted while soft commodities comprise agricultural goods or livestock. Base metals, such as copper, zinc and lead, are mined for industrial use so are linked to the economic cycle. Precious metals, including gold, silver and platinum, are often used as safe havens by investors.

Commodity prices tend to rise with inflation and investors sometimes buy commodities to protect themselves against unexpected inflation that may result from political disruption or natural disasters.

Price moves also reflect demand. In some cases, usage may be in decline while for others it is escalating. For example, lithium, used in batteries for electric vehicles, is highly sought after. Therefore, there may be little correlation between individual commodities at any point in time.

Furthermore, prices can be volatile. Mining companies may be exposed to political, economic and environmental risks. Furthermore, natural resources are often located in challenging locations. Soft commodities may be vulnerable to extreme weather and fluctuations in production costs.

Commodities, overall, have tended to exhibit low correlation with stock markets. However, many funds, with the exception of some ETFs (Exchange Traded Funds), do not invest in them directly but via listed mining companies. Such investments have tended to be more correlated with the stock markets.

Funds may focus on a particular commodity, such as oil or gold, or diversify across a wider range of resources. Morningstar bronze rated BlackRock Gold and General has a focus on gold miners while BlackRock Natural Resources Growth & Income has a broader mandate and can tilt allocations towards commodities with the most attractive supply and demand characteristics at any time.

Targeted return funds

These cover a diverse selection of funds with different investment objectives. However, the majority aim to offer a portfolio with low volatility of returns. They tend to lag strongly rising markets but aim to protect capital in a downturn.

A common approach is to try and generate positive returns regardless of market direction- this may involve using derivatives such as options and futures. These funds are found in the IA Targeted Absolute Return sector (previously IA Absolute Return). Although past performance shouldn’t be considered an indication of what might happen in the future, one with a solid track record of capital preservation is BNY Mellon Real Return.

Private equity

Private equity investments are companies not listed on a public exchange. Funds provide capital for either start-up companies or established firms which may have completed a buy-out. UK companies are following the US model of staying private for longer which has led to an expansion of the asset class.

Extensive resources are needed to evaluate private companies which are not well researched. This may involve working closely with the management and other shareholders. Liquidity can also be restricted; companies may have minimum ‘lock-in’ periods so should be seen as long-term investments.

As a result they are more commonly found in an investment trust structure. Trusts do not have limits on the proportion of unlisted stocks and do not have to sell investments if holders wish to exit. Standard Life Private Equity Trust has a consistent record and currently trades on a significant discount to NAV (Net Asset Value).

Historically, private equity has produced strong performance but should be considered a higher risk option because of the lack of transparency and greater chance of company failure.

In summary

Interest in alternatives started with large institutions but individual investors are increasingly embracing the diversification benefits they can bring, particularly for pensions. Growing demand means new funds are being launched all the time.

Extra research may be necessary to understand a fund’s strategy and objectives as well as any unique risks such as liquidity constraints. Correlations with shares and bonds can be low or even negative although the relationship of nearly all investments tends to converge under periods of extreme market stress.

Of course, you may already have indirect exposure to alternatives if you hold funds that invest in the energy, mining and property sectors. If you are looking for a ready-made solution, a growing number of multi-asset funds and trusts are using alternatives. A more specialist option is Architas Diversified Real Assets which invests across the alternatives universe.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.