Market Musings 180223:
All About Alternatives

Explore the attractions of alternative assets in a diversified portfolio

Summary

• Alternative assets can be a useful way for investors to generate returns and diversify away from stocks, bonds and real estate.

• There are a number of benefits, but also pitfalls from investing in these alternatives

• Alternative asset classes perhaps worth considering today include LBO private equity funds, infrastructure funds and both trend-following and merger arbitrage hedge funds strategies.

Podcast

How abruptly will world growth and inflation slow down?

Our senior strategists provide a round-up of macro-economic news and give their outlook for 2023.

They consider different regions of the world and discuss which asset classes they favour at present. Don’t miss this golden opportunity to catch up with macro news and listen to our strategists’ views to help you navigate the year ahead.

What are Alternative Assets?

Alternative asset classes are a set of alternative investments to consider in addition to the traditional asset classes of stocks, bonds, real estate and cash.

These include:

• Commodities

• Private equity

• Private debt

• Infrastructure funds

• Hedge funds - especially trend-following strategies

• Specialist strategies - investing in farmland, forests, art, insurance policies, litigation finance etc.

What benefits for investors from Alternative Assets?

Capturing the liquidity premium: assets that are illiquid - i.e. not easy to buy and sell quickly and at low transaction costs - should provide a higher long-term return to investors, to compensate them for this lack of liquidity.

In general, the more illiquid the investment, the greater the liquidity premium that will be required to make it attractive alongside other, more liquid assets.

Private equity is a classic case of an illiquid asset class that has relatively high transaction fees, cannot be bought and sold with the same ease and at the same low transaction costs as listed shares, but which over time has generated superior long-term returns to patient investors.

US Private Equity Funds averaged 11% CAGR from mid-2000 to mid-2021

Source: CAIA, Cliffwater

Alternative asset classes are also included in investor portfolios for reasons of diversification -i.e. a zero or negative correlation with stocks and corporate bonds, helping to thus smooth overall investment portfolio returns in volatile years (such as 2022).

There may also be potential tax benefits to consider - e.g. for investments in forestry and farmland, or for investments in early-stage venture capital funds (a high-risk form of private equity for young companies).

Long-term illiquid assets classes can reduce behavioural biases

“Volatility smoothing” is one feature of many illiquid alternative asset classes, which can help to lower the investment risk from behavioural biases.

Simply put, investors in private equity, farmland or forestry assets for example, cannot panic sell these assets due to fears of an economic downturn, as one can in publicly-listed stocks and corporate credit.

We should be clear on this point - it is not necessarily that the assets in reality have lower sensitivity to an economic recession, but simply that prices are not set on a daily or even intradaily basis by the market.

Moreover, valuations of private assets are rather only recalculated on an infrequent basis (monthly, quarterly or even semi-annually) and often on the basis of “mark to model” rather than “mark-to-market”. This allows fund managers to smooth volatility of prices and returns even more.

Bottom line: this “smoothing” of asset price volatility that one sees generally in unlisted assets, combined with the relative difficulty of selling out, can act as powerful inhibitors to selling for investors who might otherwise sell out when the economic outlook darkens. This can then protect investors, to some extent, from their own behavioural biases which can otherwise act to hurt their long-term returns - by selling at or near the lows, and buying at or near the highs.

What are the potential pitfalls?

There are of course a number of potential problems and risks one should be aware of before investing in these alternative assets:

• A long-term investing horizon is essential, due to the illiquidity of the underlying assets. Investors should not invest too heavily in private assets, keeping only a minority of their overall portfolio in these private assets.

• Manager selection is key: There is huge variability in risk and returns from different managers. Even if the “average” return of the asset class like private equity is impressive, your particular fund return may bear no relation to this average..

• Opaqueness of underlying investments, strategy: investors should always understand what they are investing in - but this can be sometimes difficult for a number of complicated investing strategies.

• Beware of buying during an investment bubble - growth private equity funds heavily invested in technology start-ups in 2020 might be a good example of this risk today.

Which private asset classes do we favour today?

Leveraged Buyout (LBO) private equity funds - able to benefit from the relatively low valuation of smaller-cap companies in today’s stock markets. But, the higher cost of leveraged loans (debt) on the back of higher interest rates will reduce internal rates of return for private equity funds in future.

Infrastructure - energy, technology, regulated utilities, sustainability, security-related. There remains huge demand for infrastructure investment worldwide on the back of a number of key themes - the race to zero carbon, the increased emphasis on European energy security, implementation of 5G mobile internet connectivity, and greater social infrastructure such as social housing and healthcare facilities.

Since the beginning of 2000, the Global Listed Infrastructure index from GLIO has risen from 100 to 809 in euros, for an average annual return over the 22-year span of 9.5%, more than double the 4.5% average annual return from the MSCI World index over the same span.

In 2022, while the MSCI World index lost 18%, the global listed infrastructure index gained 1%, outperforming both listed stocks and bonds.

Global listed infrastructure +710% in euros since start-2000

Source: Bloomberg. Note: in euros

Trend-following hedge funds are a good diversifier against stocks and bonds, benefiting from a bumper 2022 as they were able to exploit strong and persistent macro trends in stocks, bonds and FX.

While trend-following funds have often shown modest performance when stocks and bonds are rising, CTAs (large trend-following funds) returned 20% in 2022 (according to the Societe Generale CTA index) while stocks, bonds and real estate suffered to varying degrees.

Trend-following hedge funds had a bumper 2022

Source: Societe Generale

Merger arbitrage hedge funds are another hedge fund strategy that try to profit from small arbitrages that can appear in announced mergers and acquisitions of listed companies. This arbitrage profit potential can exist as there is always a risk that the announced transaction is not completed, which can then result in a large loss for this strategy (which tends to buy shares in the target company to be acquired, while selling shares of the acquisitor company).

This strategy tends to show a relatively low correlation with stocks and bonds over the long-term: while returns tend to be less spectacular than other hedge fund strategies, this strategy also tends to offer far lower volatility as well.

Over the four calendar years 2019 to 2022, merger arbitrage funds have returned an annual average of 6% per year, according to hedge fund data provider BarclayHedge. Note again that merger arbitrage strategies managed a small positive average return in 2022…

Merger arbitrage funds perform steadily - relatively uncorrelated

Source: Barclayhedge

How can you invest in Alternatives via listed vehicles?

There are a number of ways that investors can invest in these alternative assets. One of the easiest ways in the UK is via listed investments trusts or sometimes via ETFs.

For listed investment trusts, one can screen for available trusts in a number of alternative asset class categories via the very useful theaic.co.uk website.

• Listed private equity and venture capital trusts;

• Listed unlisted credit/debt trusts;

• Listed infrastructure trusts, including trusts focused on renewable energy generation and storage;

• Listed hedge funds;

• Managed futures ETFs (US only)

Otherwise, for investors with large enough investment asset portfolios, they may have access to some of these funds, but these tend to be only for specific high net worth investors with sufficient financial market knowledge.