Investment Strategy

Four ways alternative sources of return may suit volatile times

By Matthew Hopkins
Sydney, Australia

Investors braving financial markets face a long list of challenges with most share markets sliding into bear market territory at some point over the past year and bond yields dropping to record lows.

These market challenges have occurred against a backdrop of slowing global economic growth, which shows few signs of picking up to any meaningful degree following several years of International Monetary Fund downgrades.

Meanwhile, interest rates remain at historically low levels, and in some cases, have plumbed negative territory, leaving monetary policy makers little room to manoeuvre to restore vigour to flagging economies.

Over the coming year, we expect global interest rates to remain low if not shift lower, leaving term deposit returns unattractive and returns relatively subdued. Meanwhile, bonds offer among the lowest investment returns of any asset class over a medium-term horizon, in addition to potential risks embedded in low interest rates. If and when interest rates do rise, bond investors face losses as a result of capital depreciation.

The Australian share market remains one of the highest-yielding markets in the world. Thanks to franking, we see gross dividends above 6.5% as sustainable over the coming year.

However, we also see markets remaining volatile at least until the end of the year which can create a less-than-ideal scenario for investors seeking stable returns. Furthermore, we do not believe bonds or shares, on their own, will boost returns the way they once did. Historically low interest rates have rendered bonds expensive and shares, whilst not excessively expensive, are struggling to maintain meaningful earnings growth.

This suggests other options, such as alternative assets, may be increasingly required to do some of the heavy lifting in investment portfolios.

Defining alternatives
The definition of alternative assets and strategies across the industry is very broad with the term meaning different things to different investors.

Alternative investments access a broader universe outside of traditional asset classes, such as equities and bonds, and can include direct assets, such as private equity, real estate and agriculture.

They are very useful diversification tools in a broader portfolio because they usually have low to moderate correlations with stocks and bonds. However, direct assets are also illiquid and require capital to be locked up for significant periods of time.

Alternative strategies are a second broad subset of investments that derive returns mainly from exploiting opportunities in the inefficient segments of mainstream capital markets.

Typically this includes hedge fund and absolute return strategies, which seek to capitalise on the mispricing of assets relative to each other. Arbitrage and relative value strategies would be included in these segments, where the overarching goal is to produce returns that are driven by market inefficiencies and the skill of the manager, rather than the direction of the broader market. We define absolute return strategies as anything that has a sound fundamental rationale for producing excess returns; that aims to deliver those returns relatively consistently; and are not driven or explained by broad market movements.

Assets and strategies typically classified as alternative

Alternative Assets (market-based) Alternative Strategies (skills-based)
Commodities Equity long-short
Agriculture Equity market neutral
Real Estate Event driven
Infrastructure Relative Value
Real Assets Global macro
Private Equity Managed Futures
  Multi-strategy
  Artbitrage-style premia

Four functions of alternatives
The key role of alternative investments in multi-asset portfolios is to improve the overall risk/return profile. Here are four vital functions alternatives can fulfil in a multi-asset portfolio:

  1. They broaden the set of returns from a limited set of traditional asset classes to a much broader set of non-traditional assets, such as agricultural land or business, infrastructure or private equity. This is important for the robustness of portfolio returns and increasingly important in the current environment where bonds are expensive and equities valuations appear stretched.
  2. They diversify a portfolio away from market risk (beta) towards strategies which are more reliant on investment skill (alpha), such as equity market neutral strategies.
  3. They can benefit from increases in market volatility through allowing faster moving capital to respond to market dislocations. Well-designed alternatives strategies can benefit by being liquidity providers in times of market stress rather than being victims.
  4. They can help the portfolio adapt to changing market environments. Managed futures, for example, are well designed to benefit from extreme market moves in either direction.

Final thoughts

Investors braving financial markets have faced the most challenging conditions in decades as weak global economic growth eats into returns and shows few signs of picking up to any meaningful degree.

Increased volatility made financial markets difficult to navigate, and even advisers who successfully guide their clients through a growing number of challenges may find clients’ returns less than adequate. Furthermore, we see markets remaining volatile at least until the end of the year, which can create a less-than-ideal scenario for clients seeking stable returns.

When done well, we believe allocations to alternatives can help multi-asset portfolios achieve their target returns with lower overall volatility and lower exposure to the risk of extreme losses, which is critical for investors in or near retirement. Alternatives can help grow wealth steadily and provide peace of mind in retirement by delivering a relatively smooth performance.
 

 

  • Diversification
  • Goals-Based Investing Update
  • Risk Management

Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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