With the change in economic cycle fund managers are turning down the dial on alternatives. Darius McDermott, managing director, FundCalibre, looks at why and asks whether alternatives still have a place in portfolios.
If you put “60/40 investment portfolio” into any internet search engine you’ll get a load of headlines asking whether the traditional way of investing is dead.
There has historically been a negative correlation between equities and bonds, meaning in falling equity markets investors could usually find solace in the bond market. But last year both equities and bonds simultaneously suffered, prompting many to question how appropriate the 60/40 allocation now is for an investor.
For clarity, I’m not in that camp. Research from Goldman Sachs shows that the classic 60/40 portfolio has generated an impressive 11.1 per cent annual return between 2011 and 2021*. Even after adjusting for inflation, its 9.1 per cent annual real return stands above long-term levels of around 6 per cent*. That’s not to be sniffed at.
But the challenge in this period was that investors were scouring high and low for sources of income in a low interest rate world. Step forward alternatives. Many investors – including ourselves – turned to the likes of infrastructure, renewables, and other global real assets to make up the income shortfall. It has been estimated that there was more than $13 trillion allocated globally to alternative investment asset classes at the beginning of 2022**.
But we now appear to be in a different economic cycle – the response to which has been a sharp rise in interest rates, making it far easier to achieve meaningful dividend returns. Instant access cash ISAs are now offering well over 3 per cent, while the likes of UK equity income and corporate bond funds are offering in excess of 4 and 5 per cent respectively.
The sharp rise in bond yields has resulted in a number of multi-asset managers beginning to dial down their alternatives exposure in favour of traditional fixed income. Which raises the question of whether they still remain an integral long-term holding when yields are so readily accessible?
BNY Mellon Global Multi-Asset Income manager Paul Flood has recently halved his alternative exposure, increasing his bond allocation as a result. He says it is hard to ignore the fact bonds are more attractively priced but believes the role of alternatives is still essential given the importance of inflation linkage.
He says: “Bonds are buyable again, but alternatives have a major role to play given we’re in a world of rising inflation and interest rates. If inflation is likely to be higher/more volatile you need something to work with bonds, because interest rates are the key determinant of asset prices – you need something with positive correlation with inflation and interest rates, as a number of alternatives have.”
The pessimist would tell you that alternatives have only flourished in a zero rate environment, but they finally have a real challenge to overcome in the shape of the risk-free rate. They’d also argue they’d want to see more from a risk reward perspective from the asset class in this environment.
Aegon Monthly Diversified Income co-manager Vincent McEntegart says targeting a 5 per cent yield on his fund made alternatives a necessity for much of the past few years, but he and his team has now cut back exposure, increasing his bond allocation to almost 50 per cent. However, he says alternatives remain as crucial as ever, in terms of investors having a diversification of income streams.
For me, it’s a case of not forgetting the lessons of the past. We’ve already seen on the back of Global Financial Crisis and the pandemic that dividends and yield can disappear quickly from both traditional asset classes. Alternatives play a different role in this environment – if the sun shines, planes fly, the wind blows, or music streams – it is completely irrelevant to what happens in the bond or equity market – but there are alternative investments paying a dividend based on these events. Beyond these greater levels of income diversification, there are assets like infrastructure or renewables which offer inflation protection.
Alternatives manager KKR says a portfolio made up of 60 per cent in stocks and 40 per cent in bonds won’t cut it long term, even if there is a recent upturn for the model. It states: “While the 60/40 portfolio could snap back in the short-term, our fundamental, long-term view that the correlation between equities and bonds has turned positive has not changed.***”
Instead of the traditional model, KKR suggested considering a 40/30/30 per cent equities/bonds/alternatives allocation. These alternatives included a 10 per cent portfolio holding in private credit, along with infrastructure and real estate.***
It’s hard to ignore the drive towards bonds after such a dearth of opportunities in the past decade, but I keep coming back to the fact that returns will be harder to achieve going forwards – particularly with rates unlikely to be anywhere near zero any time soon. In that environment having as much diversity as possible within a portfolio is likely to help investors navigate macroeconomic uncertainty over the long-term.
Funds to consider:
VT Momentum Diversified Income looks to produce a high level of regular income, with the prospect of preserving the real value of capital in the long term. The managers have a value-focused style and will invest across all asset classes including UK and overseas equities, fixed income, property, and specialist investments held through third-party funds. The fund currently has over a third of its allocation in specialist assets (37.6 per cent)****.
Waverton Multi-Asset Income seeks to achieve capital growth in-line with or ahead of inflation (targeting CPI +2.5% over the long-term) and provide a consistent and sustainable dividend. The fund invests in direct equities, fixed income, and alternative strategies. The team places risk at the centre of the investment process by focusing on protecting capital in weak markets. Almost 20 per cent of the fund is currently sitting in alternative investments****.
CT MM Navigator Distribution aims to deliver investors a high and reliable income, with the potential for capital growth. It is a multi-manager, multi-asset portfolio, which generally contains between 25 and 35 individual funds, balancing diversification, and risk. The team is targeting a yield that puts the fund in the top 10% of income generators in its sector. Alternative assets in areas such as music royalties, supermarket freeholds, aircraft leasing, infrastructure lending and asset backed debt tend to be held via investment trusts, the weighting of which is currently close to a low for the fund’s 15-year plus history*****.
*Source: Goldman Sachs Asset Management
**Source: Capital Connection
***Source: KKR
****Source: Fund factsheet, 30 April 2023
*****Source: Columbia Threadneedle, May 2023
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
