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Not all investment alternatives1 are created equal, just as some alternatives might not provide the portfolio diversification qualities the name suggests.
It’s no surprise alternatives have gained a mainstream foothold after 15 years of quantitative easing (QE)2, taking up increasingly large portions of portfolios, in many cases at the expense of traditional bond and equity holdings.
But with printing presses at Central Banks now cooling3, it’s timely to revisit the purpose of alternative assets, how alternatives perform in different market scenarios, and whether their inclusion continues to stack up as we enter a new cycle.
Dipping into the alternatives bucket
The value of the alternatives industry remains small compared to traditional investment markets which combined was valued at US$230 trillion in 2020; in January 2020 the value of the alternatives industry set a new high at $US10 trillion4.
Despite being in its infancy compared to traditional asset classes, cryptocurrency is possibly the biggest headline grabber of the group, with currency debasing QE programs making the case for high profile speculators to step in and support any number of wild and weird crypto names.
Bitcoin became the retail poster child for the crypto hedge against extraordinary measures employed by Central Banks since 2008, but analysis of this crypto’s performance shows a significant beta with US equity markets5.
Freight is another alternative considered in our analysis with similar diversification characteristics to Bitcoin. The analysis – a snapshot of the findings provided in the table below – considers seven asset categories, including: cryptocurrencies, freight, timber & forestry, frontier equities, distressed opportunities, fine wine and catastrophe bonds.
Freight showed significantly higher returns than traditional assets, albeit with exceptionally high volatility. While both Freight and Bitcoin tend to have low correlations to traditional assets, the significant volatility we believe also means they would only be appropriate as a small allocation within a portfolio
Source: First Sentier Investors, Bloomberg, Datastream, Internal Proprietary Models as at 30 June 2022, covering the period 28 February 2013 to 30 June, 2022. Returns and volatility data are calculated using monthly data.
Past performance is not indicative of future performance.
Volatility in freight reflects the exposure to the mostly commodity-linked Baltic Exchange Panamax index, an over the counter derivative index that provides a benchmark for the price of moving the major raw materials by sea.
Our analysis shows that fine wine, for instance, has a low correlation with traditional assets. Investors can get access to fine wine (the derivatives, not the liquid itself) through an index that includes 50 out of the 100 top wine labels. The index reflects the returns of the wines bought and stored in a cellar over a period of time.
Meanwhile, the analysis also highlights that timber and forestry, and frontier equities6, which have high correlations with equities are largely driven by systemic risks and would be expected to deliver similar performance to US equities.
Do alternatives still fit?
The holy grail of asset allocation is to find positively compounding real return assets that are negatively correlated. Historically, the pre-eminent asset classes to provide this outcome were equities and bonds.
Going forward, achieving that outcome is likely to be a more difficult task. As the return outlook is uninspiring7, we have explored a possible framework for the addition of alternative investments to portfolios. Given the diversity of alternative investment strategies, it is not possible to unequivocally determine whether they may be suitable for a portfolio without a robust understanding of investors’ return requirements, investment horizon, risk tolerance and liquidity needs.
It is clear based on the analysis of alternative assets that adding alternative assets to a portfolio of traditional assets provide benefits in overall risk-return portfolio characteristics.
However, investors should be aware that not all alternatives are created equal. The significant amount of Bitcoin beta highlighted by the analysis shows that it is strongly influenced by US equity risk, but the low correlation indicates that idiosyncratic factors are driving the returns.
We acknowledge these investments have idiosyncratic risks and operational requirements due to their highly bespoke nature and underlying illiquidity. Implementation considerations in achieving and managing an optimal exposure should therefore not be underestimated.
1 An alternative investment is a financial asset that does not fit into the mainstream equity (corporate stocks), income (debt issued by corporations or governments) or cash (low-risk deposits) investment categories. (Hereafter referred to as alternatives or alternative assets)
2 Central bank purchasing of longer-term financial assets, also known as quantitative easing (QE) was first introduced by the Bank of Japan in 2001 and adopted by other major developed country central banks in response to the global financial crisis in 2008-2009. United Nations Department of Economics and Social Affairs https://www.un.org/development/desa/dpad/publication/un-desa-policy-brief-no-129-the-monetary-policy-response-to-covid-19-the-role-of-asset-purchase-programmes/
3 The initial phase in which the Bank built up its stock of bond holdings is often referred to as ‘quantitative easing’, or QE for short. That phase ended in February this year. https://www.rba.gov.au/speeches/2022/sp-ag-2022-05-23.html
This document has been prepared for informational purposes only and is only intended to provide a summary of the subject matter covered. It does not purport to be comprehensive or to give advice. The views expressed are the views of the writer at the time of issue and may change over time. This is not an offer document and does not constitute an offer, invitation or investment recommendation to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any material contained in this document.
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References to “we” or “us” are references to First Sentier Investors a member of MUFG, a global financial group. First Sentier Investors includes a number of entities in different jurisdictions. MUFG and its subsidiaries do not guarantee the performance of any investment or entity referred to in this document or the repayment of capital. Any investments referred to are not deposits or other liabilities of MUFG or its subsidiaries, and are subject to investment risk including loss of income and capital invested.
If this document relates to an investment strategy which is available for investment via a UK UCITS but not an EU UCITS fund then that strategy will only be available to EU/EEA investors via a segregated mandate account.
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