A poor outlook for growth, rising interest rates and stubbornly high inflation have caused global equity markets to drop precipitously, while bonds, historically one of the key diversifiers to equities, have suffered the greatest downturn in decades.
Investors reliant on the conventional playbook - equities for growth and bonds for diversification - have found themselves wrongfooted. This does not sound the death knell of the traditional 60/40 style mandate, but it does suggest investors seeking diversification and attractive real returns must look beyond equities and bonds.
Investors wanting to add alternative sources of returns and diversification to their portfolio - as well as protection from inflation - need to understand the varying characteristics of alternative assets on offer.
Deep Dive: Alternatives offer diversification as stocks and bonds fall in lockstep
With the potential for attractive returns comes the inevitable risk trade-off. Alternatives offer different levels of liquidity and may therefore be difficult to sell quickly. Some may also be more volatile than equities or bonds - at the furthest end of the spectrum, the recent ‘crypto crash' provides ample evidence of this.
There are three alternative allocations that have the potential for positive real returns, a good level of income, and diversification - without exposing investors to unnecessary risks or overpaying.
Hedge funds
There are many different kinds of hedge funds offering various risk/return profiles, and carefully selected hedge funds can be an invaluable part of a well-diversified portfolio. Today's more volatile market conditions are particularly well suited to many hedge fund strategies, providing greater opportunities for them to deliver attractive returns. The ability to generate positive returns, even when equity or bond markets are falling, makes hedge funds particularly attractive for investors right now - provided they can identify the right strategy at the right time.
Our holding in Neuberger Berman Uncorrelated Strategies fund provides exposure to a basket of different hedge fund strategies, all of which aim to generate uncorrelated returns to equity and fixed income markets. The hedge funds themselves also have low correlation with each other, which reduces the overall risk of the fund and gives it the ability to withstand different market environments.
The fund is well diversified, thanks to Neuberger Berman's rigorous fund selection process, as well as its performance-based fee structure, meaning investors do not pay for returns they do not get - both features that buck the ‘expensive and risky' hedge fund stereotype.
Infrastructure
Infrastructure - defined as the physical structures necessary for society and the economy - has become an increasingly popular alternative investment.
Investors can choose to gain access to either economic infrastructure, such as transport or utilities, or social infrastructure, including schools or hospitals. Infrastructure investments typically exhibit stable and predictable cashflows, and generally provide inflation-linked distributions.
Deep Dive: Investment opportunities in energy transition
Energy storage is a key infrastructure that will help the UK decarbonise as more renewable energies come on to the grid. We hold the Gresham House Energy Storage fund (GRID), which capitalises on the opportunities in the battery storage market.
The UK's increasing reliance on renewable sources of energy means it needs a solution for supply-demand imbalances. Battery storage systems represent a cost-effective way of addressing this issue. The trust has performed strongly, as a beneficiary of high power price volatility and strong operational performance. GRID continues to be the market leader for battery storage in the UK, with about 30% market share.
REITs
Probably the best-known alternative asset, property offers good inflation protection - as rental income and property values tend to increase with inflation - along with steady income. To gain exposure to property we invest via real estate income trusts (REITs), which are companies that manage a portfolio of income-producing properties, from which they pay out dividends to shareholders. Investing in REITs allows investors to access the potential benefits of property without sacrificing too much liquidity, as REITs can be bought and sold far more easily than the underlying properties themselves.
We invest in Home REIT, a REIT that manages a diversified portfolio of homeless accommodation assets let to registered charities, housing associations, and other regulated organisations that receive housing benefit or comparable funding from local or central government, on very long-term and index-linked leases.
As the homeless population in the UK has risen, there is a critical shortage of affordable, high-quality accommodation for homeless people. Local authorities have a duty to house the homeless, but the severe shortage of fit-for-purpose accommodation has meant councils have been forced to house people in B&Bs or guesthouses, which can be significantly more expensive than the properties Home REIT lets.
Adil Alaoui is an alternatives analyst at Sarasin & Partners