In this article:
This content was correct at the time of publication and is no longer being updated.
As the bull market matures and as equity & bond valuations grind higher, it may be prudent for investors to start positioning their portfolios for the end of the cycle. Alternative investments have developed over the past few years and they can offer diversifying characteristics for investors that are be particularly useful around cycle turning points.
The ‘alternatives’ asset class provides a range of opportunities with low correlation to traditional securities: real estate, catastrophe bonds, low-risk infrastructure, and other alternatives strategies can offer effective benefits for portfolios at the end of the cycle.
Alternatives have changed
Just a few years ago, poor transparency, lock ups and regulatory restrictions meant that alternatives were inaccessible to all but the most pioneering investors. But times have changed. Alternatives have become a staple of institutional investment portfolios.
According to Willis Towers Watson's Global Alternatives Surveys, the top 100 alternative asset managers combined managed over USD 4 trillion at the end of 2016, a 10% increase on 2015, and USD 640 billion more than 2014. Real estate, private equity and hedge funds dominate alternatives, comprising nearly 70% of assets under management.
In the longer term, investors are intending to boost allocations to alternatives still further, with all but one of the major alternative asset groups expected to see increased allocations (chart 1). In the shorter term, institutional investors are also seeing fund terms for investing in alternative strategies shift in their favour (chart 2).
One reason why alternatives are particularly sought after right now is because of the high valuations in the bond and equity markets, but for many investors it actually makes sense to allocate to alternatives on a semi-structural basis. Waiting until the end of the cycle until establishing alternatives exposure risks missing out on the advantages they offer during the rest of the cycle. For less liquid alternative asset groups, such as real estate and private equity, it may prove costly in terms of performance to enter these markets late in the cycle.
As alternatives are a heterogeneous group of strategies and asset types, it’s worth looking at the role some of these specific strategies can play in portfolios. But bear in mind that specific investments, as well as the strategy and asset type, are paramount in alternatives investing.
Real estate: quality matters
There are many options available in real estate but some are more suitable than others at this stage in the cycle.
High-quality real estate which includes commercial assets such as offices, logistics and retail property can be particularly useful when we are late in the rental growth cycle if they benefit from a long lease and sound tenants (such as the government). They provide a good income, an illiquidity premium which raises returns, and a relatively low correlation to the wider economy.
However, some parts of the real estate market have become more expensive in recent years. Yields in prime real estate have compressed significantly making it more vulnerable to a deterioration in sentiment or a cyclical downturn (chart 3). The weight of capital has driven returns in prime property to all-time lows – 100-150 basis points lower than in 2008 – while pricing is at an all-time high. A 25 to 50 basis point movement in yields will result in a 10-20% fall in capital values.
Other changes to the market have increased the likelihood of volatility too. Globalisation means that very large pools of capital are moving in and out of of certain markets, particularly the more liquid gateway cities making them more volatile. For example, c.80% of purchases in the City of London were made by overseas investors. This change in the blend of ownership, together with increased capital flows, introduces more volatility.
Similarly, currency has a greater bearing on real estate now than ever before. Investors in London property saw a 20% fall in the value of their asset following the depreciation of the pound post Brexit. Again, this is likely to increase capital flows in and out of the market.
In the event of a market drop, it might be uncomfortably rocky for a while, but quality real estate assets are still very much a dependable holding at end of cycle and into a downturn if investors ensure that they have strong income cash flows, and can hold onto their assets.
Catastrophe bonds offer excellent diversification value because natural disasters are typically uncorrelated to market movements. Recently, there have been a number of weather-related disasters in North America, which have resulted in large scale property damage. This has caused losses to insurers and owners of cat bonds.
If these losses result in a ‘reset’ of premiums to the higher levels we’ve seen in the past, it may be an opportune time to take exposure. However, there remains a large pool of capital ready to move into the cat bond market if pricing becomes particularly attractive. On that basis, we expect any re-pricing to be more modest than we would have seen in the past.
Infrastructure has typically been perceived as a lower risk, income-oriented asset class with some diversification value versus traditional assets. Infrastructure’s predictable, long-term cash flows, which are linked to inflation in various ways, are generally viewed as a relatively safe bet versus equities.
Within infrastructure, sub-sectors like social infrastructure (public private partnerships) tend to be highly insulated from the vagaries of the wider economy. However, it has become increasingly challenging for investors to source new investments in this space.
There are slightly more economically sensitive forms of infrastructure investment still offering good return prospects, as long as you’re willing to exclude large trophy assets. By considering carefully where to sit in the capital structure (senior, mezzanine or equity), it’s possible to tailor exposure to the cyclicality embedded in more economically sensitive assets while still benefiting from many of the most desirable aspects of the asset class.
Additional tier 1 (AT1) bonds
If we start seeing interest rates rise during this late cycle stage, AT1 bonds, issued by banks, could be useful. AT1s respond differently to rising rates than equities. While bank shares benefit from controlled rate rises, the effect on AT1s is more ambiguous. Given the perpetuity of AT1s, they can lose value if rates rise and their call option is not exercised by the issuer. However, a lot of AT1s were issued when credit spreads were wider than they are now, consequently many still look likely to get called and generate positive returns even if rates rise.
If rates increase by less than expected or remain compressed, AT1s can benefit, and are likely to be called (at their first call date) by the issuer who will then have to issue new AT1s at the prevailing market rate to maintain capital requirements. This new batch of AT1s could be attractively priced if credit spreads widen from where they are now.
Private equity will tend to be highly correlated to public equities, with the downside potential often likened to holding midcap public equities with additional leverage to boot. Just because private equity has an ‘alternatives’ label, investors shouldn’t assume defensiveness. But private equity can play a part in a portfolio at the end of the cycle by making capital work harder. For example, a well considered and structured investment in a barbell of cash and private equity can provide better returns for a similar level of risk compared to richly-valued public equities.
Additionally, if the cycle is rolling over, investing with a skilled private equity manager might present a chance to deploy capital into bargain opportunities before the next recovery. Such an approach needs to be well researched given that it depends not only on timing, but also on an expert manager with strong execution capabilities.
Other alternatives strategies
There are numerous alternative strategies but some will offer more defensive characteristics than others:
Equity pairs trading can provide a defensive profile. The strategy waits for a weakness in the correlation of two normally highly correlated stocks, such as Shell and BP, before shorting the over performer and going long in the underperformer. When the securities return to their statistical norm, the position is closed. The strategy effectively means that the individual positions hedge or de-risk one another. In theory, this market neutral strategy allows traders to profit in virtually any market conditions without being exposed to the market direction.
Long bias and long/short strategies could work well in the near term, particularly where the manager has a distinctly contrarian mind set. These types of managers tend to avoid holding popular momentum-driven stocks, such as ‘FAANG’ stocks. Although momentum securities are often highly profitable towards the end of the cycle leading the market upwards, they are also likely to be the securities that push the market down the most when it turns.
Trend following is a strategy that might be counter intuitive for investors concerned about herd behaviour but it can prove particularly successful in a downturn. Trend followers use rules-based strategies and can quickly latch on to prevailing developments in equities, currencies and other markets.
During a crash, investors may underreact, manifesting itself in the form of buying the dip, being in denial of the change in the cycle, or they may simply take too long to react. Nimble, systematic trend-following programmes exploit market movements quickly and hold no emotional attachments.
However, be warned that trend following is not without risk. It is far from a guaranteed hedge and can even work against the investor in some downturns. But it can play a role in the portfolio as long as expectations and portfolio exposures are carefully managed.
Discretionary macro is a strategy that allows investment managers to go long or short, across all the major markets including equities, bonds, interest rates and currencies. The strategy tends to be overseen by a human and decisions are made based on macro-economic analysis.
The manager will typically have a very good technical understanding of financial markets. They rely on being able to predict the evolution of economic and investment cycles in advance of the average investor, or they structure trades in a way that thrives off the volatility created as problems develop, with little regard to the specific catalyst.
The current landscape of high valuations is challenging investors to reassess their investments and adopt a range of alternative approaches. Investors need to turn over more stones and diversify portfolio positioning to generate adequate future returns.
Although high valuations in bonds and equities have spurred a shift towards alternatives as this cycle matures, the increase in alternatives investments isn’t just a cyclical fad. It’s part of a longer term trend playing out in the market.
Alternative asset strategies are increasingly accessible, and investors are recognising the benefits of a wider tool kit. Alternatives can help their portfolios deliver better risk-adjusted returns in a broad range of market environments and can provide valuable portfolio flexibility as those market conditions continue to change.