Richard Dunbar,
Senior Investment Strategist,
Investment Solutions

Guide to alternatives

The benefits of diversification – combining assets that produce returns that aren’t perfectly correlated, to reduce risk and generate higher risk-adjusted returns – have been well documented.

However, the current investment environment is a challenging one for anyone looking to diversify their portfolio. Prompted by record low bond yields, stock market volatility and an equity and bond market that have often moved in tandem, investors have begun searching further afield for assets that can aid diversification.

Many “alternative” assets have grown so much in popularity that they are already heading towards the mainstream. More esoteric areas, which were previously considered the domain of a narrow band of investment experts, are experiencing a sharp rise in interest. The main attraction of these assets is that they provide a different return stream to both traditional asset classes, and those that have been considered “alternatives”.

We have been investing in a growing number of these assets of which it’s worth taking a deeper look at some of the examples:

Fund of hedge funds

A hedge fund is a managed investment with fewer restrictions than those faced by traditional funds. Hedge fund managers are authorised to use instruments such as derivatives and short-selling, with the aim of maximising returns. For hedge fund managers, the direction in which asset prices move in is not necessarily important. Through the use of derivatives, they can exploit these sharp market movements, regardless of their direction. The possibility of making a positive return in a falling market is clearly a key attraction and can also aid diversification.

In particular, fund of hedge funds have proved popular with investors. A fund of hedge funds will invest across a range of hedge funds, providing access to funds that would not normally be available to the man in the street. Well-diversified funds can help protect investors from some of the losses we have seen during periods of financial market turbulence.

Insurance-linked securities

Sometimes known as ‘catastrophe bonds, insurance-linked securities exist to help transfer some of the financial risks of natural catastrophes from insurers or re-insurers to investors. A contract is issued to cover a certain time period and if no natural disaster or other specified event occurs before the maturity of the contract, investors receive back principal investment as well as interest payments.

The selection of these risks and extent of exposure to them are obviously crucial from the investor’s perspective, but some attractive opportunities exist in these markets. One of the main attractions of these securities is the lack of correlation between their returns and the returns produced by other financial markets.

Renewable Infrastructure

Infrastructure has become an increasingly popular source of returns in recent years. Infrastructure funds invest in companies that build or maintain the transport, communications, power, water, waste disposal or similar services that allow a nation’s economy to function. In the last two decades many of these companies have been privatised, making them easily accessible to investors.

Increasingly, we have been investing in the infrastructure of the renewable energy industry, which includes wind, tidal and solar power, along with hydroelectric and biomass facilities. The shift to renewable sources of energy is going to continue, but state funding is insufficient for the provision of capital to build and sustain such undertakings – private funding must make up the shortfall. When building wind farms, investments are usually made by large utility companies, while solar power facilities are often funded by smaller private developers. Neither are natural long-term owners of the finished product, however, and this is where closed-end renewable infrastructure funds come in. A number of funds have been set up in order to buy the working wind and solar farms and which are now providing some relatively attractive returns, with dividends often in excess of 6%.

Peer-to-peer lending

The growth of peer-to-peer lending has come about as a result of the gap that was left when high-street banks slashed lending to small businesses. The market is run by companies that set up platforms for loans that match lenders and borrowers. A thorough credit-rating check on potential borrowers is undertaken by the platform operators and a rate of interest set that relates to the borrower’s creditworthiness. Potential lenders can then choose the level of risk (and potential reward) they want to take on.

Investors can gain access to the peer-to-peer market via closed-end funds, such as the Funding Circle SME Income Fund, which gives access to the peer-to-peer lending market for small and medium sized businesses.

There has been some discussion in the media around the risks involved in this market, but it is our belief that there some good reliable companies in this market that are taking advantage of changes to the way the banking sector works. New regulation and increased capital requirements on traditional lenders means that some of these new operators will prosper from these changes.

Global loans

The global loans market is another area in which an opportunity has arisen due to the scaling back of lending by banks. We have been invested an increasing amount in the global loans market over the last couple of years.

These loans are generally made to small and medium sized companies. One of the main differences between loans and a traditional corporate bond is the method of repayment. Unlike a bond, the loan is paid back over its length, rather than in one payment at the end of the term.

Loans also rank higher than bonds in a company’s structure, meaning lenders get more back if the company defaults on a payment. Companies also normally rank loan repayments above bond repayments, yet interest rates are typically higher. This provides a potentially attractive level of income and is leading to a growing number of institutional investors  to launch funds that allow smaller investors to take advantage of these attributes.

Before investing in such assets, investors need to do their homework. Investment should be made on merit, not just because returns from an asset are different. But we believe that the assets outlined above do provide the potential for attractive returns, which have a low correlation with those provided by more mainstream assets.

Alternative assets should not be seen as a panacea and they will certainly not all thrive in a bear market, but when held as part of a diversified portfolio, exposure to the right alternative assets should help investors to both boost returns and smooth the ride through any future market turbulence.

Alternatives

Investment Idea

Corporate Bonds

Investment Idea

Equity diversification

Investment Idea