Global Head of Alternatives
The ‘Alternative’ balanced investment diet
When I was young, my mother told me to "eat my greens"; they helped give me a balanced diet alongside the meat and potatoes. It was certainly better than no other vegetables at all, but today we know that relying on a few green vegetables isn't enough for a long life. The British Government tells us that we need "five a day"; the Australians drive for a mix of eight different fruit and vegetables.
In the same way that a well-balanced diet is good for living longer, building a balanced investment portfolio should also provide a better chance to generate long-term and higher quality growth.
Investors can generate returns in a variety of ways. Government bonds can provide a regular yield, although after inflation is taken into account this isn't often a big return, if a positive real return at all! Most investors need to find more healthy calories from somewhere. Corporate bonds typically pay investors a bit more - reflecting the risk that the company collapses before they have repaid all their debts. Most investors focus on the least risky companies – possibly the equivalent of moving from boiled to roasted potatoes.
Equities are the other common investment – the meat in most portfolios. Equities can be volatile, but they have a long history of performance and are very easy to get hold of. Investors still feel most comfortable designing their portfolio around them. Tied to economic growth, equities should provide a long-term return derived from corporate earnings - the income that the companies generate. Because the risks are greater than bond investing, the compensation should be bigger than lending to governments and well ahead of inflation.
Now let's not think there is anything wrong with the meat and potato base – they have served us well in the past and they will continue to do so. But we know there is more to healthy eating today. As we walk through the supermarket, the sheer variety of fruit and vegetables available today is amazing. Ten or twenty years ago some of these things would have been seen as too exotic; luxuries to try once a year. The options available to the institutional investor have also ballooned in recent years – fund managers have institutionalised; regulations have sanitised; exotic investments have become more familiar. Alternative investments have become notably more mainstream.
But let's not see these new investments as simply garnish or seasoning. They can help provide greater balance to our portfolios – a better variety of nutrients – that can help us achieve our long-term goals. These new investments can give us access to truly diversifying sources of return – return streams that don't rely on an equity risk premium for their main source of growth.
Alpha strategies can generate returns through manager skill rather than market exposure. Some exploit risk premia such as value, carry and trend; others rely on unique insights or experience to find returns where other investors don't (or can't) look. Each alpha opportunity might be small - and several won't work as hoped - but a blend of quality managers and strategies can provide a reliable and differentiated source of growth.
Real assets, such as infrastructure and property, can generate their returns from their day-to-day operation. This could be a solar panel farm providing electricity to the grid; an office block collecting lease payments from its tenants; or contracted payments from a local government department for the operation and maintenance of a hospital. Not only are the underlying holdings real physical assets, but the investments overall should rise with inflation too – making them also “real” from an inflation perspective.
Private equity provides another source of returns benefiting from an illiquidity premium. Venture capital investments fund early stage, start-up companies, providing capital for expansion; buy-out funds work with spin-offs and management buyouts, supporting the restructuring of an established business or division. Specialist private equity investments can also be found in areas such as energy and mining, for example.
Finally, investors can also allocate to a range of more exotic credit strategies, rather than just investment grade corporate bonds. High yield and emerging market debt funds, for example, provide exposure to a different set of creditors – and often with a higher return premium for the investment. Litigation financing provides capital to support commercial litigation cases; real estate and infrastructure debts are backed by real assets. Insurance-linked strategies earn an insurance premium – accrued to the investor in full in the absence of financial loss from the catastrophe insured against (for example a hurricane).
So in the same way that a mix of fruit and vegetables gives you a better blend of nutrients, diversifying across various return sources can help promote more reliable growth in your investment portfolio. A dish that balances out economically sensitive (and sometimes volatile) equity assets, with alpha strategies, cash-flow generative real assets, a diversified mix of income generating credit and insurance strategies and some return enhancing private equity should prove to be most nourishing. Investors might need some help with pulling the meal together – but we can be there to help. Popeye did okay with a diet dominated by spinach, but for most of us, a more balanced approach will be healthier – and more enjoyable too.
Andrew McCaffery, Global Head of Alternatives