The past few years have given investors pause for thought on traditional bond/equity allocations. In the volatility experienced since the start of the year, for example, bonds have not necessarily offered protection against equity market gyrations – an awkward situation that could persist if inflation remains an issue.
As such, asset allocators are increasingly debating an alternative approach to portfolio construction and diversification. Could alternative investments be the answer? Or should professional investors just be looking to manage their bond and equity allocation differently?
Clearly a far broader range of alternative options exists today than ever before, including private equity, private real estate, private credit, hedge funds and digital assets – according to research by J.P. Morgan, total assets under management continue to expand and have now surpassed $33tn (£24.8tn).
Many of these alternative options claim uncorrelated returns with stockmarkets – though it is by no means clear all provide them. Equally, many have been weak in recent years: private equity, for example, has been in a difficult spot, as has renewable energy. Others have provided a return so bland that investors might as well have been in cash.
Nevertheless, some asset allocators see value in a carefully selected portfolio of alternatives. Morningstar, for example, is one of a number of major asset allocators that has upped its weighting to alternatives in recent months – adding 3% to 5% in alternatives in its Cautious and Moderately Cautious portfolios, and also for the Active, Blended, Governed and International Managed Portfolio ranges, as well as the CG Morningstar 20 and 40 multi-asset funds.
It is also worth noting that, among alternative investment trusts, discounts have narrowed sharply. In a recent research paper, Stifel points out there has been a sharp re-rating in the Infrastructure and Renewables sectors, and some of the debt funds (though the private equity sector, where NAVs have not moved significantly, has still lagged). This suggests private investors and wealth managers may be receptive to the inclusion of selected alternative options.
Mark Preskett, a senior portfolio manager at Morningstar UK, says the group’s broader adoption of alternatives had three main drivers. “Credit spreads are very tight and we were looking for something that could fulfil a similar role in portfolios,” he explains.
“We are also seeing a breakdown in the diversification between equities and bonds. There is evidence that, in a higher inflation environment, bond/equity diversification is not as significant. Finally, there are also more and more products available in this part of the market – and at better fee rates – so we had more choice.”
“Alternatives do have a place – but they have to be liquid, they have to be well understood and they have to be doing something different to the rest of your portfolio. Else, what’s the point?
We wanted a diverse mix of clearly defined strategies, each of which aims to have low sensitivity to the ups and downs of conventional equity and bond markets, as well as to each other.”
Morningstar focused on three areas: global macro strategies, equity market neutral and systemic trend following. “We wanted a diverse mix of clearly defined strategies, each of which aims to have low sensitivity to the ups and downs of conventional equity and bond markets, as well as to each other,” says Preskett.
Among its new holdings are AQR Managed Futures, BlackRock Tactical Opportunities and Winton Trend, plus Brevan Howard Absolute Return Government Bond, Fidelity Absolute Return Global Equity – Equity Market Neutral, M&G Global Target Return, Royal London Absolute Return Government Bond and Tellworth UK Select.
Notably absent from the Morningstar list are any private assets – yet this is an area that is garnering a lot of attention. In this piece for Wealthwise, for example, Wealth Club founder and chief executive Alex Davies points out the organisation’s research suggests virtually all (98%) of advisers and wealth managers plan to increase their exposure to private markets.
He attributes this trend to “a combination of ongoing global stockmarket volatility, the sector’s track record of consistently attractive returns, and the recent lack of IPOs. The main private markets they expect to recommend are private equity, real estate, venture capital, private debt and infrastructure.”
Certainly, there are arguments in favour of private assets. As Davies points out, of the 159,000 firms globally with revenues over $100m, around 140,000 – some 88% – are private. With a dwindling number of IPOs globally – and particularly so in the UK – many of these investment opportunities go nowhere near individual investors.
Still, while there are arguments for their inclusion, it is not clear that diversification is one of them. Gavin Haynes, investment consultant at Fairview Investing, points out that infrastructure, real estate and private equity proved extremely correlated to interest rates when the cycle turned. “Property and infrastructure proved interest rate-sensitive,” he notes. “Commodities meanwhile were linked to the performance of the Chinese economy, which was doing terribly.”
While the inclusion of commodities can help protect against inflation and improve the diversification credentials of diversified real assets funds, this did not work as well as it should have done in 2022. The performance of these funds that year suggests they did provide some protection against falling equity and bond markets – yet many still fell.
We have had a very good look at this alternatives space and the types of assets we consider to be investable. Ultimately, we concluded they are not adding to the portfolios – and therefore they shouldn’t be there.”
Not everyone feels that the inclusion of alternatives is necessary. AJ Bell Investments, for example, removed its allocation to alternatives in its 2025 strategic asset allocation for MPS products, arguing they did not provide adequate diversification to portfolios.
At the time, Ryan Hughes, managing director at the group, explained: “We have had a very good look at this alternatives space and the types of assets we consider to be investable. Ultimately, we concluded they are not adding to the portfolios – and therefore they shouldn’t be there.”
Ben Kumar, head of equity strategy at 7IM, takes an even stronger stance, arguing in this Choice Words video, a number of alternative investments “are basically either bonds or equities dressed up in a fancy gown”. “I have no interest in those,” he continues.
“There are alternative investments that pay you for taking a different risk, however – for example, one thing we like is merger-arbitrage strategies. So a deal is announced but there is that regulatory risk – is it going to get signed off by the Competition and Markets Authority or equivalent? And will that last little £2 or £3 close?
“Getting paid for that – nothing to do with growth, nothing to do with interest rates, everything to do with, Is this going to get through the legal system? – is completely sideways risk to what you are taking elsewhere. So I think alternatives do have a place – but they have to be liquid, they have to be well understood and they have to be doing something different to the rest of your portfolio. Else, what’s the point?”
For his part, Haynes maintains investors should be able to achieve good diversification through a careful blend of equities and bonds. “In 2022, there was an inflation shock and everything went down,” he acknowledges. “In the current environment, however, it is slightly different because bonds are paying a real return over inflation. High-quality bond portfolios might be paying 6%, rather than 3%, therefore they are not as vulnerable to an inflation shock.”
Short-duration bonds can be a way to minimise inflation risk, argues Haynes, “as long as people do not take a simplistic passive approach”. Equally, he says, value tends to do better than growth at times when inflation is rising. Value funds, such as Ranmore and Ninety One Global Special Situations, delivered positive returns in 2022.
As is often the case, a more nuanced approach would seem appropriate. Carefully chosen alternatives can provide some protection in portfolios but – given some types have simply magnified the returns of the stockmarket – they should not be automatically viewed as a panacea. They can be part of the answer – though, equally, it should be possible to achieve some diversification with more thoughtful equity and bond allocation.
