Since the global financial crisis, both equity and bonds have been the principal beneficiaries of central banks’ highly publicised quantitative easing (QE) programmes.
However, with current valuations for both asset classes appearing expensive, on an absolute basis and relative to long-term history, multi-asset investors should look at ways to mitigate portfolios against the risk of a steep drawdown in either equities or bonds, or both.
FTSE 100 vs BofAML Sterling Corporate bonds index over 5yrs
Source: FE Analytics
While the macroeconomic backdrop appears supportive for equities, with business surveys signalling robust growth and inflation trending higher (broadly positive for earnings growth), concerns remain that much of the current optimism is already factored into the price.
Should economic data not improve in line with the lofty expectations implied by business surveys, political risks spike or the level of fiscal stimulus in the US come in lower than anticipated, then a pullback in equities seems probable.
Similarly, the current nominal yield on developed market government bonds offer little protection against rising inflation. If economic growth continues to improve, the Fed is likely to further tighten monetary policy, and the European Central Bank and Bank of Japan could follow suit. In this scenario a large rise in bond yields seems credible.
Given this outlook, we have become increasingly mindful of the requirement to incorporate investment strategies whose return profile is less correlated with equity and bond markets into portfolios.
We believe one of the more efficient ways to hedge portfolios against this downside risk is through increasing the exposure to alternative investments. We have designed an alternative investment strategy that exhibits a low correlation to bonds and equities, targeting a defined total return (per annum) across the economic cycle. To identify investment opportunities, we principally look for strategies which have supportive macro drivers and/or strong support from sector fundamentals.
As a result of our analysis we have been introducing infrastructure, absolute return, convertible bond and alternative Ucits funds into portfolios.
Whilst in isolation each asset class and investment strategy carries their own level of market risk, we believe the combination of strategies has the potential to lower aggregate portfolio volatility and enhance portfolios’ risk-adjusted returns. 
In our portfolios’ infrastructure holdings, we have introduced the Lazard Global Listed Infrastructure and VT UK Infrastructure.
The Lazard fund invests in equity securities of infrastructure companies with a minimum market capitalisation of $250m. It seeks long-term, low-volatility returns that exceed inflation by investing in companies with monopoly-like industry characteristics that provide essential services.
The VT UK fund invests in the equities and bonds of UK listed funds and targets income streams generated by infrastructure assets that are typically dependable either on government support or due to their quasi-monopolistic structure.
While both funds exhibit some equity risk, they typically have a low beta and therefore offer some downside protection in the event of an equity sell-off.
In the absolute return space, we like the Brooks MacDonald Defensive Capital and Premier Defensive Growth fund.
Brooks MacDonald creates a portfolio of defined return assets, such as preference shares, loan notes, convertibles, structured notes and other defined assets whose return profile are not solely dependent on market growth. The Premier Defensive Growth fund aims to generate positive returns over a rolling 36-month basis but with less than a quarter of the volatility of the FTSE All-World index through investing across investment themes, strategies, asset classes, geographies and markets.
The AQR Systematic Total Return fund has been introduced within the alternative Ucits space. The strategy seeks to capture a diversified set of traditional and alternative return sources within a liquid vehicle which has a low correlation to traditional asset classes.
The fund has the potential to provide long/short exposure to the markets and unlike traditional long-only strategies that rely heavily on rising markets for returns, the dedicated long/short strategy focuses on generating returns that are independent of rising, falling or sideways trending markets.
Finally, we have added the Ferox Convertible Bond Fund. The fund is different to traditional convertible bond strategies as it utilises convertibles to simulate low priced out-of-the-money option strategies (calls and puts) that enable it to take intelligent directional risk. This creates attractive delta, volatility or gamma positions. The fund will run many different opportunistic exposures but seeks to minimise credit risk and is essentially interest rate hedged.
An alternative allocation within a balanced portfolio adds materially to the generation of stable risk adjusted returns over the course of a cycle.
Moreover in the context of the current financial market backdrop, with equities near all-time highs and bonds yields at historically low levels, now more than ever is a compelling time to add or increase exposure to alternative assets.
Dan Smith is the investment analyst at Thomas Miller Investment. The views expressed above are his own and should not be taken as investment advice.