Alternative assets should be bought alongside traditional assets in order to achieve a high income while also managing risk, according to Fidelity’s Eugene Philalithis (pictured). 
The FE Alpha Manager, who has been a portfolio manager at Fidelity since 2007, says the investing landscape has structurally changed over recent years and will continue to shift as a result of an ageing population, regulatory changes and increasing longevity.
“My belief is that the demand for income is not a temporary phenomenon, it’s not a theme, there are real structural changes taking place that will drive the demand for income forward,” he said.
The hunt for yield has become increasingly difficult for many investors this year as a result of traditional fixed income assets such as government bonds seeing rates fall to historic lows, as well as experiencing heightened volatility.
As a result, the performance of the asset class has started to converge with equities, which has left many wondering where to turn for diversification in their portfolios.
Performance of sectors in 2015
Source: FE Analytics
While Philalithis is currently neutral on equities as a source of income due to a lack of earnings growth, he believes that the best way to achieve both protection and an attractive dividend is to buy non-traditional assets.
“If you do want income, you do have to think a bit more actively and make that part of your portfolio work a bit harder and take more risks,” he explained.
“The attractive income asset classes are now on the right-hand side of the risk spectrum, but moving from cash and government bonds into asset classes such as high yield or equities is a big jump in terms of volatility, so how are we addressing this demand for income in the current environment and in the context of low interest rates and a potential rise?”
“There are a number of sources to do that. Traditional assets such as fixed income and equities are one, high yield is another, but we think there are non-traditional areas where we can access different types of income and can maximise performance by adding them to our traditional assets.”
Alternative assets have been a hot topic recently as more investors struggle to find diversification and high yields.
Research conducted by Natixis released last month found that, excluding property, financial advisers’ model risk-adjusted portfolios hold very few alternatives at all. As such, the firm believes that advisers are putting their client’s capital at risk and they should educate themselves on the benefits of holding them as a means of diversification.
In contrast, Rathbones head of multi-asset investments David Coombs told FE Trustnet last month that many investors jump into alternatives in the hunt for as much yield as possible and to reduce volatility without considering the risks that often come with buying into such holdings.
“A lot of alternative investments demonstrate low volatility, which everyone thinks is nirvana, but I never target volatility in any investment I make,” Coombs said. “I think it’s a really flawed statistic because what volatility is so dependent on is both how often something prices and how that price is calculated, so if it’s based on subjective modelling like aircraft leasing, you’re reliant on someone setting a price objectively until one of those planes is sold, a bit like property if you think about it – property is relatively subjective and is based on transactions. But most funds are based on models.”
Philalithis, though, believes that alternatives are invaluable for income-seeking investors but also says non-traditional assets shouldn’t be bought into for the sake of it.
One example of an alternative asset the manager has selected is Greencoat UK Wind, which invests in UK wind farms to provide shareholders with an income stream which it pays through an annual dividend.
“Here we’re trying to access the cash flows that are generated by companies managing wind farms. As long as the wind farms are operational and they’re generating electricity and the government provides the subsidies, then we are seeing those come through to us as equity holders,” he said.
“There’s no risk related to cash flow generated by the company’s activity, or by general activity in the economy. Here, as long as there’s a particular level of wind that’s generating electricity then those cash flows will come through to us.”
He then offsets his allocation to alternatives with more traditional holdings, such as the Fidelity Extra Income fund which provides a yield through investment-grade and high yield bonds.
However, the manager emphasises that he won’t buy into just any alternative and hope that the traditional assets in his portfolio will offset its risk.
“We do want the alternative we’re considering to play a certain role in the portfolio. So when I’m thinking about what am I buying, I ask: is it giving me a different source of income? Am I accessing a different pool of cash or a part of a capital structure of a company? Is it diversifying other risks in my portfolio? Is there any inflation-linkage build in?”
As such, he says he has turned down instruments in the past that have been trading at attractive valuations and generating a lot of income because they still didn’t meet his strict criteria.
“Loans are an asset class we like quite a lot because they offer quite a few attractive characteristics, and there are alternative credit instruments that are linked to these that can generate a lot of income,” Philalithis explained.
“There was a listed CLO vehicle that was trading at a deep discount and looked great on paper. We went on site to meet the managers who are based in Paris and we said that if we were happy after conducting due diligence then we would make an investment.”
“However, we noticed that there were some internal tensions within the portfolio management team, we noticed there were some weaknesses in their investment management processes and although, with hindsight, this investment has done very well, when we did our due diligence we felt there were some red flags that we were uncomfortable with.”
At the moment, the manager is seeking opportunities in hybrid assets because of the additional volatility that they provide, which can create growth potential.
He is also invested in aircraft leasing and infrastructure investment vehicles, saying these assets also provide protection against inflation, which he believes isn’t being considered carefully enough as a headwind by many investors.
“It’s about thinking of the potential risks to the portfolio and considering risks in areas that no one else is thinking about. Inflation is not on many people’s radars but we think it could come back faster and at a higher level than expected, which could be a surprise and cause some volatility in markets,” Philalithis continued.
“Managing interest rate risk is also one of the more challenging aspects of managing an income strategy, and so we’re combining traditional and opportunistic income focused assets in order to do this.”
The manager currently co-runs a total of 21 onshore and offshore funds for Fidelity. Over five years, he has outperformed his peer group composite by 8.36 percentage points, providing a total average return of 26.02 per cent.
Performance of manager vs peer composite over 5yrs
Source: FE Analytics
