Market volatility since the turn of the year has heightened the perception that traditional assets such as equities and bonds are entirely correlated with one another. 
Leading equity indices falling by 20 per cent, thus flirting with bear market territory, and concerns with bond market liquidity, all serve to make investors nervous and encourage a flight to safe havens such as cash, gold and government bonds.
However, for many with longer-term horizons, this period has simply been a wake-up call that has heightened the extent the underlying constituent assets of their portfolios are interconnected.
We have seen a growing level of interest from intermediaries in ‘alternative’ assets that are designed to provide a bedrock of return, irrespective of what factors are driving traditional asset markets.
Price performance of indices over 1yr
Source: FE Analytics
The term ‘alternatives’ is very broad and covers many different types of assets, from commodities and infrastructure plays to absolute return and global macro funds. More specialised alternatives include investing in rare coins & stamps, wine and works of art.
Our approach is to hold multiple different types of assets in this space in order to maximise diversification benefits and minimise risk.
The asset allocation models on all our managed portfolios are aligned to a particular WMA benchmark, with the weight apportioned to alternative assets ranging from 5 per cent in the Income Index to 15 per cent in the Conservative Index.
Depending on the strategy, and our relative positioning versus the index, we will normally have between three and seven holdings within the allocation.
Alternatives are currently among our highest conviction holdings and represent our biggest overweight position when compared to each respective benchmark.
Infrastructure funds give a good representation of the kind of characteristics I look for when assessing alternatives.
Infrastructure assets are the facilities and basic structures essential for orderly operation of an economy. Transportation, education and health facilities, telecom networks, water and energy distribution systems provide essential services to communities.
The high barriers to entry and the monopoly-like characteristics of typical infrastructure assets mean that their financial performance is highly unlikely to be as sensitive to the economic cycle as many other asset classes.
Infrastructure investments are generally low risk, given the stable and growing demand for the basic services provided, together with regulation and the longer term contractual nature of revenue.
The nature of such businesses also means infrastructure funds will often pay a good yield as well as capital appreciation.
Our largest single holding across all portfolios are the absolute return Aviva Investors Multi Strategy Target Return and Aviva Investors Multi Strategy Target Income funds. Both funds invest in debt, equities and derivatives and are designed to benefit from market volatility.
Performance of funds vs sector over 1yr
Source: FE Analytics
Their approach to risk analysis and management is very similar to how we construct our over-arching portfolios in terms of pre-trade risk, stress-testing and scenario analysis.
These multi-asset funds have clear stated performance objectives, rather than benchmark constraints, and offer the opportunity to provide genuinely uncorrelated returns by being able to take long and short positions across various asset classes and geographies.
Within UK equities we have recently added First Trust’s AlphaDEX ETF to diversify away from traditional UK equity income funds that, given their yield requirements, typically have a high degree of commonality in their holdings across the sector, for example tobacco, commodities and financial stocks.
This smart beta product uses momentum, growth and value factors to rank and weight positions in the index on their relative score. This provides us with a unique holding within our UK equities allocation that complements our existing positions, and once again, reduces risk.
Alternative investments should not be mistaken for low risk. In isolation they can be just as volatile, if not more so, than traditional assets. Return profiles can be erratic and typically they favour a long-term investor, rather than someone looking to time the market to make a quick killing.
We currently hold the Natixis H20 MultiReturns fund, which is a global macro fund using relative value (arbitrage) strategies across bonds, equities and currencies. This fund has a targeted volatility of up to 10 per cent so it can have aggressive movements month to month.
Performance of fund vs indices since launch
Source: FE Analytics
Its real value to us is the low, and sometimes negative, correlation it exhibits to other holdings within the aggregate portfolios which, when analysed at the construction level, serves to reduce overall risk without impacting on expected return.
When looking at holdings from a portfolio construction point of view, each one should be there in whole or in part to do a specific job, whether it be to provide capital growth, income, risk mitigation or even exposure to a particular investment theme. What really matters is how all the elements knit together to produce the overall portfolio.
Historically commodities have exhibited negative correlation with equities. However, given that commodity demand and supply continues to drive markets (with exceptions such as gold) resource-based funds certainly fall into this category at present.
Alternatives can be a valuable tool to assist in engineering a well-balanced, risk appropriate portfolio, but care must be taken when adding a holding to an existing portfolio; when analysing candidates for possible inclusion many turn out to be little more than equity or bond proxies, defeating the object of holding an ‘alternative’ in the first place.
Gary Waite is a portfolio manager on Walker Crips’ Alpha: r2 managed portfolio service. The views expressed above are his own and should not be taken as investment advice.
