Alternative investments are “an accident waiting to happen”, according to Hargreaves Lansdown’s Mark Dampier (pictured). 
The research director says that these assets are often not as diversified away from the equity market as people think and points out that they can be expensive and complex.
Alternatives have been a subject of debate over the last year or so, given the heightened volatility in markets partially caused by monetary policy elongating the market cycle.
This monetary policy also caused the performance of bonds and equities to converge last year, which left many investors confused as to how to achieve genuine asset class diversification within their portfolios.
Performance of sectors in 2015
Source: FE Analytics
In an article published at the end of last year, a survey from Natixis found that, out of 2,400 advisers across the globe, more than seven in 10 said that traditional stock and bond portfolios are no longer adequate. A further 63 per cent said that advisers need to replace traditional portfolio construction, with a vast majority turning to alternatives for diversification purposes.
This view isn’t shared by everyone, however. Many investment professionals warn that retail investors will buy into ‘alternatives’ without knowing what they do, the risks involved and how uncorrelated they really are to markets.
In another article published at the end of last year, AXA Wealth’s Adrian Lowcock said: “You’ve got to be very careful with alternative investments because some of these alternative investment products may be illiquid, they may have particular types of risks, or have particular time horizons. Things such as catastrophe insurance can have a good year or a bad year, it effectively depends on random luck.”
“It’s making sure you’re well-diversified within that. Just because it’s an alternative investment, it doesn’t mean it isn’t correlated with other assets.”
However, with markets delivering both choppy and sideways returns year-to-date and resembling last year’s disappointing pattern, it is easy to see why buying into market areas such as gold or infrastructure can seem appealing for investors.
Performance of indices in 2016
Source: FE Analytics
“I think "alternatives" have a place in portfolios. Gold, property and infrastructure, for example, have all demonstrated relatively weak correlations with equity,” Parmenion’s Steve Lennon said.
“A common mistake is to invest in infrastructure equity which is much more correlated than exposure achieved via an investment trust such as 3i or HICL. However, given low correlations and attractive yields, these are trading on premium to NAV in most cases.”
“Long term, these asset classes can provide valuable diversification properties which ties in with Modern Portfolio Theory. I think it's perfectly reasonable for retail investors to hold these assets provided they are doing so under the guidance of an experienced advisor.”
Dampier isn’t convinced though and says that, while infrastructure and other sub-sectors can be seen as more defensive, they are unlikely to protect investors during a genuine rout.
“I think they’re all an accident waiting to happen, at least a lot of them are. A lot of them have gone up in price and it’s all supposed to be safe – maybe it is but maybe it isn’t, we’ll find out next time everything falls off a cliff,” he said.
“I heard all those arguments about commercial property in 2007 but when 2008 came, commercial property was not a diversifier.”
Performance of sector between 2007 and 2009
Source: FE Analytics
“Multi-asset works if everything is uncorrelated, if in a moment of crisis everything becomes correlated then you have problems. That’s exactly the problem we had in 2008. Most multi-asset classes all became highly correlated so they didn’t protect the client at all.”
“The most uncorrelated asset is cash but people generally don’t want to keep that because it’s a low return, but if you want something that’s genuinely uncorrelated to markets you’re better there.”
Multi-asset funds, predominantly ones within the IA Targeted Absolute Return sector, have proven to be popular recently, with the market area winning the title of best-selling sector in both February and March this year.
The likes of Standard Life GARS, Invesco Perpetual Global Targeted Returns and Aviva Investors Multi Strategy Target Return are bought by investors for their stable, consistent returns, their low annualised volatility and their mandates, which are often to achieve a positive total return across all market conditions over rolling set periods.
However, as Dampier has warned in the past, Whitechurch Securities’ Ben Willis says that they can be too complex for many investors to understand and, as such, they are unsure of whether the fund is performing as it is supposed to.
“One of the problems you have with alternatives such as absolute return investment vehicles is that sector is a completely mixed bag,” he said.
“You have funds in there that are doing completely different things and taking on completely different levels of risk to achieve completely different outcomes.”
“You do have to know what you’re getting into, you have to be selective and you have to look underneath the bonnet to see what they’re trying to do and how they’re going to achieve it and over what time period.”
“I think people do go into the sector not fully appreciating the divergence and disparity in the sector, so there could be some disappointment ahead for some investors.”
Will McIntosh-White, assistant fund manager of the Rathbone Multi-Asset Portfolios, believes that holding diversifiers within a portfolio is a good idea, particularly given the level of volatility expected over the coming months.
However, he does warn that investors need to understand a portfolio diversifier before buying into it.
Despite the fact it has had a difficult year so far, the assistant manager likes the Aspect Diversified Trends fund and has been adding to this in a small way across the multi-asset portfolios.
“The fund can suffer in an environment where correlations move together, as well as oscillating or mean reverting markets. Sharp moves in the market do not work well for this strategy,” he warned.
McIntosh-White says that the hedge fund, which was launched in April 2013, tends to perform well when trends are persistent over the medium term. He says the team holds it as a diversifying asset, as it will provide protection when equity markets are down.
Over three years, the fund has a correlation of just 0.19 per cent compared to the MSCI AC World.
Performance of fund vs sector and MSCI AC World index since launch
Source: FE Analytics
For retail investors though, Informed Choice’s Martin Bamford says that investors have no need to seek direct exposure to alternatives.
“I agree [with Dampier] that alternatives are an accident waiting to happen for retail investors, if they have too much exposure to this investment type in their portfolios,” he said.
“Most investors have a good deal of indirect exposure to alternatives within their mainstream equity allocations, so duplication of gold, oil or infrastructure holdings through direct allocation risks being far too exposed should a market shock push down values.”
“It is possible and preferable to achieve a good level of diversification within a portfolio by sticking to cash, fixed income securities, equities and commercial property.”
