Alternative assets look especially attractive at a time of stretched equity valuations but investors have to be mindful of the risks that come with the asset class, says Sarasin & Partners head of third party funds Lucy Walker.
The alternative asset class counts hedge funds, private equity, real estate, infrastructure, commodities and private debt among its constituents and is becoming more popular among investors because it can provide diversification, generate alpha and mitigate risk.
PWC predicts alternatives will be a £14tn market by 2020. However, they can have complex strategies and be difficult to comprehend so it is important to be aware of the risks before investing in the asset class.
Sarasin’s Walker says the first risk of alternatives is not understanding exactly what you’re investing in: “The most important thing when investing in alternatives is understanding what you’re actually investing in, because believing that all alternatives will diversify your portfolio is unfortunately not correct.”
Many alternatives overlap with traditional asset classes and have either an equity risk, a bond risk or a hybrid of both, so it is important to understand the strategy of the different assets, she said.
“For example, investing in private equity is clearly not going to be reducing your equity risk. And certainly, I would say where you’re investing in any of these areas it’s important to fund those areas from the correct asset class,” the multi-manager said.
“By that I mean, if you are investing in private equity, you fund it from your equity bucket so that you’re not adding to your risk unnecessarily.”
But Walker noted that a key attractive of alternatives is potential uncorrelated returns: “That’s where you get no market exposure at all and that is where we really believe you have the opportunity to diversify a multi-asset portfolio”.
How alternatives could be used to replace traditional asset classes
Source: Sarasin & Partners
An example of an uncorrelated strategy that Walker likes is an equity long-short strategy because it limits equity market exposure.
If you’re looking for a bond strategy, Walker suggested asset-backed bonds (which benefit when interest rates rise) and a good equity strategy would be private equity that has bond exposure, so it is yielding as well as earning capital growth.
The second risk of alternatives is high fees that can have an impact on returns.
The ‘2 and 20’ fee structure that hedge funds and private equity vehicles have traditionally employed has the potential to eat away at any positive gains. However, some hedge funds have been moving away from this structure and Walker said fees have been decreasing.
“The key here is that really, fees have such an enormous impact on returns that we have to ensure that we’re paying as low fees as we possibly can, especially in the low return world that we are really in today, we have to ensure that we are maximising our return by paying the lowest fee possible,” she said.
The third risk of alternatives is that the spread of manager performance can be much larger than in traditional asset classes.
“The more esoteric the asset class, the much, much larger the spread is,” Walker said with reference to hedge funds and private equity.
Picking a good manager is just as important in alternatives as it is in traditional asset classes. Walker said: “Management is obviously key. Whether or not they are sufficiently experienced in the area that they are investing in. But also, importantly do they have an edge?”
She said one thing to consider is whether the fund manager and the board have ‘skin in the game’. In other words, are they personally invested in the fund?
Next, she said investors need to be wary of style drift – where the investment strategy changes focus from one area to another.
“The key here is that once you’ve found a good manager, it’s actually about ensuring that they are still investing in the areas that you selected them for,” she continued.
“And certainly, my view is that when you’re moving into different areas, you need to understand why that’s happening and if you’re not comfortable with why that’s happened then perhaps that fund is no longer for you.”
Walker said it would be unreasonable for style drift to occur as a result of the fund size increasing.
The fifth risk of investing in alternatives is that some strategies are opaque and niche.
Walker said: “When a market is created in an area that is especially niche and that you haven’t got much clarity on, then it is important to really understand what it is that you’re actually investing in.”
Another thing to consider when looking at asset-backed strategies is the quality of the product.
She stressed the importance of understanding whether the asset you are investing in is of high value to the company. Walker used an example of a low-end photocopier and a high-tech piece of equipment and said if the company was struggling and needed to cut costs, it would be quicker to rid itself of the photocopier than the high-tech equipment that is more valued by the company.
“The key here is that a fund is very likely to badge itself as asset backed, but it’s really important to dig under the bonnet and understand what is it that you’re actually lending against.”
Alternatives can be illiquid investments and Walker cautioned that investors have to be prepared to ride out short-term volatility and be comfortable investing for the long term.
The final risk of the alternative asset class is ignoring the red flag. Walker said: “If it seems too good to be true, then it probably is.”
She advised not to ignore signs such as high returns achieved with little risk, overly consistent returns or an unwillingness to provide you with information you require.
“You need a really extensive amount of due diligence to get comfortable about what it is that you’re investing in.”
Given all of this, you may be wondering why you would bother investing in alternatives. Walker said there are attractive characteristics that alternatives can offer.
Firstly, Walker said that equity valuations are stretched, despite even the volatility that markets saw earlier in the year.
“We see an opportunity in alternative assets given that we have less confidence in equity markets going forward,” she said.
According to Irrational Exuberance, the cyclically-adjusted P/E ratio (CAPE) of the S&P 500 is at its second highest point in history and records show that when the CAPE has been high, 10-year returns tend to be lower.
Walker doesn’t see fixed income as an attractive investment either as the 12-month return outlook for the 10-year UK gilt does not provide attractive income or capital returns.
The manager said the market sell-off in February this year showed that equities and fixed income are too closely correlated.
1yr performance of S&P 500 vs Barclays Bloomberg Global Aggregate
Source: FE Analytics
“Whether you’re looking to grow your portfolio, to generate income, to reduce risk or to protect against inflation, there are a number of different areas within alternatives which you can use to deliver these objectives,” she concluded.