IPE Views: Is there an alternative to alternatives?
Pete Drewienkiewicz on the mystery of the ’alternatives’ label, and why investors should simply look at asset classes based on their investment goals and objectives
In a world of investments dominated by equities and bonds, the category of ’alternatives’ offers great allure to portfolio investors – the promise of attractive returns and, at the same time, potentially both diversification and downside protection is a seductive one. It is a “catch-all” label to help investors quickly categorise the universe of opportunities.
However, the label ’alternatives’ also purveys a sense of mystery, additional complexity and high fees which create unnecessarily high hurdles for some assets and strategies that, as a result, are quickly excluded from consideration. Such a broad label can leave investors thinking too myopically about the opportunities available to them. Before considering an alternative to this catch-all label, it’s useful to understand what might be meant by “alternatives”.
Same Assets, Different Process
There is a sub-category of “alternatives” which we describe as ‘same assets, different process’ which can also offer the valuable diversifying characteristics found in traditional equities and bonds. The consistent theme is that, whilst the underlying asset classes are similar, the targeted risk-return profile is more asymmetric than a traditional buy-and-hold (or ‘long-only’) strategy, making them attractive both in their own right but also as a complementary holding alongside traditional solutions.
Different Assets, Same Process
These assets are typically managed along the lines of a traditional buy-and-hold approach but, because of their underlying characteristics, can perform differently to traditional investments, in addition to providing attractive risk-adjusted returns. One such example would be infrastructure projects which have a specific risk-return profile and are typically more defensive and yield-focused.
Given the appeal of these types of underlying assets, it is unsurprising that they attract such high levels of demand from pension funds, sometimes unfortunately to the detriment of their prospective returns.
Is there an alternative to alternatives?
Rather than simply defining asset classes by their historic popularity (traditional or alternative), in an ideal world, each investor could create its own categorisation based on their specific context – their clearly defined goals, objectives and constraints. The universe of asset classes and investment strategies could then be mapped out against this specific framework
For example, is the portfolio required to deliver a steady income stream? This may allow greater scope for some credit asset classes which offer regular and certain cashflows but that may be less liquid and/or more complex in nature, and less scope for more volatile asset classes such as equities. We found this outcome-oriented approach to be incredibly valuable in mitigating the potential for asset classes such as social housing and infrastructure debt to “fall between two stools” when the spreads on offer were highly attractive for the risk taken following the financial crisis, in addition to the matching properties they could provide.
Recognising this might not be a feasible starting point for some investors, particularly where the objectives and constraints are difficult to precisely define, we find a useful starting point is to map out both traditional and alternative strategies according to (a) liquidity of the asset or strategy and (b) certainty of cashflows. As this categorisation is based on what characteristics are offered by an asset class, it helps investors to quickly narrow down which asset classes offer the best fit according to their needs, and in which order of priority they should be implemented. .
Even with what we believe is a more helpful form of categorisation, the challenges (perceived and real) of asset classes or strategies that may be unfamiliar remain.
Important questions to ask include:
What does the risk-return profile of the opportunity look like? What role will the investment play in the portfolio? Is the underlying risk premia from which returns are earned both identifiable and persistent?
In summary, when considering alternative assets and processes, we disregard categories and labels and look more closely at the underlying characteristics of the strategy. This allows for the selection of assets which should help investors meet their objectives over time.
An alternative to ’alternatives’ is needed as the label itself is not very helpful. We believe that assessing assets, both traditional and non-traditional, by the “liquidity” and “certainty” of cashflows is a far better way of understanding their potential fit within a portfolio. These lenses enable clients to make decisions about the outcomes, characteristics and combinations of seemingly unrelated assets.
Ultimately, manager due-diligence is essential as we investing in people and their processes rather than purely selecting individual assets.
Pete Drewienkiewicz is head of manager research at Redington