Why invest in Alternatives?
The investment landscape is broad and varied yet many investors’ portfolios are wholly dominated by mainstream traditional investment classes (quoted equities, bonds, gilts and residential property). These asset classes are often strongly correlated with each other and/or the wider economic environment. This correlation reduces the diversification of a portfolio, concentrating risk, meaning that when markets decline so does overall portfolio value.
Alternative investments provide diversification
Alternative investments and alternative investment strategies expand the options available for experienced and professional investors. They present opportunities to access growth and income, which is less correlated with traditional asset classes, thus improving diversification. This could be through direct private equity or debt, commercial property, or alternative investment strategies employed by specialist funds. As these investments are less correlated with the main markets and can often take advantage of volatility in those markets, investors use them as a hedge to traditional assets.
What’s more, as alternatives tend to be held in close-ended structures, investments aren't correlated to the behaviours and actions of other investors, as can be the case in more liquid structures.
Targeting higher returns
As well as enhancing portfolio diversification, alternatives can potentially deliver higher levels of returns than their mainstream counterparts. Investors are rewarded for less liquidity and longer investment terms when higher returns are achieved. For example, research from the BVCA (British Venture Capital Association) has shown how UK private equity significantly outperformed the FTSE-100 in 2017 and over the short, medium and long-term.
How alternatives can enhance returns and reduce volatility
In our own analysis (shown below) we can see that annualised returns from a portfolio entirely constructed from alternative investments are projected to be markedly higher than those achieved with a typical balanced portfolio (60% equities, 40% bonds). But what may be surprising is that adding alternatives to a portfolio containing only stocks and bonds has the potential to lower volatility too. And an increasing weighting towards alternatives continues to reduce the portfolio volatility.
Clearly a 100% allocation to alternatives is a theoretical position and would create its own diversification problems in reality. But we can see below that based on our projections, even a small 20% allocation to alternatives could enhance overall potential returns.
Alternative investments: No longer ‘alternative’?
An October 2018 report by data provider PreQin found that 84% of institutional investors plan to increase their allocation to alternatives in the next five years. The resultant growth will be driven by ‘a desire for yield and a decreasing number of public companies in the equities market’.
With most commentators predicting a downturn and even higher levels of volatility, increasing numbers of sophisticated private investors, family offices and smaller institutional investors are also looking for alternative ways of targeting portfolio growth and reducing volatility. Connection Capital’s model can help these investors to build a bespoke portfolio of alternative investments of their choosing.
Sources: BVCA Performance Management Survey 2017 and PreQin Future of Alternatives report (October 2018)