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Why the traditional portfolio mix could see a shake-up this year

7 February 2019

It’s here again: that time of year when private investors traditionally review their asset allocations and appraise investment opportunities ahead of April’s tax year end. In 2019, where best to invest capital is a particularly open question. Economic uncertainty as Brexit approaches and the impact of global trade wars are front of mind for many. And with volatility buffeting public markets – so much so that the FTSE saw its biggest fall in a decade in 2018, sliding 12.5% – the logic for sticking with the traditional portfolio mix, heavily weighted towards equities and bonds, is under scrutiny. So where does that leave private investors’ investment decisions?

Is cash king?

The reality is that while some investors will sit tight and ride out the storm in quoted equities and bonds, others will have been reducing their exposure to these asset classes over the last few years. There’s a natural tendency for investors to want to be liquid in times like these in order to capitalise on buying opportunities. By going long on cash they will be primed to re-enter the equities market when prices bottom out or will be in a position to seize other good investment opportunities when they present themselves, for example in distressed assets or direct lending.

Hearty appetite for alternative assets

But we are also seeing another side to the equation. In order to re-balance portfolios and drive overall returns, many investors are re-allocating a significant proportion of this cash to alternative assets. Private equity, commercial property, private debt and specialist funds are among the key types of alternative assets that are increasingly on investors’ radars.

So much so, that research among our client base of experienced private investors at the end of last year revealed that one in four (26%) have 20% or more of their overall portfolio allocated to alternative assets like these and almost half have more than 10% dedicated to alternatives.

Pie chart of private investor asset allocations to alternatives

Of course, such investments tend to be illiquid, but as a counter-balance to a higher allocation to cash, it’s a strategy that, while rather polarised, can make sense. Moreover, taking this kind of long term approach can enable investors to hedge against whatever holdings they do decide to keep in more volatile, shorter-term investments like quoted equities.

When you consider the strong, steady returns alternatives can generate, the rationale becomes clear. Investors in alternatives can take advantage of an “illiquidity premium”, with the expectation of higher potential returns as compensation for having their capital locked up for longer. For example, latest figures from the British Venture Capital Association (‘BVCA’) show sustained outperformance by private equity as an asset class compared to the UK stock market over the short, medium and long-term, returning 38.5% internal rate of return (‘IRR’) p.a. in 2017 versus 13.1% for the FTSE All-Share1.

UK Private Equity performance vs FTSE Al-Share
 

Re-assessing the true meaning of diversification

There’s another critical factor underlying this shift towards higher weightings of alternatives, and that’s the drive for greater diversification. We’re seeing investors seeking access to a range of sophisticated alternative strategies to reduce correlation within portfolios and smooth out returns.

Let’s go back to our private investor survey. An allocation of 20% in alternative assets might sound like quite a chunk, but it’s important to remember that there is the possibility for tremendous diversification within the alternatives spectrum. This is a broad category containing many different sub-sets of assets and investment strategies. Investors will therefore want to branch out into several types of alternatives where possible, so they can create a variety of returns streams while avoiding excessive concentrations of risk building up in any one area.

Incorporating assets with different timeframes is one way to achieve greater diversification, such as including private equity or property (which tend to have a longer-term investment horizon) alongside more liquid asset classes like equities. Including assets whose performance is completely unrelated to mainstream market movements or can even benefit from market and global economic turbulence, such as third party litigation funding or hedge funds, is another.

Emulating the institutional investor model

Private investors are not just taking a punt here. They’re emulating institutional investors, who are increasingly pursuing relatively high allocations to alternatives within their portfolios – but they’re tailoring it to fit their own liquidity requirements and risk profiles.

The well-known Yale endowment model2 now targets around half of its portfolio to the asset class, and data from Preqin3 shows that 50% of institutional investors now allocate capital to three or more different types of alternatives, up from 39% three years ago. For private investors, allocations in the region of 5-20% are typically more suitable – but still: why shouldn’t they get a slice of the action?

After all, lack of access - which has historically been a barrier to individuals acting alone, thanks to high entry minimums, sourcing difficulties and deal execution and management challenges - is less of a problem. Our model, which pools commitments from multiple private investors so that we are in effect acting as an institutional investor on clients’ behalf, changes all that. And by investing in £25,000 tranches, clients can spread their alternative allocations across multiple different types of investment, rather than just having to stick to one at best.

Striking the optimal portfolio balance

In the current climate, uncertainty looks like it’s here to stay even after Brexit day, and long-term returns prospects for traditional assets, such as equities and bonds, remain challenging. This year more than most, a careful re-assessment of the risk/return spread within portfolios would be a smart use of time, allowing investors to re-calibrate asset baskets to improve overall risk-adjusted returns. Cash may come to the fore for some, for the time being at least, but for sophisticated, experienced investors with the right risk profile, a greater emphasis on alternatives may also be a sensible counter-weight to cash, equities or bonds. The traditional portfolio mix may well see a shake-up, but the core investment principle remains the same: it’s all about striking the right balance.

Claire Madden, Managing Partner, February 2019

1 Source: BVCA Private Equity and Venture Capital Performance Measurement Survey 2017. Internal Rate of Return (IRR) per annum. Latest data available.

2 https://news.yale.edu/2018/10/01/investment-return-123-brings-yale-endowment-value-294-billion

3 Preqin Investor Update: Alternative Assets H2 2018

 


 Russell O'Connor
07760 282 586 or Email