Diversifying the diversifiers

The outlook for equities and bonds may appear considerably better than this time last year but recent market shocks would suggest carefully selected alternatives could merit a place in many portfolios

Inclusion concept. Group of color figures and wooden ones.


Last year turned out to offer precisely the kind of conditions that push so-called ‘alternative’ asset classes up an investor’s list of priorities. As inflation hit and rates rose, bonds and equities proved highly correlated, with investors experiencing double-digit losses in both of their traditional hunting grounds.

As such, many came to rue the absence of an allocation to other asset classes to help them weather the storm. Yet, while it may be too late to protect against last year’s losses, what role can alternatives play in a portfolio from here?

In reality, alternatives have not been a universal remedy against sliding bond and equity markets during the past 12 months. Looking at the investment trust sectors, for example, insurance and reinsurance, renewable energy, energy infrastructure and hedge funds were the main sectors to deliver positive returns, while infrastructure, private equity and loans/bonds saw relatively limited falls. In contrast, growth capital, UK logistics and most of the property sectors proved vulnerable to higher interest rates and fell in line with bonds and equities – or, in some cases, by much more.

Meanwhile, the case for an allocation to alternatives is arguably harder to make today, when bond yields are high and equity valuations relatively low. Do investors really need alternatives when the outlook for conventional asset classes seems stronger? For Gabriella Macari, chartered wealth manager at investment platform Tillit, their importance has certainly not diminished.

“Just because bonds are now more attractive, that does not make alternative assets automatically unattractive as they can fulfil different roles in a portfolio,” she argues. “Bonds coming back into vogue means there are more options for diversifying your portfolio. Simply replacing alternatives with bonds would narrow the opportunity set again. Diversification, even within your diversifiers, is never going to be a bad thing.”

Alternatives are cheap, too – research from Liberum, for example, shows that alternative investment trusts ended 2022 on an average 19% discount. Indeed, for the first time in a decade, every AIC alternative sector is trading at a discount – and this is particularly evident in areas such as private equity, where discounts are as high as 50%.

Alena Kosava, head of investment research at AJ Bell, sees alternatives as a broad spectrum that can take in exposure to real assets, absolute return-type strategies and private markets. Each area will have very different merits and differing relevance in today’s environment.

‘Steady Eddie’ infrastructure

Infrastructure, for example, has underpinned its ‘Steady Eddie’ qualities over the past 12 months. “The key characteristic to look for in alternatives is that they have a low correlation with equities and bonds so can provide genuine diversification qualities,” says Gavin Haynes, investment consultant at Fairview Investing.

“Infrastructure is now an area that justifies core exposure in a portfolio. This is broadly defined as investing in companies whose assets include roads and railways, airport services, utilities and, increasingly, green infrastructure projects. Infrastructure offered investors a haven that could protect them from inflation and provides reliable cashflows and income generation.”

And Kosava sees no reason to think this will change in 2023. “The contracted, regulated and inflation-linked cashflows offered by infrastructure companies continue to hold appeal,” she says. “The sector is underpinned by structural tailwinds following the publication of the Inflation Reduction Act in the US and a similar framework emerging within Europe. Steadily growing, dependable cashflows combined with a steady structural backdrop for the broader sector is likely to see infrastructure company earnings offer greater resilience at a time when the broader equity markets are grappling with pressures associated with slowing global growth and inflationary margin squeezes.”

Kosava goes on to note that the sector discounts widened in 2022 in response to rising rates. With greater stability on the interest rate front, however, this is likely to be less of a factor in the year ahead – although investors need to be careful about the extent to which infrastructure assets offer inflation protection should prices spike higher again. That protection is not uniform but, rather, based on the underlying assumptions about inflation made by individual trusts.

Another option, says Macari, would be a more generalist property trust, such as RM Alternative Income, which invests in investment trusts and Reits with global exposure to specialist property, infrastructure and specialist lending – for example asset-backed securities.

This should also be a better environment for long/short equity strategies, with markets less focused on macroeconomic considerations, such as interest rates and inflation. Recent history has shown these strategies do not always fulfil their brief, however, and Haynes warns: “Many of these strategies are more complex, so care is needed, and each fund needs to be judged on its own merits. If you are only looking at the performance of the IA Absolute Return sector, then they may appear uninspiring – yet some strategies do merit consideration.”

Kosava adds: “The return of volatility in 2022 served as a tailwind for hedge funds, including long/short equity strategies – and volatility does look likely to remain elevated. Having operated against the headwind associated with a directional bull market in equities over the past decade – putting pressure on alpha generation, particularly on the short book – the outlook for long/short equity managers is finally improving as the direction of markets is no longer assured by quantitative easing and loose financial conditions.”

That said, while this environment may afford managers more opportunity for alpha generation, they still need the skill to take advantage of it. Not all of them have displayed this over time, so picking a manager with a sound track record of generating non-correlated returns across a range of market environments is vital.

Private equity boom

Private equity has been a compelling option in recent years. Money flowing into the sector in search of higher returns has allowed more companies to fund their growth in the private market, leaving private equity investors with a broader choice of investment options. Haynes points out that private markets have seen five-fold growth over the past 15 years and are now around $10trn (£8.3trn) in size.

This was, though, a tough place to invest in 2022, with higher interest rates depressing valuation multiples in the sector. The era of ‘easy money’ seems to be drawing to a close and some private equity investment trusts are now on significant discounts to the net asset value of their underlying assets – a sign markets are now anticipating a significant revaluation of those assets.

Kosava believes there are risks that the recent turmoil in public markets has not yet fully trickled through into private equity – and private markets more broadly. As such, they may be vulnerable to further falls as the economy weakens. That said, they have already fallen a long way, and discounts could well reflect any repricing of the underlying assets.

For her part, Tillit’s Macari likes well-diversified trusts such as Pantheon International, which invests in unlisted businesses directly and via private equity funds. “The portfolio is diversified across regions, industries and stages with more than 500 underlying companies – and the top 100 as key drivers of performance,” she says. “It is an option for diversified exposure to unlisted companies across the world while the investment trust structure enables liquid access to an otherwise illiquid asset class.”

One final area to consider may be commodities. While these may not really be ‘alternative’, they can provide an uncorrelated option for portfolios. Here, Macari likes silver – highlighting the Invesco Physical Silver ETF – while Fairview’s Haynes suggests gold and other commodities “have a role to play” and points to their inflation-proofing credentials. “Values are influenced by speculative trading, however,” he adds. “As such, commodity exposure can be extremely volatile and so, in many cases, not suitable for low-risk portfolios.”

Following a correction in equity valuations and much higher bond yields, the outlook for equities and bonds seems considerably better than this time last year. Nevertheless, carefully selected alternatives merit a place in a well-diversified portfolio – not least because recent experience alone has shown how hard it is to predict when the next major crisis may hit.

This article first appeared in the March edition of Portfolio Adviser Magazine

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