Medium-risk portfolios: Alternatives exposure calms investors’ nerves
Another strong quarter for risk assets has some investors nervous, as medium-risk portfolios look for diversification through increasing exposure to alternatives
TMPI data shows allocation to alternatives has risen in medium-risk portfolios during the past three years. While not a wholesale change, or one that has happened at any great speed, the move from an average 7% in June 2013 to 10% this year is nevertheless an important one, with a trimming down in equities and fixed income.
With hindsight, investors may have been better off sticking with risk assets in Q2, instead of absolute return funds, many of which struggled. Still, private client managers report having been busy in this area. Waverton Investment Management, for example, has been increasingly focusing on lower-risk market-neutral plays, including funds from Jupiter and Phileas Asset Management.
“We have been loosening up on equity long/short and global macro funds, which have demonstrated too much volatility of late,” says Waverton director John Bellamy.
“We sold out of Standard Life Gars, having become concerned about its size and ability to replicate all of the defensive trades they used to be able to do.”
For James Spence, managing partner at Cerno Capital, there is “nothing magical” about alternatives. He says: “They too have experienced valuation compression, especially in areas that generate reliable yield. We prefer skill-based strategies and are invested in two equity long/short managers.
“In the past three years we have taken global macro positions to zero as we are less convinced they can produce consistent returns in the current environment.”
Cerno’s net equity exposure increased slightly during the quarter as the team recycled some cash back into the asset class.
Spence explains two of the firm’s targeted country positions: “The first is Japan, where we have been involved since 2011, even before Abenomics came into being. It began as a value proposition but we are witnessing an improving corporate profit cycle where companies are focusing on shareholder returns.
“The other is India. Its large economy and relatively young population is better positioned for growth and offers a different return profile from other emerging markets.”
Capital Generation Partners has also been active in its equity positioning. While at a sector level preferring defensive and cyclical stocks, the firm has been moving more towards the value factor.
“One area of value we see in equities is the relative cheapness of volatility,” says partner Ian Barnard. “We have used options, both calls and puts spreads, to enhance equity returns. Out-of-the-money calls is an attractive supplement to owning cash equities.”
The maturity of the current bull market is a concern for private client investors, which may explain why they have been more open to diversifying portfolios with alternatives.
For Spence, the problem with markets is less one of the binary question of bull or bear but more to do with expected returns.
“These have fallen as valuations have risen,” he says. “Core government bonds have the hallmark of a bubble, and equities, especially the desirable quality names, are now becoming expensive.”
One asset class Cerno is currently using is US Treasury Inflation Protected Securities (Tips), the largest single allocation to its medium-risk portfolio at 28%.
Spence says: “Future changes in expected inflation are likely to upset the nominal bond market and, at a certain point, the equity market. Tips offer a useful staging post during this phase.”
