Ignore the noise & stick to the strategy

When considering which alternatives to add to a portfolio you should start by defining the objective that you want to achieve.

As much as the only constant in life is change, volatility in markets is always present. However, over the past two years investors have not only had to deal with rising volatility across equity and bond markets, they have also had to contend with an increase in the correlation between the two asset classes. This has reduced the level of diversification that can be achieved by combining equities and bonds alone within a portfolio. As a result, many investors have been searching for additional asset classes or sub sectors of asset classes that can add further diversification to their portfolios and help protect them from heightened volatility.

The reason for adding alternatives to your portfolio is not as a replacement asset class but to bolster diversification. However out-of-favour fixed income may be, it still has an important role in portfolio construction, particularly during periods of severe stress when Government Bonds and especially US Government Bonds, are seen as a safe haven.

Define your objectives

When considering which alternatives to add to a portfolio you should start by defining the objective that you want to achieve. Some ways you might define this could be:

• Less risk than global equities.
• Minimising loss to a certain percentage over a given time frame.
• Downside protection during periods of market stress.
• Returns which are not dependent on traditional market movements.

This is an important starting point as it will shape your investment selection and portfolio construction. For us at Schroder Investment Solutions, we want our
alternatives investments to achieve the following:

• Half the Beta of global equities.
• With a correlation of between -0.5 to 0.5 to global equities.

This allows us to be more defensive or add more Beta (risk) to our alternatives investments depending on what our view is on the market cycle.

The need for true alternatives

Next you need to consider which investments may come across as ‘alternatives’ but might not provide you with the correlation benefits you want to achieve. The most common investments we see here are thematic investments which include clean energy funds and climate change funds. These give you access to important long-term trends, but should not be included in your alternatives allocation as their underlying investments are in equities.

Investment trusts also need to be treated with caution. Although the underlying investments such as private equity, infrastructure or real assets, may have a low correlation to global equities, the investment vehicle is a listed instrument and so subject to volatility driven by buyers and sellers within the equity market (known as Equity Beta). Some investment trusts exhibit less Equity Beta than others due to the make up of their shareholders and underlying assets, but market stresses can still cause equity like volatility. Including investment trusts in your alternatives allocation may make sense from an allocation perspective, but it is crucial to blend this correctly with more defensive and lowly correlated alternatives.

Hedge funds and CTAs: alternatives to consider

Hedge funds are another common addition to multi-asset portfolios. Hedge funds have their own investment objectives and you need to understand how these relate to what you want to achieve.

The below charts highlight the correlation of various hedge fund strategies with global equities.

Different types of hedge fund provide different levels of protection in your portfolio relative to global equities during periods of market volatility. It is prudent to invest in a basket of lowly correlated hedge funds that provide the level of downside protection you require.

Funds that aim to achieve consistent returns regardless of the general market direction can also be useful in portfolio construction. These include trend following strategies or CTAs which look for consistent short-term trends in the market regardless of direction which they can exploit to generate a return.

Constructing your clients’ investment portfolios

Some alternatives have properties that are primarily defensive in nature. These can help to mitigate losses within a portfolio when global equities are falling in value but are likely to lag behind in rising markets.

When constructing client portfolios you need to understand the type of contribution that different alternatives can make towards meeting their objectives, and blend these accordingly to help achieve their client outcomes.