Can you only achieve true diversification through alternatives?

Ten years on from the biggest financial crisis since the Great Depression, investors continue to focus on chasing returns from mainstream asset classes such as bonds and equities. The past few years, however, have also seen an upswing of interest in including alternative assets as part of an investment portfolio. Multi-asset funds are rising in popularity, with their clear ability to diversify a portfolio and reduce risk. The benefits of using alternative assets should not be understated.

Recent geopolitical uncertainty, from Brexit to President Trump’s foreign policy, has seen investors become increasingly more averse to risk, but in the current low-interest environment clients continue to expect a worthwhile return on their investment.

Advisers are having to adapt to these needs by investing their clients’ capital in funds that offer more predictable returns over the long-term, but which continue to make the most of any market gains. Diversification is key to achieving this balance.

Alternative assets offer potentially higher returns in the long run as they seek to outperform the traditional asset classes. Alternatives also provide a degree of market protection as they can provide a source of income or capital protection even when markets go down through hedging strategies. However, the biggest advantage of using alternatives is the level of diversification that they bring to an investment portfolio.

Alternatives tend to have a low level of correlation to both equity and bonds, meaning they can help to protect a traditional portfolio from market volatility as their value tends to move in a different way.

Such diversification is particularly important when compared against more traditional equities or bonds, which, whilst on occasion can behave differently, have also responded in the past to market changes in a similar manner. In June this year, for example, we saw a sell-off of bonds spread to equities following indications by the heads of central banks that the low interest rate era will soon come to a close. This more than makes the case for greater diversification by including a mix of alternative assets within an investment portfolio, rather than relying solely on equities and bonds, which could be riskier than investors might think.

By including assets whose returns are uncorrelated from the portfolio you already own, true diversification can be achieved, helping advisers to better protect their clients from the worst in the event of a market downturn.

At VAM Funds we use alternatives for this exact reason and spread our investments not only across assets classes but also within assets classes. Each of VAM’s three distinct discretionary strategies is well diversified with an optimal mix of equities, bonds and alternative funds, and also geography. Broadly 8-10 per cent of VAM’s portfolios are invested in alternative assets, of which there are three to four key asset types.

Infrastructure, vehicles investing in physical structures such as motorways or hospitals, is one alternative that we look to include in our portfolios. Globally, the demand for private investment in infrastructure is growing as developing nations look to boost transport links or education amid constraints on Government budgets.

These projects usually have very long-term contractual payments, are backed by Governments and typically have some form of inflation linkage. As such, they offer access to the secure and decent yield that we are looking for. The level of allocation to these assets within our Close Brothers discretionary funds currently varies from between 1.9 per cent (Growth) and 4.8 per cent (Cautious), as of 31 July.

Commodities are another alternative that we include within the VAM portfolio. Though in some cases commodities can be highly volatile investments, precious metals such as gold – the ultimate store of wealth – can provide a more secure investment. Across each VAM strategy, we have holdings in gold to provide protection against a market sell off.

VAM also employs property as an alternative asset type within its Cautious strategy. These investments provide a long-term return that typically lies somewhere between equities and fixed income investments and provides access to an underlying real asset. They offer a relatively decent yield and provide good risk adjusted returns, and as of 31 July our Close Brothers Cautious Fund has around 2.5 per cent of assets allocated to UK property.

Finally, as a means of further diversification, VAM also includes absolute return funds within each portfolio. These are designed to make positive returns irrespective of market conditions and are uncorrelated against other investments by design.

By actively managing these alternatives, not only can we ensure greater diversification, but it can also lead to higher returns in the long-term. There can be wide dispersion in returns from different fund managers when it comes to alternative strategies. Therefore, effective manager selection is critical for success and at VAM Funds we seek out managers with a high level of expertise and fully utilise this to help intermediaries manage the trade-off between risk and reward that their client wants.

Whether you include alternatives in your asset portfolio will largely come down to your appetite for risk. Whilst the use of alternatives in investment portfolios is not as well-documented as stocks and bonds, the current investment climate and potential for volatility makes a strong case for including them. Their ability to provide a greater level of diversification and consistent, if not higher, returns highlights the benefit of including alternatives to spread risk and create truly a multi-asset portfolio for your clients.

David Macdonald is sales and marketing director at VAM Funds