The New Alternatives: Hedge, Harvest or Hype

Diversification may be finance’s only free lunch, and Alternatives are often seen as an easy diversification fix for your portfolio. But, as with all things in life, you need to know what you are buying and what that actually means for your portfolio.

Some strategies that sit in the Alternatives bucket may still be correlated to equities, while others may perform completely differently. The marketing hype might tell you one thing – but remember that it is a general statement and might not mean anything for your portfolio. You are also in some instances contending with higher management fees due to the complexity of Alternatives products.

So how do you work out what which Alternatives products are right for your portfolio?

It starts with knowing the different types of Alternatives there are and what they do.

A 101 to Alternatives

Alternative investments are those assets or strategies that sit outside traditional investing, and ideally perform differently to traditional assets like stocks, bonds or cash.

According to Harvard Business School, they are usually grouped into seven types, though cryptocurrencies is a newer addition bumping the number to eight:

1. Private Equity: investments made into private companies and can be venture capital, growth capital or buyouts. Some examples include Oreana Professional Partners Fund which aims to acquire and grow financial advice, wealth management and account firms and Pengana Private Equity Trust (ASX: PE1) which invests in private equity managers for exposure to their underlying investments.

2. Private Debt: Loans, notes and credit instruments offered by non-bank institutions that aren’t publicly traded. Some examples include Finexia Childcare Income Fund which provides secured loans to established childcare operators to purchase or establish new centres or EG Private Wealth - Private Debt which offers debt investment opportunities for quality residential real estate and industrial sites.

3. Hedge Funds: Funds that use different strategies to earn returns, such as long-short equity, market neutral, volatility arbitrage, managed futures and quantitative strategies. Some examples include the Alpha Prime Trust which uses a range of strategies including long/short, momentum, arbitrage and proprietary trading strategies to generate alpha in digital currency markets, or the Frame Long-Short Australian Equities Fund which invests in Australian equities with a long-term outlook while also using short sales and derivatives to generate returns and hedge exposure.

4. Real Estate: Properties, including land or buildings. Owners can receive rent as cash flow and also growth from capital appreciation of the property. Some examples include Centuria Healthcare Property Fund which invests in healthcare properties and offers long-term leases to operators or Trilogy Industry Property Trust which holds a portfolio of industrial properties in key Australian regional and metropolitan precincts that it leases out.

5. Commodities: Generally natural resources, ranging from agricultural products, to oil to metals. Gold is a current and popular example. There are also managed funds that can provide exposure, such as Argyle Water Access Fund which owns and manages Australian water rights or Sequoia Commodities Series 18 which tracks an index of commodities across energy, industrial markets and precious metals.

6. Collectibles: purchase and maintenance of physical items with the hope they gain in value over time, such as art, cars, antiques, wines. Generally, this is something you would individually do and store in secure facilities with expert advice. It’s worth remembering these are less liquid assets so if you need to buy or sell, it can take time. One example of a fund in this space is the CHROME TEMPLE Investments Mach 1 Fund which invests in performance cars.

7. Structured Products: These typically involve fixed income and derivatives. Some examples include credit default swaps and collateralised debt obligations (CDOs). Mortgage-backed securities were famously part of the sub-prime crisis in the US leading to the GFC. It is worth highlighting the Australian versions are far more tightly regulated. Some examples are Remara Credit Opportunities Fund which invests in private credit in the form of syndicated loans, special situations debt, asset-backed securities and collateralised loan obligations or Thinktank High Yield Trust which invests in domestic commercial and residential mortgage-backed securities.

8. New category – cryptocurrencies: The most well-known are bitcoin and Ethereum, but there are many other options and the US Genius Act has created a new focus on stablecoins. Some examples of this include Global X Bitcoin ETF (ASX: EBTC) which invests in bitcoin which is stored by Coinbase or MHC Digital Asset Fund which invests in bitcoin, Ethereum, other large cryptocurrencies, stablecoins and also uses market neutral trading strategies.

Each of these types of alternatives has different types of performance drivers and don’t necessarily perform like each other.

Diversified or Correlated?

You might hear the phrase “uncorrelated asset class” bandied about. The question you need to ask yourself is “uncorrelated to what?”. The answer will tell you whether an investment will give you the diversification you need or not. There are not many asset classes that are completely uncorrelated to traditional markets, so diversification is about blending assets with differing levels of correlation.

It’s also handy to remember that the term “Alternatives” doesn’t mean risk-free – it encompasses different strategies or asset classes to traditional, and risk levels depend on the underlying investments and strategies. A strategy using derivatives and leverage might be higher risk than, say, a portfolio of gold bullion.

Often investors are looking for diversification from their equities and fixed income investments to help buffer their portfolios through market volatility. The below asset correlation matrix from Guggenheim Investments shows some, though not all, alternatives against traditional assets.

In the chart, you’ll see that some alternatives, like hedge funds, long/short equity and event-driven funds, typically have a higher correlation to US equities. This means you may receive some level of diversification from equities, but not completely.

So when might you use them? Consider hedge funds as an example. Each hedge fund will have its own aim – for example, targeting market alpha while using risk management to manage market volatility. In this instance, you should expect some level of correlation with global equity markets because the aim is to still capture some market growth.

A hedge fund like this might rise and fall with equity markets but is designed to not move as much. So you won’t capture the peaks but hopefully you won’t sink completely into the troughs either. You might then choose to use this type of strategy as part of your equity or growth allocation. Superannuation funds often classify these types of funds as “Growth Alternatives”.

You might notice that managed futures have a slightly negative correlation to US equities, along with other assets. While managed futures are a type of strategy that often sits within hedge funds so have some slight positive correlation to them, they have a narrower trading ground.

Managed futures invest in futures contracts – that is contracts based on expected price changes in assets like commodities, currencies, stock indices and interest rates. They might take a long position (where the price is expected to go up) or a short position (where the price is expected to go down). An example of this strategy is the Frame Futures Fund.

Moving onto Commodities. These on the whole have a moderate correlation to global and US equity markets, as well as fixed interest markets – although, if you break this into components, you’ll find some variation. The relationship can also switch depending on market cycles.

For example, gold has a moderately positive correlation with equity markets in rising markets, but can switch to an inverse relationship during periods of stress – that means it might hold its value or continue to rise while equity markets fall. This is why it has traditionally been used as a hedge or diversifier in portfolios.

Correlations can also increase between commodities and equity markets where the local market is heavily dependent on producing and exporting it – consider how coal and steel prices have influenced the Australian economy in the past.

Turning to Property – another popular diversifier – if you consider REITs as somewhat of a proxy, you’ll find a strong positive correlation with equity markets. Real estate is often strongly linked to economic health, particularly in Australia, so this correlation shouldn’t come as a surprise.

Real estate is less volatile and liquid than the share market, so might be used as a store of value (to an extent) or for rental yield – in this instance, it might be seen as an alternative income diversifier compared to fixed interest investments. It has a moderate correlation to fixed interest. In Australia, property outperformed shares in six out of the last 10 years, with less volatility.

Keen readers may have noticed that currencies generally have a low or negative correlation to other asset classes. Cryptocurrencies increasingly represent their own category, so be wary about getting too excited here. Prior to 2019, there was some indication that Bitcoin and Ethereum were effective hedges against market volatility, but more recent studies have found that stock markets have become strongly linked with these larger cryptocurrencies and tend to be positively correlated to commodities.

JPMorgan found that bitcoin and altcoins are more highly correlated to small-cap tech stocks compared to other parts of the equity market, so if you wanted to use it as a diversifier, it may be worth taking a closer look at the current composition of your equities allocation to see how it might fit.

Private Markets as a Diversifier

Private markets are growing in popularity, but are they a diversifier? The answer is to an extent, given there is a high level of correlation.

The CFA Institute collated research that suggested that private markets and public markets have a fairly high level of correlation and compared the value of listed private equity groups to major public indices in 2020. It highlighted that private equity managers report quarterly, while public markets are quoted daily which means that any declines in value appear less prominent while there was more opportunity to recover losses.

JPMorgan suggests that the primary reason for investing in private equity and private debt is to seek return enhancement, not as a safe haven or hedge against other markets.

It highlights that private equity comprises 86% of the total equity investment universe and found that including an allocation funded either from equities or bond allocations offered increased returns and reduced volatility. Consider that the MSCI Private Equity Index outperformed the MSCI World Investable Market Index by 450 basis points per year over the past 20 years.

Private debt on the other hand generally has a low correlation with public equities and fixed interest bonds, but also appeals for return enhancement. Private debt generally attracts higher interest income and a higher internal rate of return for investors. As it typically uses floating rate bonds, it can be valuable in rising rate environments.

Diversifiers & the Value of Alternatives

While it’s worth being aware of correlations and some of the marketing hype around Alternatives, that’s not to say they don’t have value in your portfolio – but do your research on what your portfolio needs and what the Alternatives you are considering will offer you.

Research from the likes of UBS and Dexia Asset Management have found that including alternatives can improve the risk-return profile of a portfolio, using careful product selection. Most big super funds have an outlined allocation to Alternatives these days too.

There’s a broad universe to invest in beyond listed equities and public fixed income assets, and it’s valuable to consider how even assets with a level of positive correlation to equities can offer distinct benefits to your portfolio. Just remember to consider your portfolio in its entirety and your strategy while you are doing your research. And as ever, consider expert advice to find the right options for you.

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.