Looking under the bonnet of alternative investments

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Looking under the bonnet of alternative investments

Alternative investments have been increasing in popularity over the last 15 years, with many investors starting to look beyond traditional asset classes in the search for diversification, and higher returns.

A recent study by BCG Consulting Group showed that AUM in alternatives have been rising faster than for any other investment category, with the exception of passives.

There is good reason for this. Active exposure to alternatives can provide helpful diversification, especially in times of market stress.  However, it is vital to remember that alternative investments are not a cohesive group, and a one size fits all approach will not work. Those considering a move into alternatives need to do their homework and carry out the appropriate due diligence when selecting the most suitable option.  

Market exposure

A key question for investors to consider when selecting a strategy is whether it will provide them with the genuine diversification benefits and returns they are looking for.  

This is because - contrary to popular belief - many alternatives managers actually rely on market exposure to generate returns, and this will not protect against a downturn.

Looking at hedge funds for example, statistical estimates show returns have in fact trended down over the last 25 years, with estimated alpha currently at -2 percent each year. What's more, over 90 percent of performance can be explained by exposure to the S&P 500 Index, suggesting that not all hedge funds currently provide the diversification benefits for which they have historically been used.

There are similar issues with private equity. A recent study by Brigham Young University used secondary market transaction data to look deeper into the sources of returns. The research found that private equity has delivered high equity beta and low alpha, meaning it has been highly sensitive to market volatility and not delivered excess returns.  The historically high total returns associated with private equity investments and buyout funds have in fact originated from extremely high debt levels, hence the market correlation.

Seeking genuine diversification

Of course, genuine diversification is possible and there are managers who have been able to deliver value-added alpha.

For us, the beauty of alternatives really does lie in the variety.  We see true benefit from strategies that invest across a varied suite of alternative risk premia and hedge fund strategies, rather than relying on equity beta. Over time, alternatives should be able to provide near to zero percent net exposure to traditional equity and fixed income markets.

This is a proven approach, with HFRI Indices showing that a strategy based on lower equity beta (less than 25%) has proven beneficial.

2020 outlook

As we head into 2020 and this late stage in the cycle, the market is vulnerable to shocks, particularly in the corporate sector. If buyback-fuelled equity growth slows due to rising corporate finance costs and declining margins, then we could quickly enter into the realm of bear market dynamics.

In this context, combined with the current state of fixed income markets, there is real value in adding diversifying sources of returns. And while potentially timely given the current market conditions, this is an approach with long-term merit.  However, investors should be warned against generalising and advised to scrutinise the true source of managers' performance. Only by looking under the bonnet can they ensure their investment goals are fully aligned with the strategy they select.

Michael Ho is global head of Multi-Asset and Alternatives at Janus Henderson Investors