Last year was a unique time for investing. More traditional investments in equities and bonds yielded negative returns, giving investors a reason to contemplate how to diversify portfolios to have more uncorrelated assets.
Shadforth Financial principal private wealth adviser Joshua Blythe notes that investors didn’t really cope well when their shares were down and the defensive bonds were also negative.
This prompted a radical rethink about whether it was time to consider adding other asset classes like alternatives into the mix to safeguard against further losses, Blythe says.
People tend to structure their investments based on recent history, from capital protected products which get launched after markets fall to various alternative investments that may have performed well recently when equities and bonds were down, he says.
“Investors need to be wary thinking alternative investments are a good substitute for fixed income assets like bonds based on one year of bonds being negative over the past 30 years,” he says.
“Every asset class has its own risk and the caution with some alternatives is that investors may not fully understand what they are investing in, and they may actually be taking on more risk with alternatives.”
Alternatives are certainly valid investments to consider, but those contemplating the asset class need to understand what they are investing in and how it fits in with their overall portfolio risk profile.
“Unfortunately, alternatives aren’t the high return no risk investment and if we have a rally back in bonds, then people may stop talking about alternatives,” Blythe says.
HLB Mann Judd certified financial planner Jonathan Philpot agrees, adding that alternatives can range from very low risk to extremely high risk.
However, with interest rates rising sharply in 2022 and share markets again returning to more ‘normal’ levels of volatility, investors are looking for more stable returns, which some alternative investments delivered throughout last year.
“Overall, investors need to be very careful with understanding how an alternative investment delivers its returns and the risks involved,” Philpot says.
“Some can be highly geared and some in times of crisis suffer from a lack of liquidity in the market.”
Alternatives can be considered defensive, depending on the level of sensitivity to the risk premia being selected and the form in which it is accessed, Morningstar senior analyst David Little says.
“Morningstar considers alternatives as modifying, diversifying, or eliminating the traditional risk premia found in common investment products,” Little says.
“The distinction as to whether this is then classified as growth or defensive can be blurry. An investment with no sensitivity to equity markets may still be considered by some as growth based on other characteristics, while defensive does not necessarily mean fixed income.”
He points out that there are defensive alternatives that are used to diversify exposure to traditional fixed income beta. Though generally, these are more liquid exposures exhibiting low to medium volatility, low to medium downside risk, and low correlation with both growth and defensive assets.
“Multi-sector investors might for instance include absolute return fixed income and opportunistic multi sector credit as part of their defensive allocation,” Little says.
“Absolute return fixed income generally carries lower interest rate risk and is typically less negatively correlated with equities over time, however, is more attractive relative to traditional bonds in rising interest rate environments like those seen in 2022.”
Opportunistic credit exposures can stray more into sub-investment grade credit and so increase shared risk premia with equities, something more evident in periods of market stress, meaning they have a foot in both growth and defensive camps.
Though for institutional multi-sector investors such as industry super funds, this is often labelled mid-risk, and often includes assets such as private debt, recognising that the reduced liquidity, higher credit risk, and low mark to market volatility isn’t consistent with traditional bonds, he says.
