How much should you allocate to alternative investments?

The past few years have seen the launch of increasing numbers of investment trusts focused on non-equity alternative assets such as renewable energy and niche property sub-sectors. And these assets can play a useful role in some investors’ portfolios. But not all investors need to invest in them and if you do it is important to determine how much exposure you should have to them.

A key issue is what type of alternative assets to hold as the term ‘alternative’ can encompass anything that is not mainstream listed equities and fixed interest. “That leaves quite a wide universe of investable assets and each of these have different risk and return profiles,” says Dan Boardman-Weston, chief investment officer at BRI Wealth Management.

It is important to understand the nature of these assets, how they work and – importantly – whether they will be an alternative in your portfolio. David Jane, fund manager in the Premier Miton Macro Thematic Multi Asset Team, points out that assets labelled as alternative include niche areas of equity markets. But these are less likely to be really good diversifiers to portfolios of mainstream equities as they could move in line with the broader market so wouldn’t necessarily help to diversify your portfolio’s overall return.

Alternative assets should have a different return profile to mainstream equities so that when equity markets are falling the alternative assets help your overall portfolio’s return not to fall as much as broad equity markets. Certain types of non-equity assets can help to limit or mitigate downside in lower-risk portfolios.

“The lower-risk the investor, the larger the allocation to low-risk alternative assets they should have,” says Sam Buckingham, investment analyst at wealth manager Kingswood (KWG). “This is because low-risk investors typically have the largest allocation to fixed income, which has historically worked well as we have seen interest rates grind continuously lower. However, with yields as low as they are, returns going forward are likely to be very low or even negative if interest rates start to go up. So it is sensible to rotate some of your fixed income exposure into alternative assets, which should increase portfolio diversification, reduce risk and improve returns.”

Other types of alternative assets can achieve stronger growth or income than mainstream equities and bonds. For example, private equity investment trusts could give an additional boost to long-term growth investors’ portfolios.

The right level of exposure to alternative assets depends on factors including your risk appetite, investment time horizon and the purpose of the pot of money invested. For example, if you have a lower appetite for risk it is unlikely to be appropriate for you to invest in assets that have the potential to lose a lot of your money, while long-term growth investors should be focused on assets that can deliver that.

Before plunging into alternative assets, consider what else you have in your portfolio, whether you already have enough diversification and whether the alternative assets you are thinking of adding will do different things to your existing holdings.

Another key consideration is the size of your investment portfolio. If it is very small, you should start with broad funds and maybe add to more unusual funds with a narrow focus as it grows. If you add too many niche funds or the proportion of your portfolio that they account for becomes too great, your overall portfolio could become too niche and more volatile. 

As your portfolio grows, an initial option could be a fund that invests across various different types of alternative assets, giving you diversified exposure to them via one holding. Examples of such funds include Miton Global Opportunities (MIGO) and ARC TIME UK Infrastructure Income (GB00BZ17GL78).

How much to allocate

You need to determine how much you are going to allocate to alternatives overall and how much to each different type that you have decided to hold.

Wealth manager models and benchmarks can be helpful in giving an indication of the range of exposure that might be appropriate. BRI Wealth Management, for example, tends to allocate about 20 per cent of its more cautious clients’ portfolios to infrastructure and absolute-return funds, and these weightings decrease as investors’ attitude to risk increases. “We think that allocations to alternatives will continue to increase in the future due to the paltry returns on offer from bonds,” adds Boardman-Weston.

Jane says that the low- to medium-risk funds he runs can have an allocation of 5 to 15 per cent to alternative assets, but during periods when bonds are providing good diversification this is less. The higher-risk funds have less. Premier Miton Multi-Asset Growth & Income (GB00B78H4K93), for example, only had 3.8 per cent of its assets in gold at the end of October but over 70 per cent in equities.

Matthew Yeates, head of alternatives and quantitative strategy at wealth manager 7IM, says that as they are “looking to replace lower-risk assets with alternatives, the allocations should be higher for lower-risk investors and lower for those with a higher risk tolerance. As an example, for balanced investors, we currently allocate around 15 per cent of a portfolio to alternative assets.”

They allocate up to 20 per cent of lower-risk investors’ assets to alternative investments, while for higher-risk investors the allocation could be as low as 5 per cent.

Useful benchmarks include the MSCI PIMFA Private Investor Index Series. These five composite indices aim to represent the weightings and show the returns of selected multi-asset-class strategies, determined by the PIMFA Private Investor Indices Committee. The indices include weightings to equities, bonds, real estate, cash and alternative investments in proportions that reflect the longer-term objectives for each strategy. They range from the MSCI PIMFA Private Investor Conservative Index for lower-risk investors through to MSCI PIMFA Private Investor Global Growth Index for investors with a high risk appetite and long-term investment horizon. MSCI PIMFA Private Investor Conservative Index, for example, currently has an allocation of 17.5 per cent to alternatives. And MSCI PIMFA Private Investor Global Growth Index has an allocation of 2.5 per cent to alternatives.

Risks

Because of the risks associated with alternative assets, Buckingham argues that it is important to ensure that your exposure to them is diversified. Alternatives tend to be more complex than other asset classes so you should rigorously analyse them. “There have been many examples of alternative assets that have tempted investors with high yields, but investors haven’t considered the risks and they’ve performed poorly,” says Boardman-Weston.

Yeates adds that, for example, commodities and cryptocurrency investments can promise double-digit returns but be volatile and correlated with equities.

Alternatives funds also tend to have higher fees than ones that invest in traditional asset classes. For example, Renewable Energy Infrastructure sector investment trusts’ ongoing charges are mostly in excess of 1 per cent and Gore Street Energy Storage Fund (GSF) has an ongoing charge plus performance fee of 2.74 per cent, according to the Association of Investment Companies.

Private equity trusts also tend to have ongoing charges above 1 per cent and in a number of cases higher than 2 per cent, which can be due to performance fees.

By contrast, mainstream equity and bond funds typically have ongoing charges below 1 per cent.

“If the alternative truly gives you diversification and scope for good performance, the higher fees can be worth paying,” says Boardman-Weston. “But we have seen quite a few examples of performance fees being levied [where] the hurdle rate for those performance fees is so low that the manager can walk away with a sizeable chunk of your return.”

Just because an asset is low volatility does not mean that it is low risk – it could still face problems.

Yeates adds: “Investors can mistake [being] uncorrelated with immunity to drawdowns. [Even] if assets are generating returns that are uncorrelated they should still be exposed to some volatility. However, it shouldn’t be connected to what they are seeing in the rest of their portfolio. Often investors forget this and sell too early.”

As a private investor, you are unlikely to be able to invest in alternative assets directly, but rather have to access them via funds, often investment trusts, which are listed on the stock market. This means that you won’t necessarily get the returns of those assets because these trusts’ share prices can move more in line with mainstream equities than the underlying investments. And you might not get the diversification you hoped for.

Many esoteric assets are not easy to buy and sell quickly. You can buy and sell the shares in investment trusts that hold an illiquid asset, but the trust could move to a wide discount to net asset value (NAV). Although you could sell your shares in the investment trust, if their price has fallen to far less than you paid for them you might not want to do this, meaning that you are, in effect, stuck with the trust until its share price recovers.

Alternative options

When deciding which alternative assets to hold you should consider current economic and market circumstances. 

Gold can help to diversify investment portfolios because historically it has been uncorrelated to traditional assets. “The asset’s safe-haven status is helpful when it comes to portfolio protection in times of market turbulence, which is particularly important at a time when we find government bonds unattractive,” says Sam Buckingham at Kingswood. However, the gold price can be very volatile.

Buckingham also likes infrastructure. “While its high equity sensitivity means its impact on diversification is less than [that of] gold, exposure is still warranted,” he explains. “We are likely to see huge infrastructure spending with Joe Biden as US president and it is a similar story in the European Union [following the approval of] its recovery fund. It’s also worth highlighting that infrastructure returns are often inflation-linked, which is another benefit given current inflation concerns.”

Infrastructure can be particularly useful for income investors because investment trusts focused on it typically have high yields and pay attractive incomes. However, these can trade at very high premiums to NAV, meaning that they are relatively expensive. But this is less of an issue if you have a very long-term investment horizon and will benefit from many years of income and share price growth once you have purchased the trust.

David Jane at Premier Miton highlights that highly esoteric assets such as catastrophe insurance, legal settlement insurance and music royalties are uncorrelated with equities. He also mentions ‘hard’ assets such as property, energy, agricultural commodities and base metals as a way to protect against inflation. “If weaker periods for equities continue to coincide with periods of higher inflation expectations, these assets have an obvious attraction as diversifiers in preference to bonds,” he says.