Constructing an investment portfolio that can both withstand and take advantage of market movements is key to producing attractive returns, so understanding the drivers of performance across all asset classes is vital.
Using a broad range of securities helps managers to deploy as many of these performance drivers as possible – and we think those labelled 'alternative' are critical to this mission.
Alternatives sit outside regular listed equity, high-quality corporate and government debt, while offering a wide spectrum of possibility.
As a portfolio of assets, their job, as the name also suggests, is to move in the alternative direction to the regular assets in a portfolio, to offset or at least limit drawdowns or losses.
They should 'zig' when the rest of the portfolio 'zags'.
Yet, over the past year, some of the securities that typically make up a portfolio of alternatives have moved to a greater extent in the same direction as the other assets in the portfolio.
Chart 1 shows the average monthly performance of our endowment funds’ alternative portfolio.
The months when equity markets fell are shown on the left-hand side, while the months when UK government bond markets fell can be seen on the right-hand side.
Clearly evident is the stabilising effect alternatives have on the portfolio during these difficult periods for other assets.
Alternatives also need to earn an attractive return over the long term to warrant a place in a portfolio.
Chart 2 shows how the long-term consistent returns from the alternative allocation in our endowments portfolio make them an attractive asset to own over the medium term.
So, what happened?
Alternatives, as a label, cover a broad collection of assets. To help us manage them we group them into two distinct categories: correlated and uncorrelated.
Those falling under the correlated banner give us exposure to unique assets that offer compelling returns but, at their core, are often likely to move in a similar way to traditional asset classes.
We further divide this correlated section into alternative income, which is likely to move in line with regular bonds, and alternative equity, which is likely to move with listed equities.
Within our alternative income portfolio is our direct infrastructure allocation, which offers three important properties:
- long-term, high-quality cash flows from assets such as schools, hospitals and toll roads;
- low credit risk, as many of the contracts are underwritten by local authorities or government; and
- terms often have a built-in upward inflation adjustment, which helps maintain the real value of the dividend payment from these investments.
Over the past year, the assets in this part of the alternative income portfolio have faced the most challenges, which have taken the form of a combination of external macro factors. High and persistent inflation around the world, but also specifically in the UK, meant the interest rates intended to cool this measure stayed higher for longer.
Initially, as inflation accelerated in 2021 and 2022, assets in our direct infrastructure portfolio performed well, as cash flow increased quickly as it was adjusted upwards in line with the rate of rising prices.
Yet, as time passed, these elevated rates pulled down the value of fixed income assets, which made infrastructure assets less attractive, reducing their value.
Happily, economic conditions are back to relative stability and these assets are now performing closer to our expectations.
