Alternative investments have grown in popularity in recent years. Since 2015, assets under management across all alternative asset classes has grown from $7.2trn to $13.3trn by the end of 2021, according to Preqin.
This growth has come as investors began questioning the role of fixed income in multi-asset portfolios, as a decade of low interest rates meant bonds offered scarce income and limited diversification in the event of an economic downturn.
A feature of monetary policy during this period was to get money out of the safety of bonds and into riskier assets or the real economy. In the last ten years, the S&P US Aggregate Bond index has delivered an annualised return of 1.2%, while the S&P 500 has offered 12.5%.
Four graphs explaining... alternatives
"Over the last few years, when interest rates have been rock bottom, core government bonds have looked particularly unattractive, and that is why it has really made sense to make a greater use of alternatives in non-equity parts of a portfolio," said Ben Seager-Scott, head of multi-asset funds at Evelyn Partners.
In that environment, the 4 to 6% yields that investors could get from some alternatives was "extremely helpful", according to James Yardley, senior research analyst at Chelsea Financial Services.
Bonds are back
But now that bonds are offering their best yields in over a decade and their role as a diversifier has returned to some extent, investors are being tempted to lock them back in. In this environment, the bar to allocate to alternatives is higher, analysts have said.
"Now that has changed drastically and bonds are offering a real yield again, it is only natural they warrant an increase in allocation and lower allocation to alternatives," Yardley said. "The bar is definitely higher for alternatives now if they are to make it into the portfolio."
Dan James, head of asset management at Charles Stanley, said the return of yield to the bond markets has reset the environment that investors have become used to over recent years.
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"Indeed, it does raise the hurdle rate that one would use to invest into alternatives," James said. "With cash rates around the 4% levels and yields on investment grade credit at 6% and high yield coming in around 10-12%, the bar is raised as is the diversification benefits in a portfolio."
Other industry experts, such as Invesco multi-asset product manager Fabio Faltoni, remain constructive on alternatives despite the improvement in valuations in most areas of the market.
"More supportive valuations are certainly welcome, however this is only one of many ingredients needed for volatility to normalise and for markets to recover on a more sustained basis," he said.
He encouraged cautiousness and argued that investors should not be "too quick in completely writing off alternatives", which he said can provide diversification benefits in uncertain times.
Opportunities remain
Harriet Ballard, multi-asset portfolio manager at Aviva Investors, said that although expected returns across asset classes have improved in 2023, with inflation still high investors should prepare for more frequent periods of bonds and equities declining at the same time.
"With diversification harder to achieve, alternatives have a more important role to play in our opinion," she said. "We therefore increased our allocations to alternatives last year."
Most industry experts agreed that alternative assets still have a role to play in a multi-asset portfolio. However, the investment case has shifted, they argued, and investors may need to rethink which assets they want to hold and why.
Given that some alternative asset classes had increased correlation with traditional markets last year, Ballard argued it pays to be selective and maintain a diversified approach, as the space captures a broad range of strategies along its spectrum.
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"2022 was very challenging for real estate, but the outlook appears better this year," Ballard said. "Outflows from commercial real estate are a concern that should be monitored, but we think the narrowing of the previous valuation gap to publicly listed REITs implies less underperformance moving forward."
Yardley said that many alternative trusts had now repriced for the new environment. With many trading on 20-30% discounts and offering "much higher yields", there are still opportunities in areas such as renewables, infrastructure and special situations, he argued.
"One place some alternative trusts need to do better on is on fees and costs," he said. "When there was no bond alternative they could get away with it.
"Now they are competing with bond ETFs at five basis points. If alternatives want to remain a high weight in portfolios, this is definitely an area for improvement."
Search for liquidity
Even while the outlook for equities remains challenged, Aviva Investors' multi-asset team is favouring hedge funds and other liquid alternative strategies, which Ballard said have the potential to deliver uncorrelated return streams.
"Liquid alternative strategies are well placed to take advantage of global macro trends and short-term trading opportunities," she said.
Evelyn Partners' Seager-Scott said the firm had increased its fixed income exposure and is only marginally timing equity and alternatives. However, he pointed to hedge funds, especially fundamental long/short equity or market-neutral bond strategies, as areas of interest.
Liquid alternatives back in the spotlight after year of solid performance
Falconi was also more constructive on alternatives that offer clients daily liquidity, such as absolute return. In turn, he is wary of illiquid alternatives, including private equity and infrastructure, which have enjoyed a lot of success among investors in recent years.
"As highlighted by the UK pension fund liquidity crisis in the autumn of 2022, higher interest rates and tightening financial conditions have put some of the optimism about the robustness of the asset class into question," he said.