Only two years in, and the 2020s have already given us plenty of shocks, whose impact may continue to be felt for some time. As is to be expected, serious global events are translating into significant volatility in public markets and fuelling an upward inflationary spiral, the likes of which have not been seen in decades.
As these twin pressures converge, it’s a sobering reminder to investors of the importance of portfolio diversification to smooth out exposure to risk and drive returns in times of trouble (and in good times too). Alternative investments have a critical role to play here, and this article explains why.
First, it’s worth putting the current situation into context, and looking at what is happening to traditional, mainstream asset classes.
Public market volatility is clear to see: by early March, 6% had been wiped off U.S. share prices since the start of the year and there have been major fluctuations in UK stock markets too. At the same time, prices of quoted stocks are at historically high levels, and some people fear that this is unsustainable. In liquid markets, where changes in supply and demand can instantly trigger dramatic movements, even if investors hold their nerve and choose to ride out the storms, they cannot fail to be affected by the behaviour (rational or otherwise) of others.
Seeking safety in bonds may be no panacea either. Interest rates on bonds are way below inflation, which hit an eye-watering 6.2% in February and there’s every chance it could go even higher. Since they tend to be fixed-income in nature, during times of high inflation, bonds favour the borrower, not the lender.
For some time, it’s been clear that traditional portfolio composition, which was weighted predominantly (and often exclusively) towards quoted equities and bonds, may need a re-think, with many institutional investors increasing their allocations to alternative investments in recent years. Now the argument for doing so – for private investors too – is stronger than ever. Portfolio diversification (and what form that should take in practice) is under renewed scrutiny to ensure maximum resilience in a challenging climate.
Harnessing the illiquidity premium to beat inflation
Many private investors have been building up their cash reserves during the course of the Covid-19 pandemic, both as a response to already turbulent stock market activity, and as an enabler to allow them to seize good investment opportunities when they saw them. Now, if they haven’t already, they will be looking to deploy that capital, fearful of sitting on cash for too long as its value risks being eroded rapidly by soaring inflation. Even if interest rates on cash savings accounts increase, there’s a wide gulf between the two, and one which is unlikely to be bridged any time soon. Finding investments that can beat inflation will be front of mind for many investors.
Private investments are likely to be a key area of focus as investors seek to spread risk, increase the stability of their portfolios, and boost returns. Alternative assets with longer-term investment timeframes could be a good way to mitigate risk and provide that stability, given that their closed-ended structures mean that all investors need to commit for the long-haul. The threat of a sudden, irrational, stampede to the exit upsetting the applecart is eliminated by design.
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When it comes to returns, taking advantage of the “illiquidity premium” inherent in such investments is another major selling point. By tying capital up for longer, investors are expecting a better return as a payback for their patience. As an example, investors in UK private equity and venture capital received returns of 21% p.a. over a five-year investment horizon, compared to a 5% p.a. return on investments in the FTSE All-Share Index. To put this another way, investment manager, Hamilton Lane, calculates that private equity funds have generated 83 cents more per U.S. dollar than public markets on average over the last five years. Those figures look even more compelling in an era of rampant inflation.
Diversifying via alternatives: an extremely broad range of options
Including assets with different liquidity profiles and investment horizons within portfolios, such as publicly quoted shares and private equity, is a good way to improve diversification. But it is possible to incorporate a mix of timeframes even within the private equity category itself, by investing in both primary funding rounds and secondaries funds, where investee businesses have got to a more mature stage and can, therefore, be exited sooner.
Another diversification tactic is, of course, to increase the range of assets a portfolio contains, and within the “alternative assets” bracket, there’s a huge variety of potential options. For instance, venture capital investments will have a very different risk and return profile to more established private equity opportunities, and of course there are sectoral and geographical differences that can be leveraged.
Then there is private debt, where private capital is lent to businesses on flexible terms, filling a gap in the market and enabling SMEs to achieve their goals without the constraints of traditional bank lending. Often these are offered on higher interest rates, offsetting any risks to investors should base interest rates rise and providing a bigger cushion against inflation.
Commercial property is another area to watch right now, as the market is recovering strongly after the challenges of Covid, with both capital growth and income yield moving in the right direction, as we explained in another recent post. Not forgetting assets which are even less correlated to mainstream markets, such as third-party litigation funding, or that benefit from stock market dislocation, such as hedge funds.
Now more than ever, portfolios must contain appropriate weightings of different types of assets so that choppy waters in one area do not capsize the whole boat, and so that progress in terms of positive returns can continue to be made, whatever the weather. At a time when traditional norms and certainties are being well and truly put to the test, looking again at whether portfolio composition needs adjusting to take account of current conditions – and what part alternatives can play – is imperative. With high net worth individuals expected to increase their allocations to alternative assets by 70% by 2025 (according to Boston Consulting Group), it seems that many private investors are doing just that.
Claire Madden is Managing Partner at Connection Capital.