The shifting case for alternatives

The likes of infrastructure and private equity have enjoyed an impressive growth spurt in the past few years, fuelled by investors seeking better returns and diversification.

This trend evolved in the context of low interest rates and a hunger for growth assets, which as of 2022 is no more. Indeed, the changing investment landscape arguably calls into question both the returns and the diversification arguments used by advocates of alternatives.

So while alternative assets very much still have a role to play in a portfolio, the investment case has shifted, and investors might want to rethink which assets they want to hold and why.

Growth slowdown

In 2011, roughly $693bn (£565bn) worth of private capital assets were managed in Europe, according to Preqin data. Ten years later, the figure was $2.2tn (£1.8bn). A significant portion of that growth has taken place in the last three years, with an annualised growth rate of 17.3 per cent between 2018 and 2021.

That growth was fuelled by low interest rates, and while it's improbable that the likes of institutional investors fully scrap their allocations, there are signs that the rush might be slowing down. Preqin forecasts that the growth rate of private assets under management in Europe will decrease to 10.9 per cent a year between 2021 and 2027. 

But institutional investors have also been snapping up a different type of alternative asset – infrastructure assets – at a similar rate over the past decade. As these assets are less racy and have inflation-linking features, their own growth rates might prove more resilient in the years ahead.

But there is one type of institution that is rethinking exposure to both kinds of alternatives: defined benefit pension schemes. After the September 2022 'mini' Budget resulted in a sudden jump in gilt yields, schemes' liability-driven investment (LDI) portfolios faced significant margin calls on their hedges and other derivative positions. The ensuing rush to sell assets to meet these calls not only hurt the gilt market but in some cases encompassed more illiquid holdings, with private equity assets reportedly ending up on the market at discounted prices. 

Linda McAleer, senior investment research consultant at Hymans Robertson, says that once pension funds have ensured they have appropriate collateral and liquidity arrangements in place, they will be looking to review their investment strategy in the first part of 2023.

Pension schemes targeting higher returns might still be keen on assets such as infrastructure or private debt, but much will depend on liquidity levels, and “realistically, it would not be surprising to see a lower allocation than may have been the case prior to September 2022”, she says.

The correlation question

A long-standing argument for holding alternatives goes that their performance is uncorrelated to that of liquid markets. This year has proven that, while not necessarily incorrect, that theory could do with some fine tuning.

For retail investors, the best and most convenient way to approach alternatives is through investment trusts. But trusts' share prices can move in line with risk assets. As the chart below shows, correlation varies across asset classes, but this year infrastructure, private equity and commercial property investment trusts have at least partly mimicked the ups and downs of the equity market. Hedge funds, on the other hand, have been more insulated and performed better than other alternatives – although they remain an expensive investment proposition and there is no guarantee that their positive streak will continue.

“In risk-off environments, investment trusts can be volatile, discounts can blow out, and although you may have an uncorrelated asset at the underlying level, you are owning what is effectively an equity small cap,” says Ben​ Mackie, fund manager at Hawksmoor Asset Management. In the longer term, the performance of the underlying net asset value (NAV) should shine through, but that does not mean that you will not get some equity-correlated volatility in the meanwhile.

Additionally, many alternative assets have shown this year that they do in fact have a degree of correlation with interest rates. Higher interest rates can be bad news for alternatives in two key ways: one, because of their impact on asset valuations; two, because of the leverage built into some of these assets.

For real assets such as property and infrastructure, higher interest rates mean higher discount rates and lower the value of future cash flows. This can have a negative impact on the NAV of an investment trust, something the market has been much concerned about.

The actual effect depends on how much breathing space investment trusts have between their risk-free rate (the yield of a relevant low-risk asset such as a government bond) and the discount rates they use. Infrastructure trusts are in a much better position than property trusts from this point of view, and for the former the impact has been offset by the positive effect on their inflation-linked assets.

As for private equity, asset valuations are typically based on stock market multiples for comparable listed companies. With investors retreating towards lower-risk assets and equities suffering, private equity assets are also expected to take a hit when year-end valuations are released – although perhaps not as bad as the current discount levels of private equity investment trusts would imply.

In its 2023 global outlook, BlackRock mentions valuations as a key reason for being bearish on private markets. “In private markets, valuations have not caught up with the public market sell-off, reducing their relative appeal. We are underweight private markets in our strategic views, particularly segments such as private equity that have seen heavy inflows,” the outlook reads.

Alternative investment trusts have to contend with various degrees of debt, either at the trust level (gearing) or at the portfolio level. Looking at a trust’s debt levels, at the type of that it holds (floating or fixed rate); considering potential refinancing risks can help avoid nasty surprises. Once again, property trusts are the ones that have suffered the most from refinancing issues in the past.

An edge on bonds?

Alternatives have lost some of the yield advantage they previously had over fixed income, with rates on the latter starting to look attractive again to some. Investors in private markets are meant to be able to receive higher yields in return for the higher risk and illiquidity of the underlying assets (the so-called ‘illiquidity premium’), but the gap is starting to close.

As at 31 October, the Association of Investment Companies' infrastructure sector was yielding 5.1 per cent, while renewable energy infrastructure was at 5.4 per cent and UK commercial property at 6 per cent. Private equity is a more growth focused asset class, but the private equity investment trusts that pay a dividend are also around 4-5 per cent. Growth capital, hedge funds and private equity funds of funds typically do not pay dividends at all. 

Meanwhile, UK 10-year gilt yields have been hovering above the 3 per cent mark, and the S&P International Corporate Bond Index offered a 4.2 per cent yield as of December 1 2022.

Hawksmoor Asset Management is among those that have reduced alternatives exposure in favour of bonds. “When the return prospects from a vanilla asset like corporate bonds improve as much as they have done in the last year, it's completely right that investors should be thinking about increasing allocations to those areas,” says Mackie.

Hawksmoor has not “thrown the baby out with the bath water” and still holds some alternative trusts, for example in the energy storage and digital infrastructure spaces – but has taken a more “selective” approach, Mackie says, targeting assets that promise to achieve capital growth while also generating income, with a focus on total returns.

The ability to do both makes some alternatives more attractive than traditional fixed income, argues Lucy Coutts, investment director at JM Finn. Somebody with a relatively low risk appetite can get about 4 per cent from an investment grade bond, which is a real term loss in the current inflationary environment.

Coutts’ personal view is that inflation “is going to be more sticky than the market thinks” and may linger well after interest rates peak. If that is the case, conventional bonds might not necessarily be the best place to invest, as they do not tend to do well in inflationary environments – unlike alternative asset classes such as infrastructure that have inflation-linkage built into their revenues.

A further point to make is that alternative investment trusts have the ability to grow their dividends. “The thing about bonds is that you don't get any income growth,” adds James Carthew, head of investment company research at QuotedData. “You could cope with an alternative asset on a lower yield than a bond, if you thought you would end up with dividend growth that would outstrip it in time.”

For alternative investors looking to combine income and capital growth, it all comes back to looking at the long-term trends. For example, Coutts notes that there is going to be significant infrastructure spending across the world over the next few years and adds that the energy transition “is something I think investors would find hard to ignore”.

Energy infrastructure will be especially important in Europe as the continent strives to wean itself off Russian fossil fuels. Between 2021 and 2027, Preqin forecasts that Europe-focused infrastructure will see the highest compounded annual growth rate in its assets under management of all major global regions, at 17.8 per cent. Natural resources are expected to grow more than in 2018-2021.

Overall, alternatives can still offer diversification, inflation-linking features and better total returns than bonds. But investors should make sure they have carefully selected the assets they hold in their portfolios, and in some cases brace for some short-term pain.

Return to: Where to invest in 2023