Why 2024 will be tough for 'alternative' investments

The last time interest rates were where they are today, more than 15 years ago, two-thirds of the investment trusts in the infrastructure sector and all of those in the renewable energy sector did not yet exist. For some of the vehicles private investors use to gain exposure to alternatives, the current environment is very much uncharted territory, and difficult to navigate at that.

The table belowshows how trusts investing in alternative asset classes have fared in the past two years. Performance was firmly negative for property and infrastructure in 2022 and 2023, while private equity recovered this year after a less than stellar 2022. As energy prices fall back, renewable energy and commodities did much worse this year than last.

For infrastructure and private equity, interest rates peaking should help stabilise valuations, but the investment case still looks less straightforward than it was when rates hovered near zero. Income-generating alternatives have to contend with enhanced competition from bonds, while growth assets, whether they are listed or unlisted, face a challenging environment. This broad summary appears to leaves alternatives in a fairly tight spot as we head into 2024, but share prices have already absorbed a lot of bad news.

Diversification wanted

Part of the rationale for holding alternatives has to do with diversifying away from the classic equity/bond portfolio. But the past two years have caused private investors to question how they get exposure to alternatives. 

Daniel​​​​ Lockyer, senior fund manager at Hawksmoor Fund Managers, notes: “Investment trusts are volatile. The underlying assets might be relatively safe and stable, as we've seen from infrastructure and some of the other assets, but the share price is volatile. I think it's harder to justify those as diversifying assets today.”

This scenario has been particularly striking for infrastructure, where discounts have widened considerably and share prices have revealed the true extent of their correlation with gilt yields. The chart compares the main infrastructure subsectors' 2023 net asset value returns and share price performance, highlighting just how wide the gap between the two is. Joseph Rowland, fund selection specialist at Investec Wealth & Investment, says the market “was surprised by the inherent interest rate sensitivity of certain assets such as infrastructure”. 

One vehicle that has been better at providing diversification in the past two years is hedge funds. “Certain hedge fund strategies should be able to profit from tougher, more volatile markets going forward,” Rowland says, pointing to BH Macro (BHMG) as an example. But they remain an expensive proposition and results across the sector have been very mixed this year, with currency also skewing performance data. BH Macro was down 21.9 per cent between the beginning of the year and 6 December in share price terms, partly due to the merger between Investec and Rathbones, which together own close to a third of the shares and are expected to cut back accordingly. The net asset value (NAV) has held up better, but the trust is now at a 12.9 per cent discount after trading at a lofty premium over the course of 2022. 

An infrastructure problem

Many investors bought infrastructure trusts for their dividends, but higher bond yields means these assets now face a tougher competition on this front. As of 5 December, the AIC infrastructure sector had an average yield of 6.1 per cent, renewable energy paid 7.1 per cent and 10-year gilt (UK government bond) yields were at 4 per cent. At the end of December 2021, those same yields were 4.3 per cent for infrastructure, 5.2 per cent for renewable energy and 1.3 per cent for gilts.

Bonds have had their own struggles in the past two years, but analysts are broadly optimistic about the asset class for 2024. Lockyer argues that while high-yield bonds are looking unattractive because spreads are lower than historic levels, active bond managers are finding attractive opportunities among investment-grade corporate bonds, yielding in the high single digits. “So our starting point is that alternatives have to offer more than, say, 8 or 9 per cent a year to justify owning something more complicated and less liquid than a vanilla global bond fund,” he says. 

It is not all doom and gloom for infrastructure, because the discounts on which they trade are seen by many as an opportunity. Mick Gilligan, head of managed portfolio services at Killik & Co, has looked at the discount rates used by infrastructure trusts for their valuations. The rate reflects the NAV return investors should get if everything goes according to plan. This can then be adjusted to account for the difference between the share price and the NAV, giving an estimate of the annual return on offer when investing at the current share price. 

The result is roughly 6.5 per cent for BBGI Global Infrastructure (BBGI), 8.5 per cent for International Public Partnerships (INPP), 8 per cent for HICL Infrastructure (HICL) and 11 per cent for 3i Infrastructure (3IN). “These returns are significantly more attractive than they were 18 months ago and are sufficiently attractive when compared to bonds, given their scope to rise with inflation over time,” he argues. 

Lockyer agrees that there are still opportunities in the sector, pointing to Greencoat UK Wind (UKW) as an example. “You're getting a very decent yield, plus inflation-linked growth on that dividend over the coming years. That's more attractive than, or as attractive as, bonds.” The dividend growth promise is ultimately the key advantage infrastructure has over fixed income. Even infrastructure dividends have struggled somewhat to keep up with high inflation recently, but they should fare better in the medium term as price growth normalises. 

There is also the hope that if interest rates start falling next year, infrastructure assets could stage a recovery – there were hints of this in November, when the AIC infrastructure and renewable energy sectors climbed by 8.1 and 6 per cent, respectively. 

But Stifel analysts are cautious on this point and still expect significant merger activity across alternative investment trusts rather than a uniform rebound. “We are not expecting a sudden knee-jerk upswing in share prices as the market starts to focus on falling interest rates,” they say. A lot of “damage” has been done to share prices and valuations of alternative trusts, they add, and “we suspect some previously supportive investors such as multi-asset funds will now take the view that some of these funds’ assets are not suited to listed structures”.

Some of the many infrastructure trusts that listed when interest rates were low might not survive a tougher environment. If some vehicles end up winding down and the assets are sold at NAV prices, this is not necessarily a bad outcome for investors, particularly given where discounts are at the moment – but it would mean a smaller sector in the future.

Private equity

Private equity is about capital growth and not income, so arguably doesn’t feel the competition from bonds quite as keenly. In addition, most private equity trusts have been in existence since before the 2008 financial crisis and have experienced high interest rates before.

But a high-rate environment is not ideal for private equity either, given managers often rely on high levels of debt and also have to contend with discount rates impacting valuations – although the specifics do vary depending on which private equity companies and areas you look at. Unlisted, early-stage companies can be expected to struggle in a recession.

Lockyer argues that ultimately, private equity is only attractive if you believe that it can outperform listed equity in the long term. Given where interest rates are, this is likely to be harder in the next decade than it was in the last, although listed equities are not expected to have the smoothest ride either.

While private equity trusts’ share prices had a decent 2023, discounts to NAV remain wide. “Higher borrowing costs are difficult to model as much of this debt will be at the underlying company level, rather than at the investment trust level,” Gilligan says. “It is another reason why, although private equity investment trust discounts may narrow over time from their current level of close to 40 per cent, they may struggle to tighten much below 20 per cent.”

Rowland says that while private equity does look risky in the current environment, you get paid for that risk. “I see an asymmetric risk on the upside, because a lot of the risk is priced in,” he notes, arguing that discounts to NAV act as a cushion against further falls. "We're looking for managers that have done the right things ahead of time, such as turning down their debt profiles and hedging the floating rate exposure, and for exposure to defensive sectors and business models, such as mission-critical tech or certain parts of healthcare."

More growth-focused areas of private equity, such as growth capital, are riskier in the current environment – although again a fall in interest rates could help. As of 5 December, the AIC’s growth capital sector was trading at an average discount of 50 per cent.

Overall, it’s a very mixed picture for alternatives. The environment remains challenging, what will happen to the economy and interest rates is inevitably hard to predict, and investment trusts are facing some structural issues of their own which hinder the narrowing of discounts. But there are reasons to hope that for some of these assets, 2024 will be a better year than 2023 was.