Financial markets this year have lurched from one bout of volatility to the next. The war in Ukraine; soaring inflation; higher interest rates; and now fears of recession have, for most investors, been disastrous for portfolios.
Equity markets had their worst start to a year in decades, impacted by both higher discount rates – a key component used to value the future cashflows of a company – as interest rates increased, and also by growing recession risks.
Bonds offered little in the way of diversification with rising bond yields resulting in falling bond prices in tandem with stock prices.
Clearly traditional asset classes haven’t been up to the task of protecting investors as we emerge from a decades-long benign investment environment. Classic investment strategies, such as the 60% equity - 40% bond portfolio, have been found wanting (see Chart 1).
Chart 1: Sharp change in fortunes for the 60/40 portfolio after long period of strong performance
Source: Bloomberg, August 2022.
MSCI World Total Return
World Government Bond Index Total Return*
Monthly rebalanced, 60/40 portfolio Total Return
*WGBI = World Government Bond Index Total Return from 30/9/1989 - 28/6/2019, then Barclays Global Agg Treasuries Total Return Index (all hedged to USD)
For illustrative purposes only. No assumptions regarding future performance should be made. Past performance is not a guide to future results.
For some time now, we’ve seen less value in many traditional asset classes. Instead, we’ve allocated capital to a much broader range of asset classes, including alternatives.
Alternatives encompass a range of assets which offer differing risk-and-return characteristics and often genuine diversification benefits.
Some of our preferred alternative asset classes include infrastructure, certain areas of the property market, asset-backed securities and niche areas such as litigation finance, music royalties and healthcare royalties.
This year a number of these have provided meaningful diversification benefits for investors. Here’s a deeper dive into each one:
Alternative asset classes that have provided diversification this year
- Infrastructure. Includes renewables, social and economic infrastructure assets. These assets have offered an attractive level of income, inflation-linked cashflows and often limited sensitivity to economic cycles. Investors have benefited from the high and stable income and inflation linkage in the current environment. Renewables have had a particularly good 2022 with soaring power prices supporting performance.
- Specialist property. While property as an asset class has not escaped some of the turmoil faced by traditional asset classes, some more specialist areas of the property market have been more resilient e.g. student accommodation, healthcare assets and residential housing assets. These tend to be less impacted by changes in the macroeconomic environment and have varying degrees of inflation linkage.
- Asset-backed securities (ABS). Securities backed by pools of assets such as mortgages or corporate loans, are floating rate in nature and therefore benefit from rising interest rates which negatively impacted most other areas of fixed income.
More recently, however, prices have moved in sympathy with broader markets as investor focus pivoted from inflation to recession. However, the structural hedge provided by ABS against default gives us comfort in its long-term return prospects.
- Special opportunities. Investments which often have idiosyncratic return drivers or are specialist in nature. As would be expected, our allocations have not all followed the same path this year reflecting the broad array of fundamental drivers.
For example, our litigation finance investment is driven by the outcome of litigation cases rather than inflation, recession or war. Investments including music royalties and debt backed by drug royalties have again not been impacted by inflation or rising rates.
Our precious metals royalties provided diversification during the flight to safety brought on by Russia’s invasion of Ukraine, but they have been impacted by lower precious metals prices more recently.
Our long-term outlook for the global economy and financial markets remains clouded by the risks posed by recession, inflation and the response of the world’s central banks.
While we expect inflation to moderate in the medium term, there’s a significant risk of prolonged higher inflation for some time.
At the same time, we remain concerned that the actions taken by central bankers to tame inflation could result in a recession.
Therefore, bonds alone may continue to offer less diversification benefits than during earlier periods of equity market stress.
Will alternatives keep performing?
Our preference continues to be for asset classes where returns are long term in nature, sustainable across an economic cycle and often come with a natural income.
In addition, asset classes with limited sensitivity to economic cycles and built-in hedges against inflation will continue to be highly desirable.
Many of our alternative asset classes have these positive attributes. While each alternative asset class has its own risks, we believe these can continue to generate attractive long-term returns and provide diversification benefits.
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
Diversification does not ensure a profit or protect against a loss in a declining market.
Investments in asset backed and mortgage backed securities include additional risks that investors should be aware which include those associated with fixed income securities, as well as increased susceptibility to adverse economic developments.