Traditional asset allocation no longer provides sufficient diversification; an alternate approach is necessary
Chief Investment Office 2 Mar 2022
- After years of easy monetary policy & low yields, investors are looking elsewhere for higher returns
- The relative calm in the PE universe amid the pandemic makes it an attractive asset class
- Good track record with manageable default rates in private debt markets offer credible yield options
- Myriad of strategies in hedge funds allows investors to achieve targeted risk-return objectives
It has been years since the notion of alternatives as a mainstay of asset allocation gained acceptance in the investment world. Unsurprisingly so. Research has shown that alternatives help enhance returns, provide diversification and reduce risks.
Rising interest in alternatives among portfolio allocators has seen assets under management (AUM) grow from USD4.1t in 2010 to USD10.8t in 2019. And the robust momentum continues. According to Preqin, assets are slated to reach USD17.2t by 2025 as investors seek to venture beyond traditional asset classes.
Today, alternatives can no longer be perceived as a “satellite” investment given that its market size is broadly equivalent to the market cap of European equities or Japan/UK equities combined. Alternatives should, and will, constitute a significant segment of strategic asset allocation.
What is driving investors towards alternatives? Years of monetary accommodation by global central banks, coupled with technological disruption globally, have resulted in bond yields staying structurally low. More importantly, bonds are also becoming increasingly correlated with risk assets. These factors suggest that bonds are no longer as effective for diversification as compared to yesteryears. This, inevitably, has resulted in investors looking for other avenues in the alternatives space.
According to the Callen Institute, a supposedly “well diversified” investment portfolio consisting of 60% equities and 40% bonds would possess 99.85% equity risk concentration. However, when alternatives like real estate, high yield bonds, and hedge funds are added, the equity risk concentration falls to 79%. These findings suggest traditional asset allocation no longer provides sufficient diversification for investors and an alternate approach is necessary.
What do investors look for in alternatives? According to a survey conducted by InvestNews, the main reason for investors to allocate more assets to alternatives is for the purpose of diversification (at 66%). To incorporate alternatives into traditional asset allocation, a “factor approach” is utilised to analyse risk assets (both traditional and alternative) as this allows evaluation to be made on a common basis.
In general, investors allocate capital to alternatives for the following reasons:
- Growth Enhancement
- Income Enhancement
- Diversification
The demand for alternative assets is set to rise as the asset class goes mainstream. According to Preqin, the number of investors allocating funds to alternatives has grown from 3,500 in 2008 to 11,000 by 2018 – an increase of 214%. The momentum is slated to stay strong in coming years.