By Jayson Forrest
Lachlan Brumby (Russell Investments) and Jason Petras (Resonant) consider the benefits of alternatives from a risk-return perspective, including the strategies that may perform well in the current high interest rate environment.
Lachlan Brumby
Russell Investments
Jason Petras
Resonant
Paul Saliba
SQM Research
The increase in interest rates over the last 18 months, which has been driven by inflation, has essentially resulted in higher volatility in many asset classes, causing market dislocation. However, trading-based alternatives, like hedge funds, thrive under these types of conditions. From that perspective, we think the opportunities for active managers across the whole spectrum, particularly within alternatives, should only be getting better
As investments, alternatives represent a broad bucket, ranging from private equity and private credit, through to venture capital, unlisted infrastructure, and hedge funds. There are primarily four main reasons why an investor would want an exposure to alternatives in their portfolio: for income, for growth, for risk diversification, and as an inflation hedge.
In the current economic environment, where the official cash rate in Australia has increased from near zero to 4.35 per cent (May 2024), Jason Petras — Director, Investments at Resonant — believes this higher inflationary environment is ideal for many alternatives within a portfolio.
“The increase in interest rates over the last 18 months, which has been driven by inflation, has essentially resulted in higher volatility in many asset classes, causing market dislocation. However, trading-based alternatives, like hedge funds, thrive under these types of conditions,” says Jason. “From that perspective, we think the opportunities for active managers across the whole spectrum, particularly within alternatives, should only be getting better.”
In addressing an IMAP webinar on ‘alternatives in portfolio management’, Jason believes that from an absolute-return point of view, the likes of active hedge funds are heading into a “richer hunting environment for what they do”.
It’s a view shared by Lachlan Brumby — Senior Portfolio Analyst at Russell Investments — who adds that commodities are also interesting, and not just because interest rates are now higher, but because of the current macro economic environment.
He also likes unlisted property and unlisted infrastructure in the current environment. “What we’ve seen play out with these asset classes over the last year, especially as rates increased, is the need to get an expansion in the capitalisation rate. That has been a headwind for some of the valuations of these assets,” says Lachlan.
“However, some of these assets with very high occupancy rates have been able to grow their rental income, particularly some of the office buildings that have high ESG credentials. This has helped to dampen some of the capitalisation rate offset that would otherwise have to be entirely driven by property devaluation.”
Some of these assets with very high occupancy rates have been able to grow their rental income, particularly some of the office buildings that have high ESG credentials. This has helped to dampen some of the capitalisation rate offset that would otherwise have to be entirely driven by property devaluation
And what about gold?
With inflation cooling but remaining sticky, gold has done particularly well, even with bond yields increasing year-to-date. One of the drivers for that has been the buying up of gold by banks as an offset against market and geopolitical volatility.
“Gold can also be an interesting diversifier in a portfolio, particularly in the current environment,” says Lachlan. “We have gold in our portfolio as a hedge. We have seen client interest in gold increase, along with other precious metals, like silver.”
According to Jason, gold has been a position Resonant has been holding in many of its portfolios, including its headline portfolios, for quite some time now. However, he adds that where gold can become tricky with certain portfolios is when investors have an income or yield focus. In that type of scenario, Resonant will move to Treasury bills or a short-dated instrument within the fixed income market.
“However, that approach can be quite reactive because you don’t have as much protection in the portfolio against scenarios like long-term high inflation or hyper inflation. Obviously, there is a floor to where interest rates can get cut to — zero per cent — whereas gold has the ability to keep going. So, gold is a powerful hedge. We’re big advocates of gold and don’t anticipate reducing that any time soon, given the inflation environment we’re dealing with.”
We definitely believe there are liquidity profiles in these funds that you need to fully understand. It’s essential to understand that if there were issues within this structure, then what are the rules around redemptions and what sort of gating mechanisms does this vehicle have? You then need to factor these into a worst case scenario to understand how this may impact your investment profile
Portfolio management
Resonant seeks to have the flexibility within a mandate to move between defensive and growth alternatives in a portfolio. Jason says Resonant looks at alternatives as alternatives, and doesn’t try to bucket them as a defensive/growth mix.
“For us, it comes back to what is the purpose you’re looking to achieve by having an allocation to alternatives. Is it about having an absolute-return focus? Is it about building defence within the portfolio, or is it an outright hedge you’re looking to achieve? We don’t think there is a right answer to this, because everyone is going to have a different objective within their strategies,” says Jason.
Brendan believes it’s important to look at how alternatives work in different scenarios, both in isolation and within a multi-asset portfolio. He says it’s important to consider the purpose of the alternatives exposure you’re looking for — income, growth, risk diversification, or inflation hedging — and how it performs.
And when it comes to portfolio liquidity, Jason confirms that within Resonant’s SMAs, they generally use funds (or instruments) with daily liquidity. However, he acknowledges that there are situations where Resonant will be working with a group that uses the SMA as a core, with satellites around it, which may include alternatives — anything from private equity through to structured products.
“Within an MDA or managed accounts structure, you have the ability to position ‘alt’ satellites around your core. The flexibility, technology and availability of investments are all there to enable that to happen,” says Jason.
However, he cautions that if you do actually run too many illiquid investments within an SMA or to a level that capital becomes locked, you actually run the risk of having to deconstruct the entire SMA. That’s because rebalancing a portfolio with too many illiquids is very difficult. “You could argue that if you’ve got a part of the SMA that can’t be liquidated, then the rest of the SMA can’t be liquidated. So, managing the liquidity profile of your different underlying assets in a smart way is very important.”
Importantly, Lachlan believes that if the investor is taking on illiquidity risk, then the adviser needs to have a deep understanding of their client’s appetite and need for the particular illiquid strategy they are investing into. He also acknowledges that not all platforms can accommodate assets in investment models that don’t have daily liquidity. That’s why Russell’s multi-asset managed portfolio enables investors to gain exposure to some alternatives with less liquidity, but in such a way they are not personally giving up all their liquidity.
There are many things to consider with private credit in order to get a deeper understanding of what the product is like and what the risks of the product look like. Importantly, you need to be comfortable with the experience and skillset of the team managing the fund
Private credit
With an increasing number of private credit funds coming to market, Jason believes this is a space advisers need to be aware of. However, given the illiquid nature of private credit funds, Jason says these funds wouldn’t be something Resonant would put in its SMA.
“For us, track record is an important consideration in understanding how long the manager has been doing that type of strategy. We find that there are quite a few managers that haven’t been through a full cycle, so you really need to take a close look at the manager,” says Jason.
“We definitely believe there are liquidity profiles in these funds that you need to fully understand. It’s essential to understand that if there were issues within this structure, then what are the rules around redemptions and what sort of gating mechanisms does this vehicle have? You then need to factor these into a worst case scenario to understand how this may impact your investment profile.”
Lachlan adds that advisers need to recognise there are different private credit strategies with quite different objectives, like lending to distressed corporates, mezzanine financing, or lending to the middle market.
He says there are a number of issues to consider when investing in private credit, such as:
- How many underlying credits are in the portfolio;
- What sort of yield is the fund trying to generate;
- * What are the underlying corporates the fund is lending to;
- What does the leverage look like of those corporates; and
- What are the sector exposures of the corporates.
There are many things to consider with private credit in order to get a deeper understanding of what the product is like and what the risks of the product look like,” he says. “Importantly, you need to be comfortable with the experience and skillset of the team managing the fund.”
About
Russel Pillemer is Chief Executive Officer at Pengana Capital; and
Zivan Wong is Portfolio Manager, Private Equity at MLC.
They spoke on ‘Private markets’ as part of an IMAP Specialist Webinar Series on ‘Investing outside the mainstream’.
The session was moderated by Paul Saliba — Sector Head Equities and Fixed Income at SQM Research