Alternatives: A portfolio diversifier

By Jayson Forrest

Frederick Pollock (GCM Grosvenor), Alexander Chambers (Wellington Management), and Kieran Canavan (Centric) believe there’s a lot to like about alternatives, particularly in multi-strategy portfolios.

There are some compelling reasons why advisers should consider an allocation to alternatives as part of their client portfolios. One of these reasons is the reduced expectations on traditional investment returns over the next decade — both defensive and growth asset classes.

According to Kieran Canavan — Founder and Chief Investment Officer at Centric — defensive assets are expected to deliver between 3-5 per cent per annum, whilst growth assets are forecasted to return between 5-8 per cent per annum. A balanced portfolio (60/40) is expected to deliver a return of around 5.7 per cent per annum over the next decade. He believes an allocation to alternatives can help boost an investor’s overall return on investment.

“There are also times when equities and bonds move in tandem, which happened in 2022,” says Kieran. He adds that in a scenario where equities and bonds become highly correlated, it’s important for portfolios to have an uncorrelated exposure to other assets, like alternatives

Speaking at the 2024 IMAP Independent Thought Conference, Kieran believes another reason why advisers should consider alternatives is for their diversification factor, which in a traditional 60/40 portfolio is particularly important considering the ongoing risk of recession.

In making the case for alternatives, Kieran says that as an asset class, alternatives have six key characteristics that managers and advisers can lean on when constructing portfolios. These are:

1. Alternatives are a distinct asset class.
   Alternative investments are those investments that do not fit the description of traditional assets, such as shares, property and fixed income.
   
   
2. Ability to short.
   Alternatives allow the manager to take both long and short positions across multiple markets and instruments, whereas a traditional investment allows the manager to take long only positions in a specific sector.
   
   
3. Absolute return focused.
   Alternatives are typically absolute return focused with a performance and volatility objective, rather than an objective to outperform a specific benchmark.
   
   
4. Portfolio diversifier.
   Alternative assets tend to have a lower correlation with major equity and bond markets (traditional asset classes).
   
   
5. Flexible strategies.
   They are flexible investments and typically not constrained by markets, strategies, securities or risk profiles.
   
   
6. Downside protection.
   Importantly, alternatives place great emphasis on low volatility and capital preservation (reduced market exposure).

According to Kieran, Centric is constantly seeking complementary strategies that improve the risk and return characteristics of client portfolios. However, he acknowledges the universe of alternative investments is vast and complex. This means managing an effective mandate in this ecosystem is very difficult, requiring significant resources and expertise.

To overcome these challenges and fulfil its own requirements, Findex established an advisory relationship with two global managers in the alternatives sector — GCM Grosvenor and Wellington Management. As alternative assets tend to have a low correlation with traditional asset classes, like equities and bonds, Findex works closely with these investment specialists to develop uncorrelated strategies.

“We look at alternatives from a macro level, both from a Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) perspective. For us, it’s about getting the right balance in our portfolios by tapping into the diversification benefits of alternatives. So, getting investment specialists to manage that for us in such a complex environment was critical,” says Kieran.

“SAA is our medium-term anchor, which we last reset in October 2021 for a rising rate environment. And we also look at TAA. From a tactical perspective, when we’re dealing in alternatives, very often they are less liquid. We’ve managed to get both of our programs to monthly liquid alternative investments (alts), which wasn’t easy to do, but it can be done.

“We typically do quarterly rebalancing. However, because alternatives tend not to be as volatile as equities and bonds, we don’t rebalance them throughout the year. We have quite a wide range in alts. However, we have changed the range of alts to about 30 per cent in a balanced portfolio, where typically we would allocate to about 20 per cent and then leave 10 per cent to either run the alts allocation up or come down as necessary.”

Frederick Pollock — Chief Investment Officer at GCM Grosvenor — agrees the alternatives universe is extensive, and believes it is advantageous for advice groups to work closely with specialist managers in this space.

Sitting within the alternatives space are absolute return strategies, which he refers to as “code for hedge funds”. In recent years, the absolute return approach to fund investing has become one of the fastest-growing investment products in the world.

“The term ‘hedge funds’ hasn’t marketed well for about 25 years, so now they’re often referred to as absolute return strategies. The fastest growing category in the absolute return strategies space are ‘multi-managers’ — both hedged and unhedged.”

When Wellington Management thinks about building multi-strategy portfolios, it starts with defining what clients want. According to Alexander Chambers — Vice President and Director of Alternatives, Hedge Funds APAC at Wellington Management — there are a couple of key objectives the manager wants to achieve for its clients.

“Firstly, we want to generate positive returns in a way that’s stable and consistent. Secondly, we want to build portfolios that are diversified, with low beta to equities and credit, with assets that are complementary to other investments in the portfolio. And thirdly, it’s important to have downside protection, which enables us to withstand equity stresses and market volatility.”

Alexander believes this is currently the most exciting time he has seen post-GFC for long/short investing and to be in multi-strategy portfolios. He bases this opinion on what he calls the three ‘Ds’ — divergent, dispersion, and disruption.

“In terms of divergence, the global economies today are all moving in different ways with different monetary and fiscal policies. This year, we’ve already seen the U.S. and Europe cutting rates, and Japan raising rates, which shows that economies are diverging. We think that’s great for long/short investing,” he says.

“Dispersion is back. There is a higher cost of funding. Stock pickers in the long/short space are very excited that some companies’ share prices are moving on fundamentals. And in terms of disruption, we’re seeing big mega trends in global innovation and technology advancements, like artificial intelligence (AI). This is also providing great long/short opportunities.” 

And what about mega trends like AI? How are managers using AI to acquire additional market insights and help build portfolios to better withstand different market environments?

Frederick concedes that the use of AI in the industry is complicated. He says people have been using machine learning and other advanced ways of collecting data and building models for some time.

“AI is the next evolution of machine learning,” he says. “Everyone trading stocks and credit are trying to figure out AI, but I haven’t yet seen anyone do anything particularly smart with AI and make money out of it. A lot of capital is being spent on AI to try and create models around it and to enable companies to be at the cutting-edge with its use.

“However, it’s still early days. There’s no doubt the development of this technology will improve and be taken up by more businesses.”

When it comes to AI, Wellington is trading the theme, but it’s also interested in how it can embrace the technology to improve its own business efficiency. “Where we aim to take advantage of AI is to look for the winners and losers in this space, rather than actually use it for model portfolios,” says Alexander.

Frederick Pollock is Chief Investment Officer at GCM Grosvenor; and

Alexander Chambers is Vice President and Director of Alternatives, Hedge Funds APAC at Wellington Management.

They were part of a panel discussion on Growth Alternatives at the 2024 IMAP Independent Thought Conference in Sydney.

The session was moderated by Kieran Canavan — Founder and Chief Investment Officer at Centric.