The role of alternatives in portfolios

By Jayson Forrest

Emily Barlow (Perpetual Private) and Russel Pillemer (Pengana Capital) discuss how private markets and illiquid assets can fit into a portfolio.

Lukasz de Pourbaix (Fidelity International) explains why investors should consider contrarian strategies in a portfolio.
Emily Barlow, CFA is Investment Director, Senior Living and NFP at Perpetual Private
Emily Barlow, CFA i- Perpetual Private
Matt O’Neill - Senior Analyst at Drummond Capital Partners.
Matt O’Neill - Drummond Capital Partners.
Russel Pillemer is Chief Executive Officer at Pengana Capital
Russel Pillemer - Pengana Capital

Alternatives can play a number of different roles within client portfolios, making it essential for advisers to properly define the objectives they are looking to achieve with their portfolio, including the role played by alternatives in meeting those objectives.

However, Emily Barlow, CFA — Investment Director, Senior Living and NFP at Perpetual Private — cautions that investors typically have different views on alternatives. She says when looking at different strategic asset allocations, investors define alternatives in various ways and allocate them differently within a portfolio.

Perpetual Private splits its alternatives into growth and defensive buckets, as they both play very distinctive roles within client portfolios. “It allows us to blend those two buckets differently, depending on the client’s objectives,” says Emily.

Speaking at the 2024 IMAP Portfolio Management Conference in Melbourne, Emily says in relation to portfolio construction, Perpetual looks at both the growth and defensive parts of the portfolio from a total portfolio perspective.

In terms of growth alternatives, Perpetual looks for a total return throughout the market cycle, comprising of income and capital growth. Within the growth bucket, it looks at private equity, infrastructure, property, and hedge funds. In contrast, with its defensive alternatives, Perpetual is looking for income. This is predominantly made up of private credit, but there is also some allocation to core real estate.

You do not want to diversify your portfolios too much, because what you’ll find is those portfolios will start to look more like listed portfolios and become more correlated. So, all you’re doing is building complexity and cost into part of your portfolio, without actually getting the risk and return benefits you’re looking for from an asset class

Emily Barlow, CFA

Key tenets to an alternatives program

When allocating to alternatives, Emily says Perpetual Private is seeking a smooth journey for client portfolios. This means the alternatives used need to have a low correlation to traditional asset classes and ideally, a negative correlation during periods of downside for equities and bonds.

However, before allocating to alternatives, she believes advisers should carefully consider the following five key questions as part of the portfolio construction process. These are:

1. What is the market opportunity and how will alpha be generated and sustained versus listed markets?

For example, is there a thematic you’re able to access through alternatives that you’re unable to access otherwise, like Australia’s ageing population. Can these structural themes be accessed through assets like infrastructure?

2. Are the return drivers different to traditional asset classes?

Within alternatives, investors are looking to access idiosyncratic risk, says Emily. “You do not want to diversify your portfolios too much, because what you’ll find is those portfolios will start to look more like listed portfolios and become more correlated. So, all you’re doing is building complexity and cost into part of your portfolio, without actually getting the risk and return benefits you’re looking for from an asset class.”

3. Can you get access to manager insights to enable better-informed investment decisions?

It’s important for advisers to have good relations with the managers they invest with. Not only does it make investment due diligence easier, but if something does go wrong with a portfolio, advisers are able to access the insights they need to be able to explain any issues, like performance, to clients.

4. Can you capture an illiquidity and complexity premium?

Alternatives are a complex and expensive asset class, so investors need to make sure they are getting compensated from a risk-return perspective, when compared to traditional asset classes. 

5. What are the liquidity, fee and hedging implications at the total portfolio level?

“Do you need to make adjustments elsewhere in the portfolio to compensate for the fact that maybe you have slightly different hedging within your alternatives and slightly more expensive assets,” says Emily.

“There is clearly an opportunity to allocate to alternatives,” she says. “Governance and manager selection is important when allocating to alternatives. If you get it wrong and allocate to a strategy that doesn’t perform well, you’re typically stuck there. So, you need to make sure you get the manager selection right.”

Provided you’ve got a couple of months to work through a situation, private credit can actually be reasonably liquid. The reason is because private credit loans are quite expensive for borrowers, they tend to be paid back quickly.

Russel Pillemer

Global private credit

Ask Russel Pillemer — Chief Executive Officer at Pengana Capital — for his views on private credit and he’ll tell you that it’s only a matter of time before the global private credit “revolution” reaches the shores of Australia. Once that happens, he believes this asset class will become a fundamental component of managed accounts.

Russel’s confidence comes from looking at overseas trends, where sophisticated investors — like  large family offices, sovereign wealth funds, and pension funds — are allocating to global private credit as a meaningful part of their portfolios.

“For these investors, global private credit is not seen as a small allocation to alternatives but instead, as a fundamental allocation,” he says. “Large family offices are allocating approximately 20-30 per cent of their portfolios to this asset class. This is driven by the fact that the risk-return trade-off in this segment is so compelling. You can essentially get a double-digit return with low risk and low volatility. ”  

According to Russel, global private credit encompasses a broad subset of the market, ranging from syndicated loans through to distressed debt, venture debt and other specialised parts of the market. However, Pengana Capital considers bilateral loans to the mid-market (corporations with valuations of $500 million to several billion dollars) as being the ‘sweetest spot’ in the market.

“Bilateral loans are loans where the private credit provider steps into the place of a bank, and essentially provides a one-stop solution to the corporation for its capital requirements,” says Russel. “Generally, the types of companies sitting in the mid-market space do not go bust. So, there’s a very low chance of losing your capital with this type of lending. These loans also have very low volatility associated with them, which makes it a compelling asset class.”

Russel believes when investing in private credit, diversification is key. He says this can be obtained via a fund of funds model, where advisers can get access to some of the best managers in the marketplace.

“Ideally, you want a portfolio with several hundred, if not a couple of thousand, underlying loans. By doing so, you diversify the risk across a range of areas, like manager risk, sector risk,  geographical risk, and industry/sector risk.”

For advisers considering global private credit as part of a portfolio allocation, Russel believes the structure that makes the most sense for investors is a listed structure, which makes it easier to implement into portfolios. However, he concedes there are two fundamental issues with that type of structure.

The first issue is the discount to Net Asset Value (NAV). Advisers need a mechanism in the structure to ensure that the asset does not trade at a discount to NAV. And secondly, as these are global exposures, they need to be hedged back into Australian dollars, which is difficult to do.

Governance and manager selection is important when allocating to alternatives. If you get it wrong and allocate to a strategy that doesn’t perform well, you’re typically stuck there. So, you need to make sure you get the manager selection right

Emily Barlow, CFA

Diversification and liquidity

Thinking about diversification and liquidity when allocating to alternatives, Emily believes advisers should consider alternatives from a total portfolio perspective. She says advisers shouldn’t use alternatives as part of the portfolio that provides liquidity. If they do require liquidity, they shouldn’t be invested in illiquid alternatives.

“From a liquidity perspective, alternatives can be difficult to manage,” says Emily. “If you have multiple clients, you have to manage capital calls, ideally from a private equity perspective. So, you want to use a structure that enables that, because managing capital calls across a pool of clients is complex.”

Perpetual has approached this by creating funds with both growth and defensive buckets, which enables it to manage liquidity through more liquid parts of the portfolio. This means advisers don’t have to worry about managing capital calls. 

Russel considers private credit as a separate asset class and therefore, believes it should not be used as part of the alternatives bucket. That’s because private credit has certain liquidity dynamics that are quite different to other alternatives, like private equity.

“Provided you’ve got a couple of months to work through a situation, private credit can actually be reasonably liquid,” says Russel. “The reason is because private credit loans are quite expensive for borrowers, they tend to be paid back quickly.”


It’s about finding appropriate investments that can allow you to invest more of your portfolio into private investments (like private equity and private credit), while being confident that your portfolio is manageable. That’s where the game is going to be played out

Russel Pillemer

Future direction

Looking ahead, Emily is bullish about the future for alternatives. She believes the appetite by investors for responsible investing will continue to increase. And although alternatives have generally been put in the ‘too hard’ basket for responsible investing, Emily thinks that will change. She points to more managers focusing on providing better data and greater transparency of their holdings, particularly around aspects of ESG, like carbon emissions and corporate advocacy. This trend will increasingly open up responsible investing to the alternatives asset class.

“I also believe artificial intelligence will play a role within private markets.” says Emily. “Whilst I can’t see anytime soon where AI will replicate the risk-return profile to create easy and cheap versions of these funds, I do think AI will feed into the overall portfolio management process. That will help with data and transparency, and perhaps improve a manager’s processes to reduce its costs and fees.”

According to Russel, investing in private markets, which are growing much faster that listed markets, is really where the game is being played today. He says investors can get better risk-returns from investing in private markets than listed markets.

“Investors should be increasingly investing more in private markets but it’s up to managers and allocators to provide the solutions that make this feasible for investors,” says Russel.

“It’s about finding appropriate investments that can allow you to invest more of your portfolio into private investments (like private equity and private credit), while being confident that your portfolio is manageable. That’s where the game is going to be played out.”

About

Emily Barlow, CFA is Investment Director, Senior Living and NFP at Perpetual Private; and

Russel Pillemer is Chief Executive Officer at Pengana Capital.

They spoke on the topic ‘The role of alternatives in portfolios’ at the 2024 IMAP Portfolio Management Conference in Melbourne.

The session was moderated by Matt O’Neill — Senior Analyst at Drummond Capital Partners.


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