Why aren’t investors eating their free lunch?
Diversification can lead to better investment outcomes, and listed alternatives can help embed this principle in portfolios.
The investment world is full of truisms, pearls of wisdom concealed within a dull shell. Some are trading maxims, like ‘buy low, sell high’. Some bear a Nobel laureate’s stamp of authority, like Harry Markowitz’s claim that diversification is ‘the only free lunch’ for investors.
These all make intuitive sense, but they don’t really tell us much. How do we know whether a price is low or high, for example? What makes a portfolio diversified?
As asset allocators, we have plenty of metrics to inform our answer to the first question about valuations. There is no consensus about the second, however.
Most investors, of course, agree that diversification is a minimum requirement for a multi-asset portfolio: blending together the different performance profiles of different assets should result in improved risk/reward outcomes due to the lower overall volatility in the portfolio.
But what specific assets, in what combination, help us achieve this? Some commonly accepted standards have emerged through time: portfolios shouldn’t be significantly overweight single securities, single geographies, or single sectors; and they shouldn’t rely on equities alone for growth.
Pass the alts
Those guidelines give us solid foundations for building a diversified portfolio, but we would argue that just as important as diversifying across traditional asset classes is diversifying into alternative asset classes.
Within these alternative categories, we consider a host of assets: high-yield bonds, property, infrastructure, emerging-market debt, and many more.
Accessing some of these alternative assets can be relatively straightforward: exposure to various alternative credit markets, such as global high yield and emerging-market debt, is now available through index or actively managed funds. Others – notably direct real assets like property, infrastructure, and farmland or forestry – are less accessible.
We are certainly not alone in appreciating the value of such diversifying assets. We can use the Pension Protection Fund, for instance, as an example for a well managed, sophisticated institutional portfolio. The fund’s most recent annual report revealed that it had invested significant parts of its portfolio across private equity, property, infrastructure, timberland and farmland, and non-government and non-corporate debt. Once we strip out its liability hedges, we see how its return-seeking portfolio has allocated significantly to alternative credit (20%) and other alternatives (26%), while limiting the allocation to standard equities (21%).
We have seen similar portfolio compositions from other sophisticated defined benefit (DB) and defined contribution (DC) trust-based schemes, yet a surprising number of bundled DC propositions have still not fully embraced alternatives, and continue to rely on an equity-focused portfolio. All portfolios in the chart below have a broadly similar long-term return expectation, but vary widely in their level of diversification. We would expect the more concentrated portfolios to be more risky over time.
Price versus value
One potential explanation for this lack of diversification in mastertrusts’ portfolios could be the charge cap and value-for-money requirements. Many providers have gone for an ‘as cheap as possible’ approach which has typically undermined diversification.
We certainly acknowledge that true diversification through alternatives requires the use of some higher-value building blocks in portfolios, so it is not exactly as ‘free’ as Markowitz contended.
But investing to obtain the predictable benefits of diversification should be an easy decision for anyone willing to spend more than the bare minimum for a better outcome.
After all, the value-for-money case for upgrading an old-fashioned balanced portfolio of equities and bonds should be straightforward when the extra cost for genuine diversification through alternatives can be achieved from as little as 5-10 basis points (0.05% to 0.10%).
Getting the alts right in DC
There remains a question mark or two over how to allocate effectively to alternatives in a DC portfolio. Unquoted alternatives create additional complications, as they tend to be illiquid and aren’t tradable in investor-friendly increments – you can’t allocate to forestry one tree at a time – while DC schemes typically require daily pricing and daily liquidity.
With this in mind, we believe listed alternatives are a straightforward implementation vehicle. Liquidity is achieved for investors because they can buy and sell their shares in these vehicles to other investors at any point in time. And as this trading doesn’t change the number of shares or the capital available to the listed structure, it doesn’t need to meet daily redemption requests and is able to own the less-liquid underlying assets.
Equally, listed alternatives can overcome the challenge of underlying assets that are not priced on a daily basis: their real asset price is part of the listed alternative’s balance sheet and is reflected in the calculation of its net asset value. But there is also a daily share price for the listed vehicle that investors can trade on, and this will directly reflect current market conditions.
Our research shows that listed alternatives provide similar risk-adjusted returns to direct investments in real assets over the long term. There is admittedly more volatility over the shorter term with listed alternatives – a function of their daily pricing and trading and their equity beta – but most investors should be able to look through this noise. Over the longer term, the listed alternative’s share price is mainly driven by its underlying assets, and the returns on the underlying assets are passed through the listed alternative to the underlying investors.
For all these reasons, we view listed alternatives as a great addition to portfolios. They meet all the requirements for DC schemes – daily pricing, daily liquidity, low fees – and they can improve portfolio outcomes.
Why, oh why, isn’t everybody using them?