Adding alternatives appropriately means nailing the decision framework

As alternative investments become more mainstream, more investment teams are grappling with the question of how to systemically embed them into portfolios in a manner that is both intentional and beneficial.

The task is made more difficult by its problematic starting point. What even are alternative investments? Rather than something tangible like equities or debt, alternatives by necessity are defined as everything else, or the things that don’t fit into traditional asset classes.

As Atchison principal Kev Toohey explained during a keynote to open The Inside Network’s recent Alternatives Investment Symposium in the Hunter Valley, “the definition tells you what it’s not, not what it is”.

The key to defining alternatives, he said, is relativity. An alternative investment is only regarded as such because of its relationship, or lack thereof, with other investments. If it doesn’t fit within the pre-determined buckets for other asset classes, it goes into the alternative sleeve.

According to Toohey, relativity is also the key to understanding how alternatives should fit within an investment portfolio.

In its simplest sense, he explained, the addition of alternatives to portfolio construction can take place three ways. You can either put it outside of the traditional 60/40 (equities/debt) portfolio as a separate investment, keep it within the portfolio and sacrifice a portion of the equities allocation, or embed alternative investments within the broader, more traditional asset classes.

In practice, portfolio constructors employ more nuanced asset allocation than a standard 60/40 split between equities and debt. Atchison, for example, starts with a baseline of five primary ‘traditional’ asset class categories; Australian shares, international shares, real assets, duration debt and floating rate debt.

How you fit alternatives into the existing asset class structure from there depends on a few things, he explained. Firstly, you need to handle the relativity question by asking if it can fit anywhere else.

“For any new prospective investment, we first aim to allocate within these five elements of the ‘traditional’ asset class framework,” Toohey said. “Analysis considered includes tracking-error profiles, and sensitivity of investments to key economic and market forces.”

From there, liquidity becomes a key determinant. In a recent whitepaper, Toohey explained that his group will consider the liquidity profile of any strategy in the context of both the liquidity needs of the end client, and the importance of the liquidity profile of any other investors who share access to liquidity pools. This is crucial when constructing a separately managed account profile, he added, where liquidity impacts can negate the effective balancing of the asset class structure.

“Where the asset is unlikely to be able to support sufficient real liquidity through full market cycles to match the liquidity structure required, we prefer to use explicit client-level side-pocket semiliquid alternative allocations,” he said.

Apart from the liquidity profile, Toohey warned that there are several considerations to navigate when investigating how to fit alternatives within the asset class structure.

1. Don’t buy black boxes, i.e., investments that lack DD
   transparency
2. If you don’t understand how and why a strategy adds value –
   don’t invest.
3. Beware of low correlations that are masked by investments that
   are not frequently traded.
4. Beware of less-liquid strategies, of low historically realised
   volatility, being a poor measure of implied actual risk being taken
5. Not all liquidity is equal: ‘structured’ liquidity tends to dry up
   when you really need it.
6. Who are you in the liquidity pool with – will they run for the hills
   at the first sign of a problem?