Alternatives: Portfolio weighting depends on investor’s risk appetite

The definition of alternative assets may have evolved over the past 20 years, but their role in a portfolio – to diversify returns and manage risk – is essentially unchanged. 

“[Alternatives are] often just assumed to be anything outside equities and fixed interest,” DPM Financial Services consultant, Dominic McCormick, told attendees of a panel on Definitions, frameworks and philosophy at The Inside Network’s Alternatives Symposium.

He pointed out that in the early 2000s the alternatives category generally referred to non-correlated liquid alternatives, or hedge fund-type strategies. Today, private assets, including hedge funds, are all grouped together under the alternatives banner.

When it comes to finding a place for alternatives in a portfolio, Atchison investment analyst Mishan Dahia said that when considering the asset allocation or design of a portfolio, an investor really needs to understand their own growth and defensive preferences. Once that allocation is understood, they can ascertain how much they should allocate to alternatives.

“So, you may have three to five per cent alternatives in a conservative portfolio, all the way up to 15 to 20 per cent exposure in aggressive portfolios,” he told the symposium.

Using Atchison’s approach as an example, Dahia highlighted the many ways that alternative investments can be categorised.

“We run them as hedge funds that will include macro strategies, multi strategies, currency, long/short. We also run real assets, or real estate, which would be direct, which could be residential property, commercial property and indirect or RMBS.

“We run infrastructure, so infrastructure could be transport, utilities, airports and the like. We run natural resources, which is grains, metals, timberland, farmland. We run private markets, which is broken up into private equity and private debt, and that can also include venture capital. And we also run ‘other’.

And the ‘other’ category of alternatives is tangible and intangible; tangible being things such art and collectibles, and intangible being things like patents, music royalties, and the likes of, most recently, non-fungible tokens (NFTs) and cryptocurrency,” he said.

All these sub-categories of assets can offer investors uncorrelated drivers of returns outside of traditional asset classes. But how much value alternative assets can deliver to investors may depend on the market cycle.

“Over the past 25 years, bonds and equities have been in a growth regime, and that means, as a result, their correlation has been zero or –0.4. But post-pandemic, as in post-2022 all the way through to 2025, we’ve moved into more of an inflation regime. And what does that mean? It means we’ve gone from zero to –0.4 in correlation of these traditional asset classes to 0.59, which means there’s a 59 per cent correlation between bonds and equities,” Dahia said.

Given the close correlation of these two major asset classes, which usually account for the bulk of most investors’ portfolios, it’s more important than ever in the current cycle to have exposure to assets that provide returns uncorrelated to bonds and equities. This is even more critical given the expectation that central banks will cut interest rates, leading to an even more inflationary environment.

“It’s a different regime. It’s a different world. We’ve gone through 25 years of growth, now we’re in this inflationary regime. And so, it will be interesting to see how this pans out and what happens…but it is just interesting to understand the true value-add in alternatives given the environment,” Dahia said.

McCormack acknowledged that there had been some recent discussion around private investors allocating up to 50 per cent of their portfolios in private markets in the future as they look for alternative sources of return.

“Very high-net-worth family offices, multi-generational-type clients can handle that sort of illiquidity. Your average sort of retiree, or near-retiree, should have nowhere near that, in my view, going forward. But there are ways that they can get exposure to private markets, via listed vehicles, for example,” he said.

JANA Investment Advisers senior consultant, Bill Dwyer, told attendees that JANA gets comfort from partnering with fund managers that have a long-standing track record in the relevant private market sector.

“So even if that evergreen [also known as open-ended] structure is newer, it often invests alongside the manager’s flagship closed-term fund, and that makes the performance history of those funds highly relevant,” he said.

But before committing funds, it’s important that investors understand a fund’s terms, particularly around liquidity, redemption mechanics and any lock-ups or ‘gates.’

“Semi-liquid structures should be treated as equally illiquid from a portfolio construction perspective. Fee calculations and valuation practices must be robust and equitable, especially given the open-ended nature of investor entry and exit. Frequent external valuations are essential to ensure fairness, and additionally, if the fund has been seeded with internally transferred assets, that warrants close scrutiny. Not all evergreen structures are created equal, so thorough due diligence on the structure is critical,” Dwyer said.

Investors also need to be aware of the liquidity and redemption mechanics of any alternative fund to make sure investments can be withdrawn when needed, with some funds that label themselves semi-liquid locking up investors’ funds for 500 days-plus, according to Atchison research.