For many investors, diversification is a characteristic near the top of their portfolio wishlist. And rightly so. Until recently, though, small-scale investors were limited in how they went about achieving it. A balanced portfolio, with a 60/40 split between equities and developed market government bonds, was the most popular choice. While the more daring might have ventured into the world of high-yield bonds, overall choice was lacking.
The possibilities increased in abundance when institutional investors began to diversify beyond mainstream asset classes. With equity market volatility and record-low bond yields among the defining features of the post-financial crisis period, smaller investors began to do the same. Markets have evolved to the point where alternative assets and strategies are now much more accessible.
A guarded outlook for the traditional asset classes
For those seeking genuine diversification this is just as well, given the clouded economic and financial outlook. The trade war, political uncertainty and the threat of recession are all weighing on prospects for global equities. Against this background, we expect only low single-digit returns from the asset class over the next three to five years. Meanwhile, renewed central bank intervention is likely in several major economies. As such, yields in core government bond markets will likely be low for some time. Investors are therefore on the lookout for asset classes that provide returns uncorrelated with equities or bonds.
In our diversified multi-asset portfolios, we invest in a wide range of these. Large asset classes that fall under this banner range from property to asset-backed securities and emerging market bonds. More niche areas in which we invest include social and renewable infrastructure and healthcare royalties. What they all have in common is what does not power their returns. None is influenced by the same return drivers as equity and developed government bond markets.
Bonds, but not as many investors know them
Local currency emerging market debt, for example, is one of the largest, most liquid asset classes in the world. Yields, which averaged 5.3% at the end of August, according to the JP Morgan GBI Emerging Market Global Diversified Index, are still attractive. This is the case both in absolute terms and relative to equities and developed market bonds. Additionally, currency returns provide a key component of the risk premium that investors seek. It is important to be aware of the currencies’ sensitivity to economic conditions, commodity prices and debt vulnerabilities, however.
While investors also need to consider specific country risks, it’s worth noting that emerging market economies have changed significantly. Many authorities have tightened regulatory and financial controls. Some have adopted orthodox monetary policies allied to fiscal reform over the past 30 years. Despite these changes, though, local currency emerging market bonds are under-represented in many portfolios.
Considering the alternatives
Then there are our more unconventional holdings. Typically, these ‘alternative alternatives’ provide a recurring income stream that is unaffected by stockmarket turbulence. These have previously been illiquid asset classes, difficult to buy and sell at short notice. We access them via daily-traded listed vehicles, however.
Infrastructure investments are good examples Historically, responsibility for constructing and maintaining a country’s infrastructure, whether that is energy supply, roads or railways, has typically rested with the public sector. Only relatively recently has infrastructure evolved into an investable asset class for private investors. However, since then, its popularity has grown almost exponentially. Last year, global fundraising for privately owned or ‘unlisted’ projects reached a new record level of circa $85 billion. The appeal for investors lies in the stable and reliable cash flows that infrastructure projects tend to generate.
In particular, renewable energy offers good prospects due to growing demand for clean energy and the prevalence of government subsidies. Investing in operational solar and wind farms comes with little or no construction risk or economic sensitivity. Similarly, social housing projects with long-dated, government-sourced revenues can also provide reliable inflation-linked returns. There’s also a low correlation between social housing and the more economically sensitive residential and commercial property sectors.
As with all asset classes, it’s not all upside. Investors need to be aware of the risks involved when investing in infrastructure. Some, such as liquidity risk, are relatively specific to the asset class. Renewable infrastructure is exposed to power price risk. Social infrastructure is subject to political, project-specific and regulatory risk.
Healthcare is another of the sectors that is subject to increased regulatory scrutiny. We invest in healthcare royalties, via industry-specialist lenders. The lenders provide funds for drug development by making loans secured on future cash flows from the drug’s sales. The cash flows are known as royalties.
Historically, the healthcare royalty market has had a low correlation to credit or equity markets. Even during periods of low or negative economic growth, royalties have grown consistently. Demand is immune to periods of volatility in the equity and debt markets. Instead, the success of the strategy is more closely linked to broader trends in demographics. One is the ageing of the population, which stimulates healthcare spending. Patient numbers – and treatment needs – affect royalty cash flow streams. Consequently, healthcare royalties do not move in line with financial markets.
Diversifying on merit
Investors always need to buy diversifying assets on merit, not just because they are different. But we believe that the assets outlined above do provide the potential for attractive returns. They have low correlations to those offered by more mainstream assets. These two characteristics are what makes them fit into our diversification ethos. With the right level of exposure, we think they can help investors to both boost returns and smooth the ride through any future market turbulence.
By Mike Brooks, Head of Diversified Multi-Asset at Aberdeen Standard Investments
Risk factors you should consider before investing: The value of shares and the income from them can go down as well as up and you may get back less than the amount invested. Investing globally can bring additional returns and diversify risk. A full list of risks is available on www aberdeenstandard.com
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