It's no secret that the current state of global markets is extremely challenging for investors. Equity markets remain volatile and bond yields are low, which is bad news for anybody who is looking for a steady flow of income that meets their investment objectives. The fact that global monetary policy is largely uncoordinated and asymmetric is not helping the situation.
The bottom line is that it is very difficult to predict with any confidence which way the markets will turn next, meaning that any investor whose portfolio is highly concentrated in one or two asset classes is effectively gambling heavily on certain outcomes playing out.
The challenge is how to diversify a portfolio in a way that enhances risk-adjusted returns, and which will also provide some protection against shocks such as unexpected inflation. The good news is that there are a number of alternative investments that meet these criteria; the not-so-good news is that allocating to them may mean you have to venture outside your comfort zone.
Appetite for illiquidity
Prior to the financial crisis, many investors overestimated their appetite for illiquidity. When the crisis hit, these investors paid the price for that misjudgement as they struggled to extricate themselves from their more illiquid positions. This, combined with the fact that plenty of attractively-priced opportunities were beginning to appear across the liquidity spectrum, led to a widespread loss of appetite for illiquid instruments.
Many investors remain queasy about the prospect of taking on illiquid assets. But this is unlikely to last. Sooner or later, if you are seeking exposure to high yielding assets that are uncorrelated to traditional asset classes, or which offer protection against inflation, you will have to seek out alternative assets .
Our recommendation would be to establish an ‘illiquidity budget' — in other words, a portion of your portfolio, calculated according to the fundamentals of your business, which can bear some illiquidity. Clearly, if you are faced with the choice between a liquid and an illiquid asset, which has the same risk characteristics and rewards, you will take the liquid asset every time. But when the more illiquid instrument offers a greater potential reward and you have room in your illiquidity budget for it, then you should consider it.
Some investors still regard renewable power, for example, as essentially science fiction. But all it takes is a quick glance at the amount of money being invested into the sector to realise that this is a serious business. Experts estimate that the global push to diversify energy sources will cost around $1.2 trillion (Dh4.41 trillion) between now and 2035. That money will have to come from somewhere, and investors with the flexibility to invest in long-term projects could find themselves benefiting from long-dated cash flows, a degree of inflation protection and yields that are significantly higher than those available in more liquid markets and can last for decades.
Add to this the fact that traditional energy providers are capital constrained and the regulatory environment for renewable power is favourable compared to that for oil and gas, and the sector suddenly begins to look potentially attractive from an investment point of view.
Other ‘alternative' options include private equity, hedge funds, commodities and commercial real estate. Private equity has substantially vindicated itself over the past five, 10 and 15 years by consistently offering returns that are more attractive than those available from public equity. The hedge fund industry has also recovered from the beating it received during the financial crisis, partly because the demise of proprietary trading desks in investment banks has created more space for ‘genuine' hedge funds to operate in. The direct link between commodities and production inputs has made it an attractive asset class for investors seeking inflation hedging, while commercial real estate offers an appealing blend of relatively high current income and the potential for moderate appreciation.
New asset classes
The point is that there are plenty of options for investors seeking to boost their portfolio and hedge against inflation by investing in asset classes other than bonds and equities. The first step for many such investors will be to establish an illiquidity budget that clearly establishes how much illiquidity their portfolio can bear.
Ultimately, the level and type of exposure to alternatives will differ from investor to investor according to their portfolio objectives. However, so strong is the overall case for alternatives that we believe the question facing investors is not so much whether to allocate to them, but rather when, how and which.
The writer is director and a member of BlackRock's Global Markets Strategies Group. Opinion expressed here is his own and does not necessarily reflect the views of Gulf News.
