Alternative investments have become major components of the multi-asset portfolios managed by Kames Capital, the specialist investment manager that is part of Aegon Asset Management. Co-heads of Multi-Asset Investing, Stephen Jones and Olaf van den Heuvel, explain why they put alternatives at the heart of the firm’s multi-asset portfolios.
As a multi-asset team we believe that asset allocation is the primary driver of investment returns, and that the best way to manage risk is by diversifying across a range of lowly-correlated investments. Our Diversified Growth and Diversified Income strategies bring together a wide range of investments that we group together to form the 'building blocks' of our portfolios. Many of the most attractive investment opportunities are included in our 'alternative assets' building block.
When defining 'alternative' assets, the obvious question to ask is "an alternative to what?" For most institutional investors this means equities or bonds, what we may call traditional investments. So, before looking at some of our alternative assets in more detail, what role do we see traditional investments having in multi-asset portfolios?
The role of traditional assets
Investors looking for growth have traditionally turned to the equity market, and with good reason. Since the end of 1987 global equities have delivered an average real (inﬂation-adjusted) return of around 5% per annum. But as we all know, this level of return comes at a price: namely, volatility. Sharp corrections and bear markets can wipe out years of positive returns in a relatively short time. This can be painful for investors who do not have long-term investment horizons and cannot 'look through' this volatility to focus on the attractive combination of income and growth that equities can provide over the longer term.
We believe the longer-term growth potential of equities means they have an important place in most multi-asset portfolios. Diversification, however, is key to mitigating their volatility, so we also invest in bonds for their diversification benefits and for the relatively predictable income they can oﬀer for income-themed portfolios.
Enhancing our opportunity-set with alternative assets
The opportunities for adding alpha and controlling risk do not stop with equities and bonds. By making 'alternative' investments another key component of our multi-asset funds, we can enhance potential returns and further reduce overall portfolio volatility.
Holding alternative assets that are less correlated with movements in bond or equity markets is a key factor in our multi-asset strategies. Assets such as infrastructure, asset leasing and renewable energy can offer some of the greatest potential diversification benefits, due to their low correlations with traditional assets.
Many alternatives in which we invest are very 'bond-like'; they generate an income over a number of years, albeit through dividend payments rather than coupons. This income is often backed by underlying contractual cash flows and some have a measure of inflation protection.
Let's look more closely now at some examples of alternative assets that we invest in across our multi-asset portfolios.
Hospitals, schools, transport networks, or utilities – all major projects once confined to the public sector. Squeezed government budgets following the financial crisis have brought many of these opportunities to the private sector. For investors, large infrastructure projects can generate long-term income, often with surprisingly low risk, thanks to government-backing via public-private partnerships. Infrastructure investments are relatively defensive, lowly correlated with core markets, and often provide inflation-protected returns.
In addition to listed vehicles investing in the equity capital of infrastructure projects, we also invest in listed funds that provide debt capital for infrastructure projects. This further increases our opportunity set in the infrastructure space and provides further diversification.
Asset leasing is another 'bond-like' investment that can generate attractive returns through a combination of regular income and potential capital gains.Stephen Jones, European CIO
Aircraft leasing is a good example; funds which aim to provide income and capital growth to investors by purchasing and leasing commercial aircraft.
More than 40% of the global commercial fleet is now made up of leased aircraft. Investors have the opportunity to earn an attractive yield and total return without taking on the greater risk of investing in an airline company's shares. While airline shares have seen significant historic volatility, valuations of the aircraft themselves have been much more resilient. Aircraft are a mobile, well-maintained and globally traded asset; even in the worst case of default, recovery rates are high. When a contract ends the aircraft can potentially be leased to a new customer or sold; the sale can generate good capital returns thanks to the relative slowness of aircraft value depreciation.
Renewable energy companies primarily invest in wind and solar power generation. Having acquired or built wind or solar farms they provide investors with an income stream that is often partly linked to government-backed, inflation-linked payments. The revenue split for these projects is typically around 50% regulated inflation-linked payments and 50% wholesale power prices. They share good qualities with other utility investments, through predictable revenue streams and a defensive, non-cyclical positioning. Government support for renewable energy further enhances the stability of returns through varying programs of subsidies or contracts-for-difference.
Real estate is an income-generating asset that typically provides a high initial yield plus the potential for income growth and capital growth. Our multi-asset portfolios invest through listed property companies, typically structured as real estate investment trusts (REITs). These are essentially investment vehicles that purchase properties such as offices, shopping malls and student accommodation and rent them out. They provide indirect exposure to global property markets with daily liquidity, should we need to tilt the portfolio towards different regions or sectors.
Mortgage Real Estate Investment Trusts (mREITs) are US-domiciled collective investment vehicles that provide investors with a tax-efficient way to invest in a diversified pool of real estate assets. Traditional equity REITs usually purchase and manage physical properties, generating income from the rents on the underlying properties. In contrast, mREITs invest in mortgage loans and mortgage-backed securities to generate income and drive returns. We view mREITs as offering an attractive total return potential due to their high and recurring income. Their low correlation with traditional asset classes also provides diversification benefits.
We are continually searching for new and interesting alternative investments. One example is the rapidly growing market for litigation financing. If one side in a legal proceeding has a strong likelihood of a favourable outcome, but struggles to cover the legal fees needed, there are investors able to finance the suit in return for a proportion of the winnings. Being such a niche investment there are relatively few opportunities, so litigation finance only makes up a very small proportion of our multi-asset portfolios.
Key to our goal of delivering attractive risk-adjusted returns for our investors is an understanding of the ever-changing relationships between the assets that we hold. In reality, the correlations between different asset classes change over time, so the diversification benefit is not fixed. We believe that active management and the freedom to allocate flexibly across a wide range of asset classes gives us the best opportunity to deliver attractive risk-adjusted returns for our clients.