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Rethinking categorisation

As markets face a daily barrage of sentiment-shifting signals, is it time to let go of the terms ‘traditional’ and ‘alternative’ and consider assets based on their individual liquidity profiles and the level of premium available?

Weak global growth and trade policy uncertainty have prompted central banks to take pre-emptive action. As the US Federal Reserve leads the pack with a 0.25% cut in interest rates, investors around the global are preparing themselves for the end of quantitative tightening.

With newsflow – and markets – constantly being reshaped by sentiment shifts, geopolitical outbursts and inflammatory tweets, we believe the flexibility that can be found outside of traditional equity and bond markets is going to be key for continued investment performance.

What does this mean in terms of portfolio construction?

Having a broad toolkit of investment options will be crucial, in our view.

This is why some of the world’s most sophisticated investors no longer segment their portfolios into traditional assets and alternatives. Instead, they’re taking a more bespoke view, looking closely at the characteristics of the underlying security and its function within the overall portfolio.

Reframing liquidity

This can start with a shift in attitude toward liquidity profiles. Listed and privately-held equities share many of the same characteristics and perform a similar function in a portfolio. How they are bought, sold and measured may differ, but their underlying qualities are alike.

In fixed income, private and public debt can offer the same qualities, too.

Although their liquidity profiles may differ, for long-term investors, such as defined benefit and defined contributuion pension funds, we believe that it should not make that much difference due to the time horizons they operate over – and the less liquid instruments could offer a premium.

When making the decision to broaden an investment horizon, it is important to ensure the investment manager has the skills and experience to accurately carry out what they claim.

A manager with a heritage of hunting out dislocations in the market and exploiting these hidden opportunities can help boost returns and level out other areas of a portfolio that may have been impacted by unexpected moves.

Specialist tools need skilled handlers

Those with a previous career managing long-only bonds might not be best positioned to employ derivatives and hedging instruments.

There is a potentially huge opportunity cost in a manager not using these tools – or using them incorrectly – as they could determine how well an investor travels through more tumultuous markets.

Is bigger always better?

Trustees should also consider the size of the manager they choose. In illiquid environments, very large funds cannot always keep trading.

If there is only so much of a certain security available, they may struggle to ensure all their clients’ capital is working if they have gathered too many assets.

Going against the herd

With ‘the top of the equity market’ a constant discussion point, employing a manager with access to non-directional funds may be a good idea.

These funds strip out the ‘beta’, or market return, by using short-selling techniques and derivatives. While this can produce a lower return, it also typically means these assets have lower volatility and less correlation with others in a portfolio.

This return can potentially be boosted by experienced managers applying some leverage, as long as investors are informed about how this works with the rest of their portfolio.

Not everyone is at the same stage of the journey, but from different starting points investors and managers have come together to work in closer partnership than simply ‘buyer’ and ‘seller’.

We believe education and understanding, along with a willingness to open up and explain how these more esoteric assets work on their own and within an investor portfolio, is going to be key to this partnership continuing to flourish.