Incorporating alternatives into traditional portfolios

Investment managers, asset consultants and retirement fund trustees are faced with a hard fact: traditional asset classes are no longer yielding attractive or even real returns in this low return environment. With this background it makes sense to add alternative investments to portfolios as a powerful diversification tool, says Pawan Singh, Head Alternative Investments | Multi Strategy at Sanlam Investments.

Alternatives include instruments such as private equity (buy-outs and venture capital), private debt (loans), hedge funds and real assets such as commodities, unlisted property, and infrastructure-funding equity or debt vehicles. These all hold the potential for providing powerful, risk-adjusted real returns, says Singh, with the added benefit that the returns are also significantly less correlated to traditional asset classes such as listed property, equities and bonds.

The case for alternatives

Alternatives have specific attributes that differentiate them, including reduced liquidity (an inability to convert the investment into cash easily), minimum lock-in periods (the investment may not be withdrawn within an initial designated period without penalty), asymmetric information (“insiders” have more information than “outsiders”) and the perception of limited transparency (publically available information). The upside is that investors are rewarded with a healthy compensation, often called the Illiquidity Premium, in return for this investment.

It is this premium that long-term investors such as retirement funds, with limited requirements for liquidity, should be taking advantage of.

The case for a higher allocation towards alternative assets is based on Markowitz’ Modern Portfolio Theory. Markowitz proposed a way to construct an efficient frontier: a hypothesized optimal portfolio returning the maximum possible returns, for a certain level of risk. He showed that portfolios were more optimal when investing in a range of stocks, as they would reap the natural benefits of diversification – where risk is reduced within a portfolio because each stock has different causes and effects of risk; essentially the concept of not putting all your eggs into one basket.

National Treasury supports a higher allocation to alternatives

Earlier in 2018, South African authorities adjusted investment legislation to increase allocation towards international alternative assets to 10% – creating greater scope for further diversification of portfolios by including more alternative asset classes into traditional portfolios. This change in legislation is in line with the international trends observed by Yale and Harvard. An additional 5% can also be allocated to alternative assets within Africa, bringing the total allocation towards alternative assets to 15%. This tripled allocation can be maximised by investors to complement more traditional portfolios achieving higher investment returns with moderate volatility.

Impact of a diversified alternatives strategy

The graph below shows how the inclusion of alternative assets into a traditional portfolio creates a new efficient frontier (as seen by the higher-lying blue trend line), than that of a portfolio without alternative assets (shown with the lower-lying aqua line). This demonstrates that, for a given level of risk, a portfolio that includes alternatives provides superior returns or reduces risk for a given level of return.

The risk/return profile of each alternative strategy is unique. This provides investors with the opportunity to access a portfolio mix within the alternatives range that best suits their targeted risk/return profile and appetite for liquidity. These can be blended together via a multi strategy approach, again using diversification to minimise risk while maximising investment outcomes.

Our multi-strategy approach

Many investors understand the benefits of allocating to alternative assets, but do not have the knowledge or budget to facilitate a diversified allocation – often settling for exposure to hedge funds only, or to a single private market asset class such as private equity or unlisted property. Through the Sanlam Alternatives Multi Strategy proposition, we offer you access to the full range of alternative investment strategies, including private equity, unlisted property, unlisted credit (rated, unrated, socially responsible (SRI) credit and infrastructure debt), and hedge funds.

We help you blend strategies and construct portfolios using the above strategies to meet your individual needs, appetite for risk and investment objectives. In this way we help you harness the full potential of the available capital in private (alternative) markets. Once we understand your specific investment objectives and constraints, we can propose a solution for you, and you can be involved in choices about portfolio construction, risk budgeting, governance and cash flow management.

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