Alternative alternatives in the diversified portfolio
We believe that diversification is always a crucial consideration for investors. But it appears particularly pressing at present. In developed markets, inflation and interest rates are creeping up. Government bond yields, however, are in many cases still close to record lows, meaning that they may be unappealing to investors in the event of acceleration in US interest rate rises. And after a decade-long bull run, the equity market is looking fragile, with stocks seeming expensive relative to their earnings prospects. Add in geopolitical instability and escalating US-Sino trade disruption, and we think there is potential for financial market weakness in the medium term.
The bleak outlook for traditional asset classes has left some investors feeling pessimistic. But the uncorrelated appeal of listed alternatives provides a new universe of opportunities. We invest in a select range of alternative assets with reduced correlation to the economic cycle, including infrastructure, specialist property, marketplace lending, aircraft leasing and litigation financing.
What drives revenues in these asset classes is different to what drives those of traditional equities and bonds. Typically, these ‘alternative alternatives’ provide a recurring income stream that should remain largely unaffected by market turbulence. Of course, these are illiquid asset classes, which means they are difficult to buy and sell at short notice. However, we allocate to alternatives through listed investment trusts that are tradeable on exchanges. These are public companies run by a board of directors who are answerable to the shareholders. The directors issue shares and invest the proceeds in alternative assets which they hold in a fund. In most circumstances, this gives the trusts a permanent capital structure that enables them to allocate to alternatives that would otherwise be inaccessible in a regulated vehicle. Such trusts have opened up a new universe of opportunities for non-professional investors.
Infrastructure projects generate stable cash flows with yields that are hard to find in traditional bond markets. We invest in social infrastructure (hospitals, schools), core infrastructure (transport assets) and renewable infrastructure (wind farms, solar parks). Many projects are backed by governments and benefit from state subsidies.
For example, renewable infrastructure assets are increasingly being financed via listed funds, run by specialist management teams. We target annual returns of 5-7%. While these investments may have some sensitivity to power prices, their revenues, and, therefore, dividends, are largely independent of economic factors.
We allocate to real estate investment trusts focused on property sectors that are less closely tied to economic conditions, such as social housing funds providing affordable accommodation to citizens with lower income or disabilities. Typically backed by governments and involving long-dated contracts, the key driver of returns is the rental income these properties generate. We target annual returns of 5-7%, with a yield that grows in line with inflation.
Tighter regulatory and capital requirements have forced banks to cut back on lending to smaller businesses. Innovative companies that run online platforms to match lenders and borrowers have stepped in. Unlike banks that profit by charging higher lending than borrowing rates, these firms charge a fee for arranging loans – which are less sensitive to interest-rate rises than high-grade bonds. These platforms use new technologies to perform credit-rating checks, with loans priced according to the creditworthiness of the borrowers. Investors allocate to funds such as that run by Funding Circle, a government-backed tech platform that lends to small businesses. It targets an annual dividend of 5-6% after taking account of credit losses.
Increasingly airlines are choosing to rent planes rather than own them as it provides operational flexibility. The cost of buying a plane can leave them exposed if demand for air travel drops, while if it grows they can simply lease more planes. It has led to a rise in the number of companies that lease aircraft. They raise capital to buy planes by creating pooled investment funds and pay regular income based on their lease contracts. The planes have a resale value, too, that can boost total return. Regular income means the business is relatively insulated from economic downturns.
While demand depends to some extent on the health of the air transport industry, we think it is well supported by the rising wealth of emerging economies.
We hold shares in a litigation financing firm, which provides funding to legal firms and/or claimants to cover the cost of bringing court cases to trial. It is incentivised to select cases with the best chance of winning, since it earns a percentage of awards handed to successful claimants, but bears the costs of unsuccessful cases. While legal cases can be complex, litigation financing is simple and most cases tend to be settled before they reach court. The outcomes of lawsuits are almost entirely independent of economic and financial conditions.
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 with a low correlation with those provided by more mainstream assets. As part of a diversified portfolio, exposure to the right alternative-asset funds could help investors to both boost returns and smooth the ride through any future market turbulence.
Les points de vue et conclusions exprimés dans ce document sont fournis à titre général et ne sauraient constituer un conseil en investissement ni une recommandation d’achat ou de vente de titres particuliers.
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