Alternative investments – is it time to get real?

Written By: Anthony Esse Chief Executive Darwin Alternative Investment Management

Anthony Esse of Darwin Alternative Investment Management outlines the benefits offered by real assets, particularly land-based ones such as holiday parks, in a volatile stock market, and suggests that now is a good time to consider allocations to this asset class

The past two years have seen yet another roller-coaster ride for stock markets, and whilst bonds have been performing relatively well, they are likely to be pressured by interest rate and inflation expectations. So, with all this uncertainty, is now really the time to be thinking about investing in alternative assets?

Bonds have traditionally provided a safe and steady diversification option away from the equity markets, but unlike many alternative assets they are still subject to the same market risks. So, if bond yields are low, is there any real benefit to this diversification strategy for local authority pension schemes?

It could be argued that with the total funding level across all LGPS funds in England and Wales at 98% (as per the 2019 triennial valuation), and with this expected to improve further at next year’s valuation, a low risk position in bonds to protect these funding levels is exactly what LGPS funds need. But do you have to sacrifice returns when seeking diversification from the ups and downs of the equity markets? It seems clear that the pandemic has paved the way for a new economic cycle, which in particular has seen the resurgence of inflation.

With inflation at 3% and rising, it would seem unwise to rely on bonds to maintain funding levels. In this post-Covid-19 world, real assets appear to be an attractive option as they have the potential to combine protection against inflation with the prospect of more stable returns than traditional liquid assets. Real assets offer the opportunity for diversification, inflation hedging and competitive total return potential. They may also offer a source of income, a feature that investors frequently overlook. Real assets have generally exhibited a greater ability to hedge inflation than the wider equity and fixed income markets and have generally offered stronger returns during periods when inflation is rising.

Alternative investments are often viewed as high risk / high reward, but alternatives cover a very wide spectrum and there are many products that can deliver returns higher than those offered by bonds, with relatively low levels of risk and volatility. At Darwin, we looked carefully at what assets could mimic the stable income offered by bonds and felt that land-backed real assets were the best way to help minimise the risk that comes with investing outside of mainstream markets. Holiday parks and bereavement services assets were chosen because they generated stable revenue streams.

As well as protecting funding levels, local authority schemes are of course looking for income to help them to meet their payment liabilities, and it is here that alternative assets can come into their own. The equity and bond markets have long been a source of income, and in 2021 the FTSE 100 has seen its first year of dividend growth since 2018. It is on track to deliver a 4.1% yield in 2021, but the majority of that has come from just 10 stocks so there is no certainty that this will continue, while higher dividend yields can also be a result of a decline in the share price, which will impact performance returns. Bonds have traditionally been the answer for reliable income streams, but bond rates are often unattractive compared to equity returns. If investors are willing to do their research into alternatives, they will find many products with similar income and return characteristics to those provided by bonds, but with a higher income yield.

There are of course downsides to alternative investments, the biggest probably being liquidity, and this can be an issue when it comes to both investing and disinvesting. The draw-down process involved with private equity can mean long periods when your money isn’t working for you and coupled with the private equity J curve, it is likely to be some time before you start seeing a positive return on your investment. Investing directly in property can come with substantial acquisition costs and there can be a long time-lag when acquiring property assets. Looking at unit trusts or open-ended funds instead will help to alleviate some of these issues.

When it comes to disinvesting from alternatives, and in particular real assets, liquidity is often an issue. The onset of the Covid pandemic saw a flight, not to low risk quality assets, but to cash, and led to many managers, in particular in the property sector, having to close their doors to disinvestments. This is why it’s important to view investments in real assets as long-term investments, and if you think you might need your cash back in a hurry, they are probably not for you. Being a long-term investor can have its advantages though, and many managers, will offer lower annual management charges to those willing to lock-in their investment for a certain period of time. This can work as a means of off-setting the potentially negative impact that investing in a less liquid asset can have on a portfolio.

ESG is of course a hugely important topic for local authority investors, but alternative assets don’t often come with voting rights and unless you’re investing directly in a “green” investment such as forestry or windfarms, you may think that your investment won’t have much of a positive environmental or social impact. On the contrary, and certainly where real assets are concerned, there is the opportunity to make a real impact through these alternative investments. When investing in real assets, managers have the opportunity to directly improve the land or buildings they own, to run their businesses in a sustainable manner and to become responsible employers. That has certainly been our experience and all of the businesses within Darwin’s investment portfolios are run with these issues in mind.

Investments in real alternative assets are investments in myriad businesses like ours, and whilst they don’t offer a tick-box approach to responsible investment, a good investment manager will be able to demonstrate to you the positive impact they are having. The Stewardship Code has been widened recently to move beyond simply recognising voting and engagement as good stewardship and more alternative managers will be able to sign up to it as a result, indeed it is something that we are currently working towards. This will make it easier for local authority schemes to recognise the managers who make responsible investing a priority.

With alternative investments offering genuine diversification away from equities and bonds, capital protection and enhancement, and stable income streams, now would seem a good time for local authority schemes to consider expanding their allocation to this asset class. Perhaps the next step is encouraging the consultants to devote more time to researching these assets. Much of the risk lies in investing with small management houses who are unknown quantities. But more in-depth research, combined with the opportunity for increased knowledge sharing that pooling provides, might help to move alternative assets into the mainstream.