Alternative investments – the right choice for income?

Written By: Jeff Munroe Strategic Adviser Darwin Alternative Investment Management

Jeff Munroe of Darwin Alternative Investment Management looks at the benefits of selective investment into alternative assets, particularly those with a focus on ESG

The year has been a challenging period for risk assets in general, with government bond yields having risen sharply from the ultra-low levels of the Covid period as inflationary conditions have accelerated due to a confluence of factors including the war in Ukraine, with pressure on energy and food prices, through to tight labour market conditions in most areas. With a considerable uncertainty regarding how these price pressures will be resolved, there is an elevated level of uncertainty and volatility in asset markets which is challenging investment decision-making for all types of investors. So, with all these concerns, how should one think about investing generally? And if you are looking for income-generating assets, are alternative assets the right choice?

Government bonds have traditionally been the income investor’s first port of call and with Gilts now yielding over 3%, there is more yield on offer than the last few years; however, they yield less than current inflation rates and there is concern over issuance as the UK looks to face recessionary conditions which always stress government finances. As the Bank of England looks set to continue to increase short rates, we must hope that 2023 will see inflation quickly receding to target levels circa 2%. This is uncomfortable for investors as there may be some factors at play which will conspire to keep inflation at higher levels for longer.

When facing economic uncertainty, investors often look carefully at income levels as a reference point for value. Within UK equities, the dividend level has grown only very moderately over many years and the current yield offers a modest premium over the ten-year Gilt yield. At near 4%, a high level of overall dividends in the UK come from a relatively small number of companies in the extractive sectors of oil and gas and mining as well as financials, including banks. These dividends can be vulnerable to economic effects as well as windfall taxes and the sectors’ own needs to invest in repositioning for factors such as lower carbon intensity. Whilst many funds are looking to avoid investing in some of these stocks entirely due to environmental concerns.

Corporate bonds offer an enhanced yield over government bonds and there is much to select from, with varying levels of economic exposure and capital structures with different amounts of leverage, but diversification in any portfolio is important. With the uncertain inflation conditions and prospects of an economic slowdown, do bonds, and particularly corporate bonds, really provide a diversification option from equity markets? And against this background what other options do local authority pension schemes have to create an effective diversification within their investment portfolios?

These are important questions, particularly with local authority schemes at healthy funding levels. With 85.7% of UK pension funds in surplus in September 2022 (source Bloomberg, Pensions Protection Fund) most funds can focus on meeting their ongoing pension liabilities, rather than adopting higher-risk strategies to meet a funding shortfall.

It seems that protecting this position would be a sensible approach, but inflation uncertainty creates a challenge for this objective as well. As the Bank of England battles inflation with tighter monetary policy and also unwinds its holdings of Gilts, there is a significant risk of a new economic cycle. Higher interest rates are likely to have their effects in areas where the growth of debt outstanding has been pronounced due to a long period of low interest rates.

In the current challenging climate, carefully selected alternatives appear to be an attractive option as they have the potential to combine protection against inflation with the prospect of reliable returns. They can also offer an attractive source of income, a feature that investors frequently overlook. Alternative investments are often viewed as high risk, high reward, but alternatives cover a very wide spectrum and there are many types that can offer bond-like returns with relatively low levels of risk and volatility, particularly when leverage levels are not high. Perhaps the biggest argument cited against alternatives is the lack of liquidity; however if your investment focus is on securing stable levels of income over the long term, then should this really be a concern?

Alternative assets cover a wide spectrum from real estate, private equity and commodities to fine wines, art and antiques. At Darwin, we looked carefully at what assets could mimic the stable income offered by bonds and felt that high fixed asset businesses with reliable cash flow streams were the best route to minimise the risk that comes with investing outside of mainstream markets. We chose to invest in holiday parks and bereavement services assets because of the long-term stable revenues they generate.

An area where alternatives can be particularly attractive is ESG, which is a hugely important topic for local authority investors. Again, this is where careful selection can have real benefits. Investors may feel that they have to invest in areas such as forestry or windfarms in order to achieve a positive environmental impact result, but in reality there can be a real opportunity for the manager to make a significant impact with the underlying investments across other alternative sectors as well. By holding a controlling stake in real assets, managers have the opportunity to directly improve the land or buildings, to run the businesses in a sustainable manner and to become responsible employers. This has certainly been the experience at Darwin and the communication opportunity with investors can be very underrated as well.

With a challenging investment backdrop for mainstream asset classes which seems likely to persist well into 2023, investors should see that selective investments in alternative areas offer genuine diversification benefits as well as providing capital protection and stable income streams, where the cash flows can have a degree of inflation protection built into them. Overall, it would seem sensible to increase allocations to these areas, yet it is vital to be selective, researching the stability of the underlying cash flows, analysing the levels of gearing used, including any derivatives, and questioning how the portfolio will likely perform against a range of economic scenarios. Done effectively, alternatives should provide an attractive complement to other asset classes and in the case of local authority pension schemes, help to secure the healthy funding levels well into the future.