It’s not diversification as usual

Bonds used to be the go-to asset class to diversify portfolios but record low yields, and in some countries negative yields, have forced asset managers to rethink the script and turn to an asset class whose time may have come.

Coupled with record high equity markets in many countries across the world, investors are giving alternative asset classes a closer look because of their diversification benefits at an unusually dislocated time for financial markets in the wake of COVID restrictions. 

Alternative or private market assets refer to those not traded on a public exchange, such as private equity, private debt, real estate and infrastructure. They cover such a broad range of investments and present differing risk profiles.

Some, such as a venture capital start-up providing seed money to fledgling businesses, are high risk. Infrastructure, on the other hand, is less volatile and lower risk with returns uncorrelated to the business cycle. Art, antiques and classic cars are also classified as alternative investments.

In the past, alternative investments were considered too hard to access, high-risk or complex for many investors. Now they are accepted as an attractive means to diversify portfolios, often achieving better inflation beating returns than traditional listed markets. 

More South African investors are including alternative assets in their portfolios as they increasingly understand the benefits offered by these investments. This echoes a global trend.

In little more than a decade, global alternative assets under management have grown, from $2 trillion in 2008 to about $5.5 trillion in 2019. Assets under management are expected to exceed $8 trillion in 2023.

The benefits of alternative investments

The main benefit of including alternative asset classes in investment portfolios is to have sufficient diversification to reduce risk and enhance returns.

Diversification – also known as the “don’t keep all your eggs in one basket” principle - requires investors to invest in a combination of assets with low correlations to one another. This should limit exposure to any single asset class or risk, as different assets react differently to the same economic event.

Private market assets generally perform differently from equities, bonds and cash. An investment in infrastructure, such as a toll road, could yield stable, predictable, long-term cash flows for 20 years and more, with inflation-linked increases each year. As a result, an investment in a toll road concession would have little correlation to South African equities and at certain times might deliver better returns.

Investors should consider having a well-diversified portfolio that can deliver a steady, above-inflation return throughout market cycles. This might include public market allocations to fixed income, public equities and cash complemented by some exposure to inflation beating investments benefits offered by alternative assets.

As with any investment, the returns for private assets are not guaranteed, but can potentially be higher than traditional investments, outstripping CPI to provide a good inflation hedge.

As alternative assets are generally less liquid, investors are generally compensated with higher returns, known as the liquidity premium.

Including alternative investments can help grow an investment portfolio. Regulation 28 of the Pension Funds Act currently allows for a maximum of 15% of retirement savings to be allocated to alternative assets, with private equity restricted to 10%.