Worshipping at the altar of alternative assets

Investors are faced with a difficult conundrum today: run the risk of accepting lower returns from traditional asset classes (stocks, bonds, cash) or use alternative assets to try to boost prospective performance, generate inflation-beating returns, and improve diversification.

In this article, we’ll look at what the asset allocators in our rated universe are doing in the alternative, real return, or other portion of their portfolios and what this means from a risk and return perspective.

Definition of alternatives

The non-traditional or alternatives asset class is a broad church. Morningstar defines it as those strategies that don’t offer a consistent beta (market return) to the more traditional asset classes. We bucket them into four groups:

• Unlisted real assets
• Hedge funds (including managed futures)
• Private equity and private debt
• Structured products

The believers

The table below shows some of our rated multisector managers and their allocations to alternatives. The funds in the table all reside in our balanced or growth categories to try to ensure a fair comparison. The balanced category is for funds with a 41-60% growth allocation and the growth category is for funds with a 61-80% growth allocation.

Table of Morningstar multisector funds with allocations to alternative investments

What is notable is the magnitude of the allowable ranges and the portion of the budget currently being used. Pendal introduced an alternative allocation into its strategic asset allocation in 2012 and is now allocating 15% of the portfolio, the highest among the non-industry funds in our rated universe.

At the other end of the table is Advance. The 6% weight appears modest compared with peers, but this allocation is likely to grow as the group plans to expand its unlisted alternatives programme over the next 12 months.

Unsurprisingly, the industry funds are far more aggressive with their allocations to non-traditional assets, due to their stickier client base and long-term investment horizon. AustralianSuper, CBUS, and Sunsuper are all permitted to have the majority of their portfolios invested in alternatives. According to our latest surveyed data, CBUS and Sunsuper have roughly 30% allocations, while AustralianSuper has roughly half as much.

Alternatives are a broad church

One important distinction in alternative investments is the choice between listed and unlisted assets. CFS, Pendal, Perpetual, and MLC have opted for the listed part of the spectrum, building real return strategies to deliver inflation-beating performance.

• CFS’ Real Return strategy targets a return of 4.5% above inflation on a rolling five-year basis. The team invests in equities and bonds across both developed and emerging markets; but they are permitted to invest in commodities, currencies, and cross-asset relative value trades. The asset class ranges are very wide, so the beta to equities and fixed income can oscillate wildly.
  
  
• Pendal’s approach uses two internally managed strategies: the Pendal Total Return Fund (16270) and the Pendal Multi-Asset Target Return Fund (42877). The former includes an AQR market-neutral hedge fund, a risk parity fund, and an alternative-risk premia fund, among others. The component strategies are given a long leash and often have volatility targets of 10% or more. The latter is a lower-risk fund designed for retirees that invests across equity, fixed income, commodities, and currencies. The portfolio is designed to have low-equity sensitivity to provide diversification benefits in a traditional portfolio.
  
  
• Perpetual allocates to the Perpetual Diversified Real Return Fund, which targets a return of Consumer Price Index plus 5%. There are wide allowable ranges and the team can invest across equities, fixed income, commodities, FX, and unlisted property and infrastructure. Options are used to manage currency risk and to alter other exposures in the portfolio. The team does avoid private equity and illiquid hedge fund strategies.
  
  
• MLC allocates a portion to third-party managers investing in catastrophe bonds. These instruments are insurance against natural disasters. They also use a Low Correlation Strategy that invest in specialist managers investing in government receivables, municipal bonds, relative value metals, and a range of other hedge fund programmes.

Industry funds are playing a slightly different game. These behemoths are able to access an illiquidity premium. That is, the additional return an investor should earn if the asset isn’t readily tradable. The industry funds can take advantage of the largely predictable inflows from generally younger members and the long-term nature of their liabilities. The three industry funds under our coverage (AustralianSuper, CBUS, and Sunsuper) all have meaningfully higher unlisted allocations than their non-industry fund peers.

The majority of AustralianSuper’s alternative portfolio is in direct investments in shopping malls, office buildings, industrial assets, toll roads, airports, seaports, and utilities. There is a smaller allocation to high-yield bonds, bank loans, and private equity. Similarly, CBUS has investments in property, with a notable domestic skew. This is hardly surprising given the occupation of its members.

However, CBUS does have more geographic diversity on the unlisted infrastructure portion of the portfolio. Similarly, Sunsuper has unlisted property and infrastructure exposure. They also have meaningful positions in a range of hedge fund and specialist alternative managers, including macro-hedge funds and event-driven managers.

It’s important to note that the strategies and securities discussed above is not an exhaustive list. We’ve also seen commodities, alternative-risk premia, long volatility, absolute return fixed income, and structured credit alongside the more vanilla stocks, government bonds, and investment-grade credit. In our view, this is a dizzying list of complex assets, and it’s important to understand whether multi-asset investment teams have the requisite skills and experience if they are increasingly venturing into these more complicated assets. It’s particularly important for those groups investing directly, not through third- party managers. The internal teams might be able to rely on an array of asset consultants with specialist knowledge, but the final decision rests with them.

The short-term results

Historically, many multi-asset managers have been highly conscious of their peer-relative performance. In fact, part of their processes often involves an analysis of how their competitors are positioned. It is unsurprising, therefore, that the long-term return outcomes have been quite similar among the peer group. As more managers introduce alternative allocations to their portfolios, we think the outcomes could diverge.

As shown below, CFS Wholesale Diversified and Pendal Active Balance have seen a notable difference in performance. This spread is partly attributable to the results of their alternative programmes. CFS’ Real Return Fund was a stellar performer, delivering 15% for 2019. Pendal’s Total Return strategy disappointed, as its allocation to the troubled AQR hurt.

One-year performance of Morningstar multisector funds with allocations to alternative investments

Investors should not overreact to short-term performance. However, the above example does highlight how the results can diverge due to different allocations to alternative assets. We’d urge investors to spend time assessing whether the multi-asset team responsible for their diversified funds have the requisite skills and experience to incorporate more-complicated assets to the strategic asset allocation.

We’d also recommend investors be vigilant about the risks these more esoteric assets bring. Traditional risk metrics, like standard deviation, aren’t particularly good at identifying the risks in less liquid assets with infrequent, and often opaque, pricing.

Simon Scott is an Associate Director, Multi-Asset & Alternative Strategies at Morningstar Australasia. For full reports on managed funds in all asset classes and a wide range of listed stocks, subscribe to Morninstar Premium. Morningstar has compiled a list of more than 150 companies that release earnings results during February 2020 Reporting Season. 

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