Key inputs related to returns, volatility and correlation are the foundational elements in constructing alternative investment portfolios
[SINGAPORE] Alternative investments are not just optional parts of portfolios now but have become essential, according to a new report by sovereign wealth fund GIC and JPMorgan Asset Management (JPMAM) released on Monday (Sep 22).
This is as opportunities for alpha and diversification in traditional assets are “shrinking”, making alternative investments such as private equity, real estate and private credit mandatory. Alpha is the measure of an investment’s performance beyond the returns generated from its benchmark.
“The pursuit of alpha from (an) informational advantage has become increasingly challenging in traditional assets – typically, stocks, bonds and cash,” the report said. It pointed out that investors’ ability to do so is now relatively limited given the data that is broadly available.
“As traditional asset classes face challenging opportunities for alpha and diversification, alternatives are addressing these shortfalls and increasingly becoming important parts of the toolkit for allocators to achieve return and risk goals,” it added.
The report pointed out that fixed income’s ability to provide “portfolio preservation” during periods such as market downturns and inflation is diminishing. That has driven investors to explore alternative investments as new sources of diversification.
“Alternatives, especially income-oriented categories, have proven to be good diversifiers to traditional assets,” it said.
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Alternatives therefore present opportunities for enhanced portfolio returns through active management and the exploitation of market “inefficiencies”, said both companies.
Building multi-alternatives portfolios
The jointly conducted research proposed an investment framework for multi-alternatives portfolios, combining deliberate position-sizing with active allocation of capital. It aims to improve portfolio returns and reduce downside risk.
Key inputs related to returns, volatility and correlation are the foundational elements in constructing alternative investment portfolios.
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“The industry still faces significant hurdles in accessing institutional-quality alternatives data, resulting in persistent market inefficiencies,” said the report. “These inefficiencies, together with significant dispersion in returns across asset classes and among managers, present opportunities for skilled allocators to generate alpha by taking advantage of information asymmetries.”
To properly set beta returns in alternative investing, long-term capital market assumptions can be tapped. Beta is a measure of the volatility of a security or portfolio relative to the overall market.
The assumptions should include expected return and volatility and a correlation matrix. Some principles from JPMAM include having a 10 to 16-year time horizon to account for a full market cycle, and to capture economic instead of accounting volatility. Accounting volatility may refer to fluctuations in earnings.
It also established a six-step process for constructing and managing multi-alternatives portfolios.
The process begins with establishing key investment objectives, before identifying the target universe of alternatives. Long-term positions will then be sized, establishing strategic allocations, before capital is actively allocated to capture near-term opportunities.
The penultimate step, the report stated, is to integrate risk management before continuing to improve and oversee the strategy.
Rewarding move
Multi-alternative assets can reap more rewards than a traditional portfolio, according to the report.
“The 65/35 global equities/fixed-income portfolio is unlikely to achieve a 4.5 per cent real return on a long-term basis; however, adding 2 per cent or more of multi-alts to it can make this target attainable,” it said.
Adding another 50 per cent of what the report called smart alternatives to the 65/35 equities and fixed-income portfolio can outperform the benchmark – which is the consumer price index plus 4.5 per cent – by another 1 per cent, according to the report.
Smart alternatives are defined as having a balanced exposure across growth and income-oriented alternative assets.