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Friday View: 16 December 2016

The alternative investment menu post-Trump

The alternative investment menu post-Trump

By Patrick Thomson
Friday 16th December 2016

As scarce returns from mainstream assets continue to frustrate pension funds, their attention is shifting to alternative investing. To combat low growth and volatility in public markets, many will increase their exposure to these less liquid assets in the next year. The reflation sentiment accelerated by the Trump US presidential election victory should support this trend, at least in part. It is worth taking a step back to consider the rationale for pension investors adding alternatives and then looking at a few particular sectors of interest for 2017.

We can think of alternatives as being on a spectrum. Asset classes with lower volatility, higher liquidity and less diversification are more like stocks and bonds, such as certain hedge funds. These alternatives will often complement returns of a traditional portfolio. As we go out the spectrum in adding alternatives exposure, from private equity all the way to real assets, private credit and direct equity stakes, the trade-off in higher risk and lower liquidity but greater return becomes more explicit.

Given the heterogeneity of assets within alternatives, institutions have to consider how these assets function relative to their traditional allocations. The underlying investment options across the alternatives spectrum have also rapidly grown more sophisticated and bifurcated. For example, the growth in private credit – from just a handful of investment options years ago to dozens of subset strategies today – has been significant.

Depending on how they are used, alternatives can serve myriad roles in a portfolio – diversification and provision of less correlated sources of return, volatility mitigation, inflation protection, return enhancement and even income. They’ve also been sought out in a low rates environment as differentiated sources of yield – for example, commercial mortgage backed securities yield an average of 8% and developed market infrastructure yields an average 6%, as compared to 10 year German Bund yielding .30%.

The rise of populism in the developed world and the transition from reliance on monetary to fiscal policy has shifted the alternative investing playbook. The prospect of rising interest rates, higher inflation and stronger short-term economic growth has prompted a reassessment of the investment sectors that could stand to benefit and infrastructure is one area that it getting tremendous interest from pension funds, sovereign wealth funds and insurance companies, faced with such low yields in the traditional fixed income markets.

But it’s not all about yield – investors are faced with the prospect of inflation as well as continued volatility. This is where infrastructure has found its way to being a mainstream asset class: as a diversifier from equity and fixed income, a strong income producer and providing protection from inflation. In addition to now being a mainstream asset class, infrastructure investing is now a favoured political theme in almost every major developed economy, and indeed also in the emerging markets also with the development on new multilaterals such as the Asian Infrastructure Investment Bank.

As evidenced by the average age of the US capital stock, government spending has been insufficient and major opportunities exist across the infrastructure sector. Investors with the scale and expertise to access the private funding opportunities that arise in the initial stages will be critical. Political support for infrastructure spending now comes at a time when families and users can afford to pay for more upgrades and investment, an important factor that was not present during the financial crisis.

Real estate will be another important focal point, as the asset class could provide a reliable source of inflation protection in a world of rising interest rates, making it an attractive alternative.

Although 2016 has been a year of key political events, much uncertainty remains. As a result, low volatility hedge funds that are truly diversifying, have a low beta to the market and continue to offer a source of less correlated returns will have an important role to play.

Meanwhile, whereas private credit has been a favoured alternatives sector of the last few years for institutional investors, it will be important going forward to identify sectors of private credit that can maintain high barriers to entry for traditional banks, given the banking sector is the midst of a fundamental repricing on the back of expectations for steeper yield curves, less regulation and lower taxes.

As pensions have begun to widely acknowledge that a static 60/40 allocation to stocks and bonds won’t be enough to meet their long-term target returns, the unique risk and return profile of alternatives will keep them in the spotlight.

Patrick Thomson is head of international institutional business, JP Morgan Asset Management

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Friday View

Friday View

16 December 2016

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