An ongoing debate for investors, asset allocators and managers of model portfolios is whether they really need alternative investments.
With fixed income and money market funds delivering a decent yield and offering diversification away from equities, alternative investments – which often charge high fees – look less appealing.
As Rob Starkey, who co-manages Schroders’ range of model portfolios, said: “It’s a very expensive position if it’s not keeping up [with] or outperforming cash.”
This is why Schroder Investment Solutions has a dual mandate for alternative investment strategies. The minimum return target is cash plus 2% after fees (using the ICE BofA Sterling 3-Month Government Bill index as a proxy for cash) and this is the portfolio’s primary benchmark. Secondly, beta should be half that of the MSCI All Country World Index.
Taken together, these goals underscore that alternative investments should be return enhancing and/or risk diversifying.
This strategy has worked in recent times. During the volatile months of July and August 2024, Schroders Investment Solutions’ alternatives portfolio provided a less volatile and higher return outcome than global equities. Performance for the two-month period was circa 1.2% net of fees versus 0.3% for the MSCI ACWI.
One reason that investors and multi-asset fund managers such as Starkey may want to add alternatives now is inflation; in particular, where it will settle in the future.
Even though inflation is coming down, Schroders’ long-term view is that it will be higher than in the past due to the ‘three ‘D’s’ of demographics, decarbonisation and deglobalisation – to which Starkey added a fourth factor, debt.
Equities and bonds tend to become more correlated during periods of higher inflation, a relationship that becomes more pronounced when inflation reaches the 3% level, creating a role within portfolios for alternative investments.
The highest allocation to alternatives within Schroders’ model portfolios, which it manages on behalf of financial advisers, is currently 14.5%. This varies depending on the level of risk, with the allocation increasing with each step up the ladder, although the most aggressive strategy is invested solely in equities.
The alternatives bucket includes absolute return, macro, multi-strategy, volatility/arbitrage, trend-following and 130/30 extension strategies, alongside commodities and real estate.
Schroders also holds equity dispersion strategies that aim to profit from the difference between the S&P 500 index’s volatility and that of its constituent stocks.
The firm’s model portfolios invest in the Landseeram European Equity Focus Long/Short fund, Jupiter Strategic Absolute Return Bond, Brevan Howard’s BH Macro strategy and Schroder GAIA Contour Tech Equity, among others.
Schroders also holds catastrophe bonds or CAT bonds, which insurers use to transfer the risk of extreme events to investors, and which are “excellent diversifiers” because their returns are not related to the stock market, Starkey said.
The commodities allocation is split between the L&G Multi Strategy Enhanced Commodity ETF, which provides broad exposure to the sector, and a market neutral strategy that aims to benefit from the difference between the spot price and futures contracts. By being market neutral in this sense, the latter dampens the portfolio’s exposure to the volatility of commodity prices.