Advisers are putting their model client portfolios at risk by avoiding ‘alternative’ funds, according to Natixis.
The global asset management firm published its quarterly Portfolio Barometer report yesterday, which found that a decent proportion of the 177 model portfolios included in the survey held no alternative investment whatsoever.
The results may come as a surprise to some investors, following the recent volatility in equity markets and the impending rate rise from the Federal Reserve making fixed income seem vulnerable – especially as many commentators have highlighted the need to generate an alternative return profile.
The Natixis report also found that analysts have reduced their exposure to fixed income since the last quarter, with conservative portfolios reducing their exposures by an average of 8 per cent, moderate portfolios by 3 per cent and aggressive portfolios by 1 per cent.
The biggest difference was found in the conservative portfolios as they have cut their fixed income allocation by an average of 7 per cent, while moderate portfolios have reduced their exposure by 6 per cent.
Average change in allocation between Q2 and Q3 2015
Source: Natixis
If this is indeed the case, why is it that the financial advisers surveyed are holding a limited range of alternative investments in their portfolios?
At first glance, it seems that a significant amount of advisers are maximising the benefits of alternatives, with 90 per cent of conservative portfolios holding at least one alternative investment vehicle, 84 per cent of moderate portfolios holding some alternatives and 61 per cent also holding some.
The analysis found that direct property and multi-strategy funds were the mostly widely used alternatives though and, when property is taken out of the equation, the average allocation to the asset class falls substantially.
Excluding property, conservative portfolios had on average a 13 per cent allocation to alternatives, moderate portfolios had 8 per cent in alternatives and aggressive portfolios held just 3 per cent.
Allocations as a percentage of total alternatives allocation
Source: Natixis
“From a diversification perspective, adding alternatives to a portfolio makes a huge amount of sense. However, advisers should investigate alternatives funds carefully when making selections – often those easiest to understand offer the least benefits,” Matthew Riley, head of research at Natixis, said.
“Most are choosing multi-alternative funds as their main non-property alternatives vehicles when in fact they are the most correlated of all alternative fund types to the wider portfolio. Some do offer excellent diversification, however, so careful research and selection is key.”
Riley believes that advisers should carefully consider all alternatives at their disposal as a means of diversification, and AXA Wealth’s Adrian Lowcock agrees, warning that investors must be careful buying into such a broad area of the market.
“You’ve got to be very careful with alternative investments because some of these alternative investment products may be illiquid, they may have particular types of risks, or have particular time horizons. Things such as catastrophe insurance can have a good year or a bad year, it effectively depends on random luck,” he explained.
“It’s making sure you’re well-diversified within that. Just because it’s an alternative investment, it doesn’t mean it isn’t correlated with other assets.”
One pitfall the head of investing warns against, as mentioned by Riley, is buying a whole series of assets within alternative investments which are closely correlated to each other, despite being uncorrelated to equities and bonds.
Tristan Scrivens, owner of Elm Financial Management, warns that financial advisers must know exactly what they are investing in for their clients before buying, as buying into alternatives without sufficient knowledge can have disastrous consequences.
“I’ve inherited clients before that have been put into a particular recycling facilities fund by their previous adviser, for example. The trouble is, the fund became too greedy and they decided to raise more money so they could increase their assets and they froze their income payments, so the clients hadn’t been able to receive income for three years,” he said.
“They can’t sell it because everything’s frozen, it’s an absolute nightmare to deal with and I’ve seen all sorts of other horror stories, so advisers should be really wary of buying into such a broad area of the market without having sufficient knowledge.”
Despite scepticism from some investors, the Natixis report found that, as well as potentially offering diversification benefits, holding alternatives can reduce overall risk levels in a portfolio.
The below chart shows the marginal risk of various categories against the wider portfolios in the survey, with the marginal risk showing the impact on overall risk levels by adding a small allocation to the portfolio.
Average marginal risk of each alternatives category on portfolio average
Source: Natixis
The data shows that, with the exception of commodities, all of the alternative strategies add a negative marginal risk to the portfolio.
It also found that almost all of the alternative funds that the portfolios already held reduced risk, even if the alternatives were relatively high-risk on a stand-alone basis.
Even so, Jupiter Merlin’s John Chatfeild-Roberts believes that investors don’t need alternatives for a well-diversified, risk-adjusted portfolio, and warns that investors should be wary of buying into the asset class in a bid to find extra returns.
“You have to look really carefully at alternative assets and you have got to know what your risks are,” the FE Alpha Manager told FE Trustnet last month.
“Paul Volker, the esteemed ex-head of the Federal Reserve, made a quip some years after being asked about financial innovation when he said the only useful innovation in finance over his time had been the ATM. What he was taking aim at was derivatives, structured products and other niche things. I know little about ligation funds and aircraft leasing, but they sound pretty flaky to me.”
Martin Bamford, chartered financial planner and managing director at Informed Choice, agrees that strong portfolios can be built without alternatives, and believes that investors should only increase their exposure if they are able to quantify the risk.
While he says that small amounts of alternatives can indeed offer extra diversification within a portfolio, the asset class should not be used as a “panacea” for reducing risk and boosting returns.
“Within our portfolios we don’t currently hold any alternatives. To date we have been able to get the desired risk and return profiles by blending the traditional asset classes of cash, fixed income, equities and property,” he said.
“In recent years there has been greater correlation between these mainstream asset classes than we would ideally like to see, but they remain a robust way of achieving diversification and predictable volatility levels.”
Riley agrees that many alternative funds are unable to offer spectacular returns to investors and are more often used as a means of diversification.
However, he says that they are invaluable as diversifiers, and that there are still examples of alternatives that can provide strong returns to a portfolio so long as advisers do their research.
“Why aren’t advisers using alternatives more, particularly those that might offer real diversification benefits or returns? It may be because they are uncertain about how exactly these funds work, – certainly an issue which has been raised to us in the past,” the head of research said.
“It is the job of the fund managers to make sure advisers are given everything they need to educate themselves, and just as importantly their clients, on the benefits these types of fund can bring to a properly diversified portfolio.”
