“Alternative” Thinking for Modern Portfolios

When building a portfolio, we think about investments within broad categories, known as “asset classes”. While stocks and bonds are often familiar categories for our investment clients, there is another category which might be less well understood: “alternatives”.

Alternatives to what, exactly? Well, typically stocks and bonds make up the majority of a client portfolio, but there is room for other kinds of investments as well, to help balance the overall portfolio and smooth the investment journey. This article focuses on explaining what we mean by alternatives, and the role they play within portfolios.

What do we mean by “alternative” investments?

Equities, or shares, represent ownership in companies. Their value rises and falls depending on company performance and how optimistic investors feel about the future of the company. Bonds are loans to governments or companies, where investors receive income in the form of interest payments. Performance of bonds is impacted by interest rates, inflation and factors affecting the likelihood of the loan being repaid.

Alternatives cover a broad spectrum of investments that sit outside the categories of equities and bonds. Some examples include investing in a commodity, like gold, or insurance-linked investments. These investments tend to perform well at different times to equity and bond markets. This means they can be particularly valuable in protecting portfolio values from falling too much during market shocks. The trade-off is that you would not expect them to always keep pace when stock markets are performing strongly. That difference, and diversification power, is precisely why they can play such a useful role in portfolios.

The investment case for alternatives

The most traditional or common idea of a “balanced” portfolio is comprised of just equities and bonds. For example, what is known as a “60:40 portfolio” – is one which allocates to 60% equities and 40% to bonds. The benefit of such a portfolio is based on the idea that if either equities or bonds fall in value, the other is likely to provide some support, as often when economic growth weakens, stock markets may fall but bond markets are prone to rise. In practice, this relationship does not always hold. There have been periods, such as in 2022, where both equities and bonds fell at the same time. 

Alternatives help reduce the reliance on equity and bond markets. By introducing a wider range of return sources, alternatives can help reduce the size of losses when equity and bond markets fall and creates a more consistent investment journey. 

Classifying Alternative Investments

Below we provide some examples of common alternatives that we consider using in portfolios:

• Insurance-linked investments: these are investments that are designed to collect insurance premiums and then pay out if there is a loss that is covered under the insurance policy. One example is so called “catastrophe” (cat) bonds, which cover the purchaser for real-world events, such as natural disasters (e.g. hurricanes). Because the occurrence of natural disasters is not usually linked to equity performance, the cat bonds can perform well at different times to equities and traditional bonds, which makes them valuable in portfolios. 
• Systematic strategies (like trend following): strategies that use computer models to spot trends across global markets (equities, bonds, currencies and/or commodities). While these investments may still be linked to stock or bond markets, they aim to make money whether prices are rising or falling. They do this by both investing in assets they expect to go up in value, while also betting against those they expect to fall. This flexibility can help them perform across different market conditions.
• Real assets (real estate and infrastructure): these include investments in assets such as property, transport networks or utilities. In our portfolios, rather than directly owning buildings or infrastructure projects, we invest in listed companies whose earnings are tied to these “real assets”. This gives us exposure to the same long-term themes and return characteristics, while still allowing us to buy and sell investments easily without locking capital away for many years. Returns are typically generated through income streams such as rental payments or usage fees. These revenues are tied to real-world economic activity, and are often linked to inflation, as such their performance can differ from traditional stock and bond markets.
• Commodities: these are physical assets (such as gold) whose prices are driven by supply and demand and geopolitics, rather than company earnings or interest rates. 
• “Alternative” credit: specialist lending to different types of companies or governments that can perform somewhat different from traditional bonds. This sits within the broader credit universe, so it is not strictly viewed as a pure “alternative” asset class. It includes high yield bonds (loans to higher risk companies which therefore generate higher income) and emerging market debt (loans to governments or companies in developing economies). These parts of the market can offer higher returns than traditional bonds, and are sensitive to different risks than more mainstream, developed market bonds depending on the type of loan.

The point here is that these “alternative” credit investments can have a different performance profile to traditional bonds, bringing diversification benefits like other alternative assets.

Summary

We believe alternatives perform an important role in our portfolios. By combining equities and bonds alongside a broader set of investments, portfolios are better positioned to deal with a wide range of market conditions. 

No single investment performs well in every environment, but a well-diversified mix of assets increases the chances of delivering more consistent outcomes over time. In today’s geopolitical and economic uncertainty, having a broad range of investments in your portfolio is more important than ever.