Proceed with caution

With markets uncertain on inflation outlook and its rate of change, central bank signaling of liquidity withdrawal in long term bond yield compression and the likelihood of global and domestic interest rate increases being brought forward as early as 2022, it is important to think about manager selection. Particularly, in terms of delivering genuine alpha and manager strategies that can protect capital should markets (specifically equities and bonds) retreat, potentially very rapidly as such macro concerns mentioned play out in 2022.

Q1 2020 provided an almighty scare to investors. However, a speedy recovery has saved those who weathered the storm, provided an opportunity for those with a well-constructed portfolio to capitalize, while others cashed out on their super at the bottom of the market. 2022 is the year to look at Alternatives to diversify your portfolio and provide uncorrelated exposure that will also stem the bleeding should we find ourselves in another bear market or correction.

Firstly, lets define the role of Alternatives within a well-diversified portfolio – that is, the aim to deliver a differentiated return stream to that of traditional asset classes such as equities and bonds, yet positively impact the overall portfolio via reduced volatility and lower drawdown in market weakness, and provide alpha. Each individual investment won’t perform each of those functions, however a well-constructed and balanced portfolio is likely more able to do so.

We recently researched the performance of alternative asset classes in Australia over the last 12 months (as at 12 Nov 2021). Unsurprisingly, those strategies carrying high market beta have knocked it out of the park with some achieving 40%+ per annum gross returns, 2-3 times above annual expectations.

What stands out is that these outsized returns compared to “through cycle” averages were achieved at much lower volatility than expected, pushing up risk adjusted returns. History indicates this is highly unsustainable, and if history repeats itself, what does this mean for manager selection going forward and the type of alternative assets that should be sought given the uncertain macro backdrop?

Jerome Lander recently pointed out in his article How wholesale investors find fund managers that get them returns - Jerome Lander | Livewire (livewiremarkets.com) that portfolio managers should look to boutique managers rather than the big players, as they are generally much more aligned to investor outcomes, and not stuck in the system. He also touched on the great divide in quality alternatives available to retail investors, as opposed to wholesale, something which is mentioned every time the Future Funds asset allocation is published.

It’s interesting to note that the top-performing strategies (global small - mid cap equities/long-biased Asian Equities/Private property) with outsized gross returns circa +30% per annum have been achieved at significantly lower annualized volatility than through an investment cycle, making for impressive Sharpe ratios of over 2.5 times.

The Sharpe ratio is a measure of the return of an investment, compared to its risk. Volatility may be a measure of risk, but it also presents opportunity for active managers to outperform, where passive managers are more likely to be the beneficiary of low volatility, such as we’ve experienced of late. Although most would agree, we do not expect this to last forever.

Historically, steep rises in Sharpe ratio reverse quickly, and the below graph could be viewed as an ominous warning.

Examining what is a more sustained risk-adjusted return (say 5 years) we find annualized returns for these strategies tracking closer to one third of these levels (say 10%) yet at a volatility premium nearer to 50%. In other words, potentially higher volatility going forward may equate to asset value drawdown. Managers that demonstrate genuine alpha combined with demonstrable ability to cushion loss or provide downside protection should be on your radar and sourced while markets are strong.

Another appropriate measurement for managers to consider is a variation of the Sharpe ratio, the Sortino ratio. This distinguishes bad volatility from total overall volatility by using the asset's standard deviation of negative portfolio returns (downside deviation) instead of the total standard deviation of portfolio returns. By studying the Sortino ratio, portfolio managers will gain an understanding of their portfolio’s exposure to negative volatility – or in other words, how it may fare against its peers during market shocks. It’s one thing to demonstrate alpha on the upside, but another on the downside.

Our conclusions are simple - consider those alternative strategies that show demonstrable alpha generating characteristics and that have less reliance on rising underlying markets. We believe that the increasing allocation to alternative strategies is not a cyclical change, but a structural one as asset allocators consider how they can weather the next storm.