August 20, 2018

Alternative investments are increasingly taking centre stage for the additional and less volatile returns they add to portfolios, as well as diversification benefits, amid a changing global economic environment, according to Deutsche Bank Wealth Management.

With central banks slowly trying to return monetary policy to “normality”, one of the side-effects is likely to be positive but rather lower returns in conventional asset classes than the high levels investors have grown used to in the last few years. At the same time, a period of abnormally low market volatility appears to be coming to an end.

Christian Nolting, Global CIO said, “While we believe that investors should stay invested in the market – albeit hedged – the portfolio diversification potential of alternatives in general could prove crucial, particularly if they can help stabilise a portfolio when the normal historical relationships between traditional asset classes do not hold, at times of market disruption. We believe investors are seeing the benefits of additional returns, the diversification away from traditional asset classes, and less volatile returns. Hedge funds for example could be seen as a partial substitute for bond allocations, while illiquid investments could potentially offer the so-called illiquid premium.”

Liquid Alternatives: Favour Discretionary Macro Hedge Fund Strategies, Manager Selection Key

In liquid alternatives, Deutsche Bank Wealth Management currently favours Discretionary Macro hedge fund strategies, which attempt to gain from macroeconomic, policy or political changes. These strategies’ potential ability to capitalise on policy divergence in the major developed economies and uncertainty has informed the firm’s ‘positive’ rating for this strategy.

Equity market neutral strategies should benefit from an increased dispersion of performance across sectors and stocks providing a more conducive environment for stock picking, and any increase in realised market volatility. However, some more speculative areas may be challenged and this tempers the firm’s view to neutral/positive.

CTA strategies should gain from the emergence of clearer market trends in fixed income, currency and commodity markets as well as in equities. Deutsche Bank Wealth Management’s neutral/positive view reflects a belief that CTAs now have a more balanced allocation, and are less likely to be affected by any further sell-off in equities.

Event Driven strategies, meanwhile, are set to reap the rewards of increased corporate deal activity but the regulatory and deal complexity makes manager selection highly important and this limits the firm’s rating to neutral/positive.

Equity Long/Short strategies may be affected by a generally negative shift in sentiment in equity markets, after years of uncommonly calm conditions and this has led to a downgrade in the firm’s assessment to neutral.

Credit strategies may appeal as an alternative source of yield, but will be affected by the evolution of interest rates and falling credit spreads: Deutsche Bank Wealth Management therefore has a neutral assessment here.

Distressed strategies will continue to suffer from an extended lack of opportunities as bankruptcy rates are low, so we currently have neutral/negative assessment here – although, given rising leverage and softening credit covenants, the firm thinks that there may be plenty of opportunities in the next distressed cycle.

While these strategies offer attractive investment prospects to portfolio, effective management selection and review is key to investing in alternatives, particularly considering the spread between top and bottom performing managers is much higher than for conventional asset classes. According to the 2018 Deutsche Bank Alternative Investment Survey, while the average return of the top quartile (25%) of managers in the year to November 2017 (across all strategies) was 13.3%, the bottom quartile of managers produced returns of – 2%.

Mr. Nolting said, “While individual hedge funds can deliver high returns, average returns can fit nicely into the risk/return spectrum of traditional asset classes. The volatility of returns tend to be lower for hedge fund indices than for equity indices, and hedge funds do provide a degree of protection against specific market falls.

However, variable returns of individual hedge funds and their suitability for different market conditions makes it crucial to examine their contribution to a portfolio and change investments accordingly to achieve the benefits of diversification.”

Illiquid Alternatives: Private Equity, Real Estate and Infrastructure Show Positive Signs

High returns, low/negative correlations with other illiquid investments and with other liquid asset classes, and in some cases, predictable income flows make illiquid investments beneficial additions to a portfolio.

Private equity continues to deliver attractive returns on both a relative and absolute basis. The appeal of private equity for investors has resulted in increasing levels of capital commitment to private investment funds, but increasing levels of investment in private equity, and the subsequent high levels of “dry powder” may have driven up pricing, putting returns under pressure. Private equity valuations have risen over recent years.

Illiquid real estate investment should benefit from the ready availability of financing and strong institutional interest in the U.S. Fundamentals remain supportive, with construction starts peaking. Income rather than appreciation will be the primary driver of returns and sector and market divergence will create opportunities. Potential risks include rising interest rates pushing cap rates higher.

Mr. Nolting said, “We are overweight on the industrial sector. Risks include upsets around the Brexit negotiations and structural issues in the Eurozone. In APAC, we are positive on the industrial sector and see healthy office rental growth momentum in several markets. Low interest rates and low vacancy in Japan could present attractive levered returns. Risks include a moderation in Chinese growth and high debt levels, particularly in China and Japan.”

Listed infrastructure may currently be trading at an attractive relative valuation to equities. Recent underperformance has been due to oil price falls, interest rate volatility and continued “risk on” sentiment. Historical dividend yields remain well above those from global equities or fixed income.

Mr. Nolting concluded, “While alternative investments can bring distinctive and positive qualities to a portfolio, they require careful acquisition, combination and management. Above all, what is needed is a realistic assessment of what alternatives can do and the risks associated with them. For example, while alternatives can have a very effective role in diversifying a portfolio, they need to be selected in a way that does not create an unintended concentration of risk. Effective manager selection and monitoring are particularly important and requires a high level of due diligence – something that an individual investor may find difficult to do on their own.”