The two traditional benefits of owning bonds in a portfolio have been (i) to provide a stable source of income; and (ii) to provide some form of protection in the event of weak equity markets.
With 10 year gilt yields hovering around 1% per annum, a long way below current and forecast levels of inflation, it is hard to make an argument that bonds can generate sustainable levels of income, without taking on material credit risk by lending to more risky companies rather than the UK government.
In a similar vein, it is not clear that there is much room for bonds to rally further to protect portfolios, in the event of an equity bear market. Over the past 30 years as interest rates have consistently fallen, bonds have proven a fantastic investment, delivering strong returns for low levels of risk – unfortunately, in our opinion, it is highly unlikely that those returns can be repeated in the future.
This leaves the industry with an issue – how to replace those key characteristics? We think that there are opportunities, beyond the usual, overcrowded strategies, to find interesting investments that can dovetail well with our core equity holdings to create a diversified portfolio and to deliver bond-like characteristics.
The phrase ‘alternative investments’ can conjure up a number of images, not all of them positive. For many investors they can signal expensive high risk, high return strategies such as hedge funds or private equity investments, with associated negative connotations. These are largely thought of as substitutes for equity market exposure.
At 7IM we think of alternatives slightly differently. From our perspective as diversified multi asset investors, whilst we are largely comfortable holding equity investments as the long term driver of growth in the portfolios, we are less sanguine about the bond market and the extremely low level of interest rates around the globe.
When we evaluate potential investments in alternatives, we employ heightened due diligence to ensure that each new investment stands the best chance of proving to be a good fit with the rest of the portfolio. From our perspective, simplicity and transparency are crucial as we only feel comfortable making investments where we fully understand all the risks and drivers of returns. We are also cost-conscious as we recognise the debilitating effect of excess fees on returns in the long run – our preference is to construct our own strategies in-house rather than buy them in wherever possible. That said, we will use best-of-breed external managers where they can provide specific expertise at a competitive price.Simplicity and transparency are crucial as we only feel comfortable making investments where we fully understand all the risks and drivers of returns.
When we focus on alternative investments that can offer defensive characteristics, one such example would be gold, which we access via listed Exchange Traded Products (‘ETPs’) which are eligible for our funds. Gold is a traditional tangible store of value that tends to perform well in inflationary environments, when cash and fixed income investments can become less attractive – this has the potential to provide some protection for the portfolios.
In a similar vein, a potential source of steady, stable returns for the portfolios is infrastructure investments. These include pooled investments in assets such as roads, hospitals or energy grids which see stable and consistent demand through time – people will always get ill and need to turn the lights on. This stable demand can lead to a similarly stable long term return profile, often with built in inflation protection. We see good opportunities in this sector as heavily indebted governments look to partner with private capital to help deliver new projects with associated employment gains. We would typically access these assets via investment trusts, which can be listed on the various stock exchanges.
Over the past 18 months we have gradually added to our alternatives exposures across the portfolios, as we have taken profits on our bond positions. As at the end of June 2017, our Balanced fund had an allocation to alternatives of nearly 25%. We would expect to maintain a similar level going forward, until we start to see value return to traditional bond investments.
Senior Investment Manager
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