Why pay the government for lending them money?
01 Oct 2020
Matthew Yeates , Head of Alternatives and Quantitative Strategy

Instead, look for alternatives

As we all know, March saw equity markets tumble globally in a matter of weeks. Not too surprising. Unfortunately, every now and again equity markets fall sharply. The astonishing thing for me was that:

  1. I was watching markets move from screens perched on my dining table in Clapham
  2. At the peak of the equity drawdown, government bonds were falling in value at the same time

The first of those was not too much of a problem; I’d bought a posh coffee machine shortly before lockdown and technology made working from home relatively seamless. On the other hand, the second of those is a big problem for the “free lunch” that multi asset portfolios are built upon - diversification. Traditional balanced portfolios usually aim to deliver diversification by mixing equities for growth and bonds for their defensive properties.

When bonds fell at the peak of the equity selloff, it was hardly the defence many would have hoped for. However, as well as being expected to rise when equities fall, investors in bonds historically could have relied on a yield income as an extra layer of defence. Given market movements over the last few months and years, investors in most UK government bonds (gilts) now receive hardly any income at all. Even worse, the yield on some gilts has joined those in Europe and Japan by hitting negative territory. In some cases, you now have to pay the UK government for the honour of lending them money.

Now, unless you really went big on eating out in August and are feeling guilty about all those half price dinners and want to give something back to the government, many bonds now look like a fairly unattractive investment. 2020 has provided the proof that investors must now, surely, look further afield for diversification.

So where to look? At 7IM we have long been believers that alternative assets are part of the answer. However, this category of investments is vast and some come complete with all the characteristics you should definitely look to avoid where possible; high fees, illiquidity and complexity.

Our alternatives selection process is focussed on identifying assets that provide the sort of diversification bonds historically offered portfolios, without the downsides listed above. In practice that means avoiding things like direct property, fine art and wine, and instead focussing on strategies in more liquid markets (no pun intended).

At 7IM, our “other” basket is composed of global real estate investment trusts (REITs) and a mix of liquid alternative strategies. The REITs offer diversification, liquidity and growth through exposure to the global property cycle. The liquid alternative strategies allocation that we have constructed brings defensive characteristics to portfolios, whilst still providing returns above inflation.

Our liquid alternative strategies include assets such as a commodity “long short” strategy. A long short strategy is a one that can benefit from both rises and falls in prices by using “shorting”. A short allows a strategy to lend assets to others and make back the difference from where a price drops to, versus the price they initially lent out. This approach is a staple of alternative strategies and is a differentiator versus normal “long only” strategies.

This strategy specifically buys and shorts commodity contracts for delivery at different points in time. It does this by looking for those that are the cheapest to hold. Contracts for delivery in the next few months often tend to be both the most expensive to hold and the most volatile. It’s because the short-term contracts are where factors around things like storage disruptions can impact prices the most. In April this year, some the price of some short term contacts even went negative. Companies literally had to pay others to take oil off their hands - they had nowhere left to store it! For the first few months of 2020, this commodity strategy made almost 30% through shorting those contracts that then went on to fall even more. This type of strategy is invested in liquid markets, is low cost to implement, and is a great example of the assets we like to hold within our alternatives allocation.

Investing in alternatives isn’t easy, but for us it is another way of making sure our portfolios are as truly diversified as possible. With bond yields having hit negative territory, investors globally face the prospect of materially lower investment returns unless they take action. For those using our funds, our alternative strategy is another part of our expertise you gain access to.

Unless you’re one of the guilt-ridden August eat-outers, carefully considered alternatives offer a more sensible way to invest, rather than continuing to rely solely on bonds for your diversification.

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