Aldous Huxley’s novel ‘Brave New World’ is set in a futuristic dystopian world where citizens are genetically engineered to be part of a specific predetermined class, with each forming their own function within society. A similar concept can be applied to investing in diversified growth funds (DGFs); each asset class should fulfil a relatively unique purpose within a portfolio, whilst being relatively differentiated from the other asset classes, therefore ensuring that the portfolio itself is greater than the sum of its parts. However, in a world of increased homogeneity within traditional asset classes, we should instead be looking for those which are genuinely diversified from traditional asset classes and explore the ‘brave new world’ of what is known as ‘diversified real asset funds.’
DGFs have been used by investors as a means of gaining exposure to a range of asset classes through a single solution, with the aim of creating an asymmetric risk-return profile. Of course the reality is that most DGFs, in the universe that we monitor, have failed to deliver a cash+4% target on a trailing five-year basis to the 31st August 2020. This is despite most meeting a volatility objective of two thirds of equity market volatility over the same period.
Faced with such a problem it may be prudent to look at some other building blocks when constructing multi-asset funds to provide exposure to more idiosyncratic factors and markets, such as real estate, infrastructure, private equity, private debt, loans, and timberland/farmland, combined into a single solution which we would consider diversified real asset funds. These funds could provide clients with direct exposure to alternative investments but in a solution that helps to reduce some of the key risks associated with alternatives on a standalone basis, such as liquidity, capital calls, factor sensitivities etc.
Combining these alternative investments together in a single solution, if managed effectively, can be used to create a risk-return profile that is genuinely diversified from traditional markets. A robust risk management and portfolio construction process can help mitigate the fund’s sensitivities to duration, inflation, and equity market beta, whilst simultaneously ensuring that clients gain exposure to asset managers’ intellectual property with reduced market exposure.
Real estate can provide a defensive ballast to the portfolio through a steady stream of cashflows, if rents remain stable and void rates remain low. Real estate has a fair amount of interest rate exposure, but this can be offset using loans which have floating rate exposure. Infrastructure can also provide stable long-term cashflows; however, within infrastructure there is a fair amount of interest rates, energy price, and inflation sensitivity[1] which can be offset by floating interest rates from loans and the inflation sensitivity offset by a private debt component. Private equity can provide a strong source of returns for the fund; whilst it will have some public equity beta and inflation sensitivity, this will be less than the broader market and will help offset the exposure to interest rates However, it should be noted that average private equity returns have been more subdued recently, reducing the added value of this asset class.[2]
This isn’t a one size fits all approach and some of the key structural components of these funds need to be highlighted, such as lock-ups, gating provisions, liquidity constraints, capital calls, the threat of a reduction in deal-flow[3], and potential structural changes to the fund during capital raising and the distribution of capital. Most of these issues are more relevant for funds that hold illiquid investments even though strategies with a reasonable allocation to liquid investments (20-40% for example) may also experience lockups, gating provisions, and liquidity constraints.
In conclusion, diversified real asset funds provide clients with access to a range of alternative investments that are differentiated from traditional markets but combined together in a single solution, helping to mitigate the idiosyncratic risks of each individual alternative investment. That said, the above highlighted issues should also be considered. A brave new world of multi-asset funds awaits us; it creates new opportunities for investors, but one must ensure that these solutions are engineered correctly to provide true diversification for clients.
Simon Woodacre is a Senior Investment Research Analyst at Buck Consultants (Administration & Investment) Limited, which is authorised and regulated by the Financial Conduct Authority.
Important notice: This article is for Professional investors only and was written as at 11th September 2020. The article is generic in nature and should not be regarded as providing specific advice or a recommendation of suitability. No action should be taken without seeking appropriate advice, taking account of how the market environment has changed since the date of this article. There can be no guarantee that the opinions expressed in this document will prove correct.
The value of investments and the income from them may fall as well as rise and will be affected by changes in financial conditions. Past performance should not be relied upon as a guide to future returns.
[1] https://www.ifminvestors.com/insights/insight-article/infrastructure-investment-in-a-rising-interest-rate-environment
[2] https://www.bain.com/insights/public-vs-private-markets-global-private-equity-report-2020/
[3] https://docs.preqin.com/reports/Preqins-House-View-COVID-19s-Impact-on-Alternative-Assets-April-2020.pdf