As 2017 draws to a close, the return outlook for traditional asset classes remains challenging. Over the next 10 years, we believe that we are unlikely to achieve the same level of returns on government bonds, investment grade bonds or equity markets that we have had historically. However, an allocation to alternative asset classes should improve portfolio returns, reduce overall risk and add diversification. Let’s look at a few of these alternative assets.
Insurance-linked investments can offer diversification benefits
Investors in this asset class are offered a return for taking on a share of insurance losses linked to extreme natural catastrophes, such as hurricanes or earthquakes. One way to access these assets is via the $25 billion catastrophe bond market where daily tradable bonds provide access to a range of underlying natural catastrophe risks. Another way is through specialist managers that write direct contracts with insurers and reinsurers to get similar exposures. This represents a $50-60 billion market.
In some - hopefully the majority - of years, investors receive positive returns, however, this will be punctuated by loss years when one or more disasters occur. It would be entirely coincidental if these losses occurred at the same time as an equity crash. In fact, in 2008, when equity and credit markets performed very poorly, there were positive returns from insurance-linked. Conversely, in the last few months, we have seen three hurricanes cause significant insurance losses in the US and the Caribbean while markets have seen positive returns from equities and other asset classes. These diversification benefits have attracted investors and more capital has been allocated in recent years. At present, the catastrophe bond market has an expected return of cash plus 2-3% net of expected losses. This is significantly less than the cash plus 6% achieved historically over the last 15 to 20 years and we do not view this as attractive. However, by investing through specialist managers, we believe that returns of 5-10% net of expected losses and fees are potentially achievable.
The destruction of capital due to recent catastrophes is leading to higher premiums
Recent losses mean that premiums for next year are markedly higher in certain areas and hence expected returns are higher. Recently, we have been allocating more of our clients’ money to take advantage of those higher forecast returns.
Although asset-backed securities form a $4 trillion market, they are absent in most investor’s portfolios
Asset-backed securities (ABS) are created by the securitisation of pools of mortgages, loans and other forms of debt. It is not a traditional asset class that investors have historically held and it can be difficult to understand. It also carries the ‘taint’ of the global financial crisis (GFC). US subprime, part of the ABS market, was the catalyst for the GFC. However, an often overlooked fact is that most of the ABS market performed very well during the GFC, and most mortgage and loan portfolios did not suffer any significant losses.
Lessons were learned from the GFC – by regulators, credit rating agencies and the broader ABS industry
ABS is now fundamentally a more robust and investable asset class. However, we still see a significant pick-up in spreads above corporate bonds at similar levels of risk. This additional spread largely seems to be compensating investors for a general lack of familiarity with the asset class, for the complexity and for the taint of subprime. It is an extra return that we are happy to seek for our clients.
The different types of infrastructure offer valuable diversification versus equities and long-term cashflow benefits
Infrastructure ranges from social infrastructure (schools, hospitals), renewable infrastructure (wind farms, solar), to core infrastructure (road, rail, airports, utilities). The common feature of these assets is that they tend to offer pretty reliable long-term cashflows – often inflation-linked. Typically, they are also not that economically sensitive, so an economic downturn does not necessarily imply a downturn in cashflows and returns are only lowly correlated with those from equities.
A number of niche asset classes can also incrementally add returns to portfolios
Examples of these include litigation finance, healthcare royalties, trade finance and aircraft leasing. None of these will ever be a large part of any investor’s portfolio but all can incrementally add to returns, all are more accessible now, and can help to improve that risk return trade-off and improve diversification.
The largest investors will be able to appoint managers for these asset classes individually though for most investors that is not really an option. Challenges include having the expertise and time to appoint and monitor managers (the governance budget), knowing when to enter an asset class and identify when to reduce it as returns are being driven down. There are also behavioural factors including differing levels of expertise and comfort.
Overall, we see an increasing trend for investors to appoint managers to manage more diversified portfolios. It is most obvious in the UK pension market where, for the last 10 or 15 years, we have seen an increase in the diversified growth sector, which now accounts for about £200 billion. Interest outside of the UK is rapidly increasing and we expect this trend to continue.
We could be pessimistic because the outlook for traditional asset classes is challenging. We prefer to be optimistic because there is a range of asset classes via which clients can benefit from improved returns and reduced risk through better-diversified portfolios.