The opportunities in Alternatives

As 2022 begins there’s plenty to be cautious about. Central Banks are starting to tighten monetary policy, energy prices are contributing to rising inflation, economic growth is being impacted by Covid-19 variants and US midterm elections are scheduled for November. This is all happening against a backdrop of record high stock markets whose valuation, from some perspectives, could be compared to the 2000s internet bubble. We also have record-breaking temperatures:

2021 being confirmed as the 6^th hottest year on record; the last 7 years being the hottest ever recorded.

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So, what effect could all these events have on different asset classes? Rising inflation and interest rates can be challenging for fixed income as an increase in rates can erode the value of the payments received. A way to reduce this effect could be lowering duration, or the average time to maturity of the bonds in the portfolio to reduce the sensitivity to changes in interest rates. Rising bond yields can also be damaging for equity valuations as future earnings get discounted at a higher rate, thereby lowering present value. Although, we remain optimistic given the types of businesses we invest in, specifically businesses that avoid controversies, are well run and are solving major global challenges and thus underpinning future earnings. Equity markets are also being hit by rising supply chain costs, delivery delays and impacts to business in the face of climate and biodiversity crises. Against this backdrop we believe, in the current market, alternatives can be an effective diversifier and provide inflation protection across a risk adjusted portfolio.

“Alternatives” are a large asset class, traditionally associated with commodities and real estate. But the fundamental quality we look for at Tribe is diversification from the traditional assets of equities and bonds. Our expectation is that alternatives will be less correlated to traditional assets. This means they can improve the overall risk and return profile for our clients over the long term as they are intended to reduce overall portfolio volatility. Including different types of assets can improve total returns, as well as deliver yield and downside protection. Importantly, alternatives have the ability to create impact returns, often more directly than the equity market. This is especially true of many of the investment trusts we’ve supported the listing of over the past few months as we’re able to provide private capital directly to areas that previously couldn’t access it.

There’s no ‘one size fits all’ approach available in alternatives and within our investible universe there are opportunities across the risk spectrum which can target different returns, liquidities and yields. As well as traditional sectors like real estate (where we focus on sustainability), there are also opportunities within microfinance, battery storage, carbon, forestry, emerging market renewables and social housing – to name a few. As an impact investor, alternatives are where we’re starting to see good opportunities to create positive changes to society.

Some alternatives, for example battery storage facilities, woodland or a basket of micro-loans, aren’t subject to short term economic forces. The biological growth from trees and the value of the timber will still happen if US equities fall. If the price of timber isn’t particularly attractive, trees that would have been harvested can be left in the ground. This is a big part of the appeal in alternatives: they can reduce volatility across a portfolio and can act as a buffer when traditional markets are volatile.

Many investors think inflation could cause markets to stutter in 2022. With some alternatives, however, there can be a degree of insulation given the underlying entities. They can also have higher dividends which, crucially, are index-linked (i.e. linked to inflation). Social housing in the UK is one example. Not only is it relatively well protected given local government pays the rent, these payments are also increased in line with inflation, unlike investing in most bonds, where you receive the same amount of money in real terms.

However, like any asset class, being too overweight in alternatives carries its own set of risks. Alternatives can suffer as a result of a sector-specific, idiosyncratic risk. For example, a life sciences business we looked at has struggled during the Covid pandemic as they have been unable to perform new diagnostic tests during lockdowns. Another risk could be damaging technical factors such as divergence of the underlying liquidity within the vehicles.

In the current environment, alternatives have become an increasingly important asset class for our portfolios given both their financial and impact driven characteristics. We consider them a good diversifier which can complement a broader portfolio with global equity exposure. Alternatives have the ability to offer total return potential, as well as inflation protection and income characteristics, which in the current market are becoming increasingly harder to find. Given the difficult market conditions for equities and fixed income, we believe alternatives offer an opportunity to access yield, reduce overall volatility and have the potential to generate impactful risk-adjusted returns.