• Wealth Management
  • July 28, 2022

Alternative assets: similar destination via a different path

The recent valuation reset is opening-up attractive opportunities in both equity and fixed income. Appropriate allocations to Alternative investments are also becoming more important in the cycle ahead.

The appropriate role of alternative assets in multi-asset portfolios is a topic of great interest to asset allocation strategists. And it’s more than simply an academic question. In theory, the risk and return characteristics of alternative assets should complement traditional equity and fixed income components. However, identifying the right alternative assets to use can be complex and accessing them can be expensive. So, the question becomes: do the benefits outweigh the costs? Are alternatives as appealing in practice as they are in theory?

Morgan Stanley Wealth Management’s research team constructs a range of model portfolios across different risk profiles. Importantly, within that range are models that include and exclude alternative assets. 

Having just celebrated the 10 year anniversary of our core models, we thought it was a good opportunity to review the data to see whether it can shed any light on the role of alternatives.

Source: Morningstar, Morgan Stanley Wealth Management Research.

Similar destination

As you can see from the numbers above, the performance of the Core and Core+ portfolios are quite similar over the long term. If we take the Balanced portfolio as an example, Core returned 8.1%pa, while Core+ returned 7.7%pa.

With such similar returns (and alternatives actually detracting slightly), the logical question is: why bother adding complexity through alternative assets? The answer is, of course, that return is only part of the picture. Risk is also critical.

A smoother path

Even if the performance was largely similar over the past 10 years, the journey has generally been smoother for our Core+ portfolios, in the sense that they bear less risk.

In particular, our Core Balanced portfolio had a realised volatility of 7.0% p.a. versus 6.3% p.a. for the Core+ portfolio.

More importantly (volatility is only a partial measure of risk) our Core+ portfolios also saw milder drawdowns (there was maximum loss of -12.0% for Core+ Balanced versus -13.1% for Core Balanced).

In summary, while the outcomes are largely comparable from a return standpoint, risk is noticeably lower.

Other important considerations

We believe the impact of alternatives is actually under-emphasised in the above data, for two key reasons.

  • Our Core+ models had only a relatively modest allocation to alternatives (between 5 and 15%) over most of the last 10 years – up until the 2021 strategic asset allocation review.
  • In the post-GFC world, buoyant monetary conditions led to significant strength in both bonds and equities, and depressed volatility. This made the environment particularly challenging for alternative investments, especially hedge funds.

As we pointed out in our 2021 strategic asset allocation review, we expected volatility to increase as central banks withdrew stimulus and this would lead to a more favourable environment for alternatives. We increased our allocation accordingly.

Although we were expecting this positioning to be rewarded over the medium term, we have been surprised with the pace at which this has actually occurred. The increased weighting to alternative assets is a key reason for the recent outperformance of our Core+ model portfolios. We expect this to continue and alternatives (particularly hedge funds), have been our highest conviction overweight position this year.

For more on how to incorporate alternative assets into your portfolio, speak to your Morgan Stanley financial adviser.

 

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