Alternative investments: a remedy to growing volatility?

Simon Lenney is Chairman of property bond provider CARLTON Bonds, and has spent 40 years operating in and around the commercial funding and investment industry. Having started his career in the corporate banking arena and latterly led teams for Barclays and Yorkshire Bank, Simon has spent the last five years as Head of Finance of a large, diverse property investment portfolio, during which time he has completed over £300m of funding transactions across a variety of sectors including residential housebuilding, hospitality and commercial space across the UK.

Over the past 40 years, I have been involved in an array of alternative investment assets. With a notable focus on property, I have witnessed both the cyclical nature of the housing market and the growth of venture capital in the UK, and am a firm believer of the importance of alternatives in a well-diversified portfolio.

Alternative investments (also known as “alternatives”) have become more popular in recent years than ever before, in part due to the ongoing market volatility and rising interest rates that have bred turbulence in the traditional investment space of late. With UK government bonds forecasting their biggest loss since 1987 and the London Stock Exchange losing its position as Europe’s most-valued stock market in recent weeks, the past month alone has been an unfortunate, but befitting, reminder of this trend.

Whether it has been via investing into property, venture capital, private equity or even collectables, many of us who have previously been staunch followers of the traditional 60/40 stocks-to-bonds portfolio in recent years have found diversifying into alternatives to be an effective solution to mitigating volatility and enhancing returns, whilst still being able to set overall portfolio risk in line with our general preferences and requirements. 

We can see this pattern reflected in overall investor data. Where in 2017 PwC estimated global alternative asset allocation to be valued at £11.2 trillion, today this figure has risen by 33% to circa £15 trillion, with forecasts suggesting it could rise by a further 40% to £21.1 trillion in 2025.

This should come as no surprise. Where the ‘fixed income’ (or the ‘40%’) element of our traditionally balanced portfolios in past years worked well when equities were climbing steadily and interest rates were close to 0%, with both stocks and bonds particularly sensitive to interest rates, generating returns via this split has become increasingly challenging following the fluctuating interest rates and volatile inflationary environment recent times have posed.

That is not to say we should steer clear of our traditional strategies, as we must still ensure our portfolio reflects the optimal balance for our investment goals. An alternative asset allocation of between 10% and 15% is not unusual to see these days, and can comfortably include a mix of options that involve strategies that provide exposure across a diversified asset base, such as property investments where returns have historically outpaced inflation, or venture capital investments that have the potential to generate considerable money-on-money returns.  

A study published by the National Bureau of Economic Research (NBER) in 2020 reinforces this idea that it is not only the lower relative market volatility of alternatives that has contributed to their increasing popularity over recent years, but also their ability to generate superior returns. This study in particular found that on average, US venture capital funds generated net returns that outperformed the market, generating an average annual internal rate of return (IRR) of 14.8% over a 30-year period, in comparison to the the 11.88% IRR returned by the US’ premier stock market index, the S&P 500, since its introduction. 

It is also worth noting that this pattern is not exclusive to US markets. In fact, in recent years European venture capital has performed better, with data by Cambridge Associates revealing that in the year to June 2021, a normalized index of pooled European venture capital fund returns outperformed its US counterpart by about two points. Additionally, over both three-year and five-year time periods, Europe was ahead by about five points

Whilst venture capital is but one example of an alternative asset class that investors increasingly diversified into with the hopes of strengthening the traditional 60/40 portfolio to withstand current market forces, by no means should investors limit themselves to exploring just one alternative asset class.

Whether it be by diversifying into property as UK house prices continue to climb considerably, targeting inflation-beating interest rates via peer-to-peer lending following consumer price index figures reaching 41 year highs, or considering private equity as a result of volatile stock market fluctuations, amid the fast-changing economic landscape of the past few years, I firmly believe most investors, in one way or another, could benefit from exploring the alternative space.

Though the past few years have further highlighted an opportunity for investors to benefit from  the alternative space, before making any investment, investors should always consider associated risks. Whether those come in the form of reduced liquidity due to longer hold periods, increased risk to capital due to investments being made into earlier stage companies, or reduced regulations due to less established governing bodies, as with every investment, alternative investments carry risks that can vary considerably throughout the space.

Ultimately, as the shifting motions of the global economic backdrop continues to dictate market patterns and the accessibility of growth-focused investment opportunities broadens on a growing scale, whether your portfolio is weighted more toward traditional or alternative investments, keeping track of how both landscapes adapt over the coming years should be a key priority for any investor.