Why alternatives might hold the key to income

From Due Diligence 30 August 2012

By Dawn Kendall

The wide range of categories covered by alternative investments, many of them with low correlations to equity and bond markets, could offer stable income streams to investors, but fundamental research is essential before picking funds

The scarcity of income opportunities is an issue with which we have all grown familiar recently. We need hardly mention that record-low interest rates are leading savers to losses after inflation and that even the cautious investor is suffering from the negative real yields on government bonds. And with persisting, and most likely on-going, equity market volatility, dividend yields are correspondingly unpredictable.

Understandably, now more than ever, investors are clamouring for a stable income stream to off-set rising living costs. A good place to look might be in the alternatives sector. Intended to be less correlated to the main asset classes of equities and bonds, alternative investments can help combat market volatility and they often offer a generous and stable income stream. That said, their contribution may come with more esoteric risks and it takes a strong investment mind to investigate the challenges of investment in this sector.

Alternative investments cover a range of categories. For a long time, it was used as a ‘catch all’ category for any investment that did not fall into the main asset classes of direct property, equity, bonds and cash. However, we recently undertook research into the sector and uncovered what it contains: hedge fund and absolute return vehicles comprise a large portion, commodities are also a prominent category and can be broken down further to energy (including oil), metals, general and soft (including agriculture). Other components include private equity, structured products, infrastructure, convertibles and derivatives.

The sheer number of sub-categories shows just how diverse the sector is and reveals the range of potential income opportunities.

When it comes to alternative fund selection, it is important to distinguish between selecting funds from relatively established categories such as property and infrastructure, and selecting from novel or unique categories such as catastrophe reinsurance; a slightly different approach needs to be taken for each. Each will offer a choice of either growth potential and/ or income.

In a portfolio of alternatives, the trick is to strike a balance between the two. Both require faith in the manager and their team. A portfolio builder will always be looking for a standout investment opportunity; while funds from the more traditional categories, however, can be subjected to extensive quantitative analysis – looking at historical fund performance data or performance against comparable funds – this data simply does not exist for the quirkier funds available, and these form the growing majority. As such, a more qualitative rather than quantitative evaluation is necessary.

So, how much would you expect to earn from an alternative investment? The Catco Reinsurance Opps Fund generates a stable income of 5.15 per cent by providing catastrophe reinsurance: writing retro-reinsurance contracts with reinsurance companies for a specified basket of catastrophe risks. The occurrence of natural disasters bears no relation to the behaviour of financial markets and, following recent catastrophes such as the Japanese earthquake and tsunami, there has been a boost in reinsurance premiums that has improved the risk-reward profile of catastrophe reinsurance to an attractive level.

Likewise, an infrastructure fund such as John Laing is able to give the investor a stable 5.5 per cent. These yields, when compared to US equity dividend yields of 2 per cent (S&P) and UK government yields of sub 2 per cent before inflation, are attractive indeed.

To select such funds, a portfolio builder will need to analyse the nature of the fund in question and what it invests in. In particular, the true diversification properties of the fund are crucial, as low correlation to other assets is one of the key potential benefits of alternative investments. If historical, numerical evidence is unavailable, it will be necessary to look at the main drivers of returns and assess their relationship with other funds in the portfolio.

It is equally important to evaluate the sustainability of the fund or investment type in question and establish its likely risk. This will most likely require a qualitative approach, considering the fund’s investment policy, and the potential impact of future events such as the implementation of regulation. If the assessment is too speculative, it is a good idea to seek an income-generating alternative if possible, as these tend to be more stable.

Fund selection processes may be tweaked to accommodate for the idiosyncrasies of alternatives but fundamental research is essential. Knowing the background of the businesses and the individuals responsible for managing the money becomes even more relevant for these kinds of investments. When ready to invest, the correlation benefits and the yield pick-up are welcome attributes to a well-balanced, diversified portfolio.