Alternative assets are supposed to offer valuable diversification benefits during periods of stock market volatility. It hasn’t worked out the way, at least so far. Equity prices have stuttered for much of the past two years, but asset classes such as private equity, infrastructure, and renewable energy – all marketed as alternatives to stock market investment – have been a letdown too.
However, some analysts think that may be about to change. “The good news on both US and UK inflation is reinforcing our view that we are at peak interest rates,” says Iain Scouller, head of the investment trust analysis team at Stifel. It expects several alternative asset classes to benefit as a result.
Why alternative assets are out of favour
First, the bad news. In recent times, “alts” have not delivered the returns they seemed to promise. Shares in the average investment trust investing in infrastructure, for example, lost 9% over the year to mid-November, according to Association of Investment Company (AIC) data, and now stand at a discount of almost 15% to the value of their underlying assets. Renewable energy funds have fared even worse, losing 13% and slipping to a discount of 18%.
Private equity investment trusts have done better, posting positive share price returns over the past 12 months. But the sector continues to be undermined by discounts of 30% or so, excluding the impact of the giant 3i Group (LSE:III) fund.
Nor have many of the specialist alternative funds launched prior to the Covid-19 pandemic offered much comfort. For example, Seraphim Space Investment Trust (LSE:SSIT) has lost a whacking 45% over the past year, while HydrogenOne Capital Growth (LSE:HGEN) is down by 47%. Hipgnosis Songs (LSE:SONG) has performed so poorly that shareholders have voted that it should not continue in its current form.
There are a range of explanations for these miserable records, but the inflation and interest rate environment is certainly a crucial part of the story.
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In sectors such as infrastructure and renewable energy, interest rates are relevant because the lure of these funds is often the yield they offer. Large-scale infrastructure projects generate significant amounts of income – sometimes with state-backed links to inflation – that managers pass on to investors. However, as interest rates have risen, yields on government debt have climbed too – and when investors can earn 5% or more on risk-free assets such as gilts and US Treasuries, there is not much reason to bother with less certain asset classes.
Worse, there’s a double whammy effect here. Infrastructure assets are valued according to estimates of their future cash flows, adjusted to present-day values; the adjustment is made with reference to bond yields, so when these are higher, the value of assets is automatically marked down.
Private equity also out in the cold
In the private equity sector, meanwhile, higher interest rates are an issue for a different reason – private equity funds take on borrowing to build their portfolios, so higher borrowing costs are a headache.
The private equity sector has also been hit by the increasing risk aversion of investors in these market conditions. Unlike with listed equities, investors don’t get continuous updates on the value of the holdings in a private equity fund; they must depend on estimates published each quarter by the manager. When they’re anxious, they therefore assume there is bad news to come, and mark the fund’s shares down accordingly.
Risk aversion also hits specialist funds hard for similar reasons – and simply because nervous investors don’t like unfamiliar assets.
Why alternative assets now merit a closer look
Given this backdrop, why might now be the time for investors to consider a return to the alternatives space?
Well, the most obvious reason is that interest rates do now appear to be close to the top of the cycle – some economists expect interest rates to begin falling in the UK and Europe over the next year or so. That will drive gilt yields down – and reverse some of the negative effects seen in alts over the past year. In both renewable energy and infrastructure, historical analysis shows a very high correlation between performance of these assets and of gilts.
However, there are other reasons to be positive too. For example, Stifel points to the latest announcements from the UK’s National Infrastructure Commission, which has just called for investment of up to £25 billion a year in renewable energy and associated infrastructure. The government’s decision to offer greater financial incentives to the UK offshore wind sector also “provides a potential pipeline of new investment opportunities”.
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It's also the case that market sell-offs caused by risk aversion hit every fund, irrespective of their individual nuances; many managers in the alts space feel they have been dragged down unjustifiably.
“We can’t do anything about the market, but we can focus on building a portfolio of assets with real potential,” says Stephen Foss, managing director of Cordian, the asset manager that runs Cordiant Digital Infrastructure (LSE:CORD).
His investment trust, currently trading on a discount of 35%, has suffered along with the rest of the infrastructure sector, despite its focus on digital assets – data centres, fibre networks and communications towers – which are a very different prospect to, say, roads and ports.
It offers a mix of both income and capital growth, Foss points out. “Digital infrastructure is part of all our lives, and that’s a massive tailwind, even before you consider growth in areas such as artificial intelligence,” he says.
Another point to consider is that sentiment can change quickly in these market conditions, particularly in specialist areas. Shares in Seraphim Space, for example, recently spiked 7% in a single day following a third-quarter update to the market that brought news of two new investments in two early stage space technology businesses.
Private equity recovery on the cards?
In the private equity space there are also reasons to be hopeful – managers have been expected to mark down portfolio valuations for the best part of two years now, but this has largely been avoided. Now it may to be time for the sector to adjust to reflect current market conditions, suggests Matthew Hose, an equity analyst at stockbroker Jefferies. “The gap could also be closed if public equity markets stage a sustained recovery,” he says.
The analyst team at Numis Securities is also optimistic. “We believe that discounts in the listed private equity sector continue to reflect a very attractive investment opportunity, with average discounts of around 30%,” Numis said in a note published earlier this month.
It added: “This is significantly wider than the secondary market for private equity funds, where we understand that buyout funds are trading at 10% discounts.”
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Still, if the alts space is now primed to bounce back, investors will need to consider their options carefully. And Dzmitry Lipski, head of funds research at interactive investor, urges investors to consider alts as part of a diversified portfolio strategy, particularly in the more specialist areas.
He says: “Specialist strategies in areas such as clean energy usually provide exposure to a relatively limited area of the market, resulting in a concentrated portfolio with potential strong style or market-cap biases.
“Longer-term investors willing to tolerate higher volatility may find it beneficial to diversify their exposure across not just one but several specialist areas in their portfolio.”
With that caveat, Lipski has one particular recommendation in this area. “Polar Capital Smart Energy fund stands out as an option for investors,” he says. “The fund is characterised by its experienced management, proven track record, and thematic investment approach.”
In practice, there are a wide range of options across an alts space that is very broad – no two opportunities will be identical, and investors will need to investigate the merits of each fund in its own right. Nevertheless, fans of alts are beginning to spot the green shoots of recovery. That means the window of opportunity given today’s low valuations may not stay open for much longer.
“Alternatives come with extra risks such as portfolio valuation, asset liquidity and often higher leverage, but in our view the extreme and historically unusual disconnect [with equity funds] highlights the oversold nature of the alternatives space,” Stifel’s recent analysis concludes.
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