When designing multi-asset portfolios, we start with four high-level asset classes: equities, bonds, cash and equivalents, and alternatives.

We define Alternatives as anything that isn’t equities, bonds or cash.

The purpose of including alternatives is for one reason: diversification. But how can we be sure alternatives are doing their job?

What goes in to alternatives

Traditionally, property is the most popular “alternative” asset class included in portfolios offered by adviser firms, if any. This is typically a function of whose risk profiling or asset allocation framework that firm is using as those frameworks are often limited in the number of asset categories they can define or model, which is a shame.

What else might be defined as alternatives? We break down this broad asset category into two sub-categories.

Firstly, alternative assets which can be described as “different things”, for example property, infrastructure, gold and commodities. Broadly anything that isn’t an equity, bond or cash exposure.

We also differentiate between direct property and property securities noting that whilst their economic drivers and long-term performance are similar, there is a trade-off between their reported volatility (a function of different valuation frequencies) and liquidity profiles.

Secondly, alternative strategies which can be described as “doing things differently,” so doing something other than just owning an asset class. For example, absolute return funds may own “traditional assets” such as equities and bonds, but also incorporate risk management overlays to be managed in such a way to beat an “absolute” hurdle rate and typically limit downside risk.

Risk-weighted strategies, and long-short equity strategies would also fall into this category.

Key considerations for sizing an alternatives allocation

When creating an alternatives allocation there are three things to consider to blend in with the rest of the portfolio, whilst ensuring good functionality.

Firstly, what is the return contribution to the portfolio: ideally it is similar or higher to the rest of the portfolio – the mix of equities, bonds and cash – for each risk profile.

Secondly, what is the risk contribution to the portfolio: ideally it is similar or lower to the rest of the portfolio.

Finally, what is the correlation of each alternative exposure and the alternative allocation as a whole to the rest of the portfolio.

Correlation is, in a way, the most important to know and hardest to evaluate. If a portfolio contains a number of alternative exposures that “look” different, but “behave” similarly to the equity/bond allocation, those alternative assets provide “diversification in name only”!

For an alternative exposures to provide “true” diversification, they have to have low or no correlation with the equity/bond allocation. Portfolio theory suggests – and practical experience proves – that the incorporation of uncorrelated assets into a portfolio means the level of risk of a portfolio can be less than the sum of its parts.

This is sometimes known as the only “free lunch” in financial markets.

An adaptive approach to the alternatives allocation

As we define multi-asset portfolios by their equity risk level, we include alternatives within the “non-equity” allocation of the portfolio.

Some asset allocators hold no allocation to alternatives. And that proved a problem for over a decade when bonds lost their mojo as interest rates were suppressed to near zero level.

Other allocators have permanent fixed-weight allocation to alternatives: this makes sense for strategic “long-term” portfolios.

We believe it makes sense to have an adaptive approach and to flex the allocation between bonds and alternatives depending on the outlook for interest rates and inflation.

When inflation and interest rates were on the rise, it made sense to have more alternatives, and less bonds. With inflation moderating and interest rates set to pivot, it makes sense to have more bonds, and less alternatives.

What’s included in the Alternatives allocation can also be adapted based on market outlook with a keen focus on those three variables: expected return contribution, risk contribution and most importantly alternatives’ relationship – correlation – to the rest of the portfolio. The less correlated, the better.

Henry Cobbe is head of research at Elston Consulting