Asset allocation

A closer look at alternative assets

When investors structure their portfolios, one thing is essential: they need long-term return and risk expectations for each asset class. As a result, in an environment of very low interest rates, they will find that it may no longer be enough to invest in only stocks, bonds, commodities and cash.

 

03/06/2021 – Reinhard Pfingsten

There is also now a new challenge. Expectations for bond markets have, once again, been reduced. This is due to the massive interventions by central banks in the bond markets. It is also unlikely to change for some time, because central banks have more or less announced their intention to maintain their expansionary monetary policies, even if inflation continues to rise. In the meantime, we are assuming a performance of -0.2% per annum for European bonds in coming years. Investors who are prepared to invest in global bond markets, however, can still achieve a positive return. But even these returns will turn negative after inflation is deducted.

Equities preferred over bonds

In this context, equities remain attractive. But here also, return expectations have been reduced to 5.4% per year. The reduction is due to slowing advances in productivity and the reversal of globalisation effects. In addition, growth momentum in China is likely to slow in the medium to long term. This is true despite Chinese GDP growth having exploded in the first quarter of 2021, rising by 18.3%. Even though investors can still earn an attractive risk premium with equities, this return is reduced.

Seeking returns in alternative assets

It is still important to make use of global diversification. But it must be noted that commodities and even gold do not really help to optimise the risk/return profile of a portfolio. It may therefore be worthwhile to explore investment possibilities in alternative asset classes in more illiquid areas. Here, asset classes such as direct real estate, private equity and private debt come into focus.

How high could the share of these illiquid assets in an investment portfolio be? Conservative investors might use up to 20% of their portfolios to establish a mix of alternative investments. Investors who are willing to take on more risk could dedicate up to 30% of their portfolios to such assets.
 
The central question to be answered is: What is the investor’s goal? Is it to reduce the risk for a given expected return or to optimise the return for a given risk? In both cases, direct real estate can be attractive, with a possible weighting of about 10%. This allocation could be at the expense of the original weighting in traditional bonds. But it is interesting to note that adding in direct real estate is also relevant for optimising equity-heavy portfolios.

Private equity is also an interesting answer to both questions for risk profiles that hold 50% or more in equities. When aiming for portfolio optimisation, investors with such a risk profile could consider allocating 10% to 15% of their portfolios to alternative investments. However, we deem private equity not to be a suitable investment for investors with more conservative risk profiles.

Using private debt for diversification

Contrary to expectations, a private debt allocation does not automatically replace a certain share of the traditional bond segment. This result could certainly come as a bit of a surprise. After all, in the recent past there has been a veritable run on credit funds, which provide debt capital for corporate financing outside the capital market and in place of banks. Based on estimates, however, private debt should only be used in more aggressive risk profiles, i.e. again, with an equity portion of 50% or more. This is because private debt could serve as a diversifier to reduce equity risk.

The bottom line is that there are ways to noticeably optimise “conventional” portfolios in terms of their risk-return profile by adding alternative sources of return, such as direct real estate, private equity and private debt.

Reinhard Pfingsten — Global Head Asset Allocation Services

Asset allocation
Source: ABN AMRO Private Banking

This graphic depicts the efficient frontier and describes the set of optimal portfolios, where you cannot expect higher returns for a given risk or a lower risk for a given expected return.

The risks associated with investments

The risks associated with investments

Find out which type of investment suits you

Find out which type of investment suits you