Alternative investments in portfolios: Their time has come

THE 60/40 strategy, once hailed as the holy grail of diversification, involves investing 60 per cent of a portfolio in equities and 40 per cent in fixed income. Despite decades of good performance, investors are losing faith in this stalwart of investing. The main reasons for this are the persistently low bond yields, and increasing correlation between equities and bonds.

Years of monetary accommodation by central banks, coupled with technological disruption globally, have resulted in bond yields staying at historic lows. According to the Callen Institute, the supposedly "well diversified" 60/40 portfolio would possess 99.85 per cent equity-risk concentration. However, when real estate, high yield bonds, and hedge funds are added, the equity risk concentration falls to 79 per cent. This suggests that bonds alone are no longer effective for diversification, and there is a need for alternative investments as an asset class.

Alternatives are investments outside the traditional asset classes of stocks and bonds. Private equity, private debt, hedge funds, infrastructure, and gold are examples of Alternatives. A rising interest in Alternatives has seen its assets under management (AUM) grow from US$7.2 trillion in 2015 to US$13.3 trillion at the end of 2021. As investors continue to venture beyond traditional asset classes, Alternatives' AUM is expected to exceed US$20 trillion in the next five years.

What makes Alternatives so attractive? The allure lies in opportunities for:

• Growth enhancement - Assets in private markets are less constrained on the regulatory front. For example, a traditional mutual fund would have constraints like a maximum limit on single security exposure. As there is less shareholder pressure for short-term earnings, investee company owners would have greater control over their businesses, enabling them to take a longer-term view, and hence drive higher returns.

• Income enhancement - Private credit has consistently generated superior returns over the public debt markets of government bonds and corporate bonds which comprise investment-grade, high-yield, and leveraged loans.

• Diversification - Alternatives have historically been less correlated with global equities than traditional asset classes. In this way, they bring diversification benefits to the overall investment portfolio.

Among the Alternative asset classes, private equity is most dominant. In the current climate where traditional business models are undergoing disruption and transformation, a particularly attractive private equity strategy is growth equity.

Growth equity straddles venture capital (investing in startups that are still developing a feasible product) and buyouts (taking over mature companies with years of operations). Ideal growth-equity targets are successful businesses with significant expansion potential that can be realised with the aid of additional capital. Growth-equity funds provide this capital, often as a minority stake. When a company achieves its potential, the fund generates returns by selling its stake at a profit.

In addition to the merits of Alternatives outlined above, growth-equity exposure also provides investors with the following benefits:

• Access to a wider investment universe - Growth-equity funds significantly widen the universe of growing companies available to investors, by providing access to privately-owned companies. This is a pertinent benefit because growing, successful companies are increasingly opting to remain private.

• Exposure to growth sectors - Growth-equity deals tend to be in sectors that expand more rapidly than the economy. Such sectors include technology, healthcare, and fintech - all of which have historically produced a significant number of unicorns. Such investment opportunities are not typically directly available to investors in the public markets.

• Distinct risk-reward profile - Growth equity offers a risk-reward profile at the intersection of venture and buyout investments. On one hand, compared to venture capital, growth-equity funds exhibit lower capital losses because the companies they invest in are more established and have fewer early-stage risks than startups. On the other hand, unlike buyouts which are typically highly leveraged, growth-equity deals involve minimal debt. Rather than siphoning off cash to service a company's debt, almost all the capital can be dedicated to its expansion. This gives growth-equity investments potentially greater upside.

Meanwhile, investors should also be mindful of risks associated with growth-equity investing. For instance, performance depends on the expansion success of a fund's portfolio companies, something that is inherently uncertain. A fund's performance is also closely related to its ability to select targets and collaborate with the companies' management to add value. This emphasises the importance of picking the right funds to invest in.

In summary, investors would do well to consider Alternatives as a means to diversify sources of returns and risks in their portfolios of publicly traded bonds and equities, especially given today's environment of heightened uncertainty, added risk, and lower returns. Lay the foundations for a well-diversified investment portfolio that is ready for the future.

The writer is Chief Investment Officer at DBS Bank