Building portfolios capable of generating attractive returns for investors with acceptable levels of risk is probably at its most challenging, given a context of low fixed income rates and high stock valuations, as well as the prospect of rising inflation. This is why the traditional bond/equity mix that has worked quite well over the last 40 years needs to be reconsidered and new allocation models deployed.

Among the most promising opportunities available are core alternative asset classes, which offer low volatility and attractive diversification characteristics. These are core alternative asset classes if a large percentage of the total return comes from cash income and their cash flows can be forecasted over long periods of time with a low margin of error. Examples of this include senior secured loans and real estate assets.

1. Including core alternative assets can improve portfolio returns compared to traditional portfolios.

A mere 10% of the portfolio dedicated to Core Alternative Assets can significantly improve portfolio returns, whether by switching to bonds, stocks, or a balanced decision between both options. For example, the expected annual return can be increased by +0.5% by redirecting bond allocation to Core Alternatives, while downside risk can be improved by 1.9% by switching stocks for these asset classes.

2. A diversified portfolio of core alternatives can deliver potentially better returns and significantly greater resilience compared to alternatives alone.

Cross-correlations within the universe of Core Alternative Assets result from fundamentally different return drivers for each asset class. All components of a portfolio must be assembled in such a way that there is a low correlation between each component, thus delivering higher returns and lower volatility than if a portfolio with only one class of Alternative Asset were chosen, as can be seen in the following charts.

3. Contextualizing the liquidity trade-off

Replacing 10% of the portfolio with alternative assets, although it provides less liquidity, is within the liquidity budget accepted by most investors, especially in an environment where the public market is expected to deliver unacceptably low rates.

Delving deeper into the above, when reviewing the spectrum of less liquid assets, Core Alternatives have a more or less hybrid liquidity characteristic, with relatively short lock-ups and higher cash flows than those available in some areas of private markets. Given that many investors will not require immediate use of the income stream, reinvesting income within Core Alternatives can generate net return multiples equivalent to those of less liquid strategies such as Private Equity.

Investor portfolios continue to be composed of stocks and bonds, despite well-founded concerns that it will not be possible to achieve returns and risk levels consistent with historical experience. In this context, investors need solutions that can improve returns without adding risk. Core alternative assets are a solution just around the corner that can generate stable returns above public markets, while providing attractive protection against downside risks along with resilience to inflation and rising rates.

Source: Preqin and JP Morgan Asset Management.