A liquid alternative

Constructing a portfolio with diversified sources of return is an important consideration for many investors. However, while diversification may be a sound principle, achieving a reward for it requires a disciplined approach.

Government bonds may offer a place to hide during periods of financial distress, but the impacts of extraordinary monetary policy have left prospective returns on bonds and cash wallowing well below inflation. The value of bonds with negative yields, which guarantee buyers a loss if they hold the bond to maturity, has grown to US$12.5 trillion, according to Bloomberg. Last year also saw a number of occasions when bonds and equities sold off in unison, just when investors needed their negative correlations to hold up. This illustrates the importance of having a framework to assess the benefits of diversification and identify opportunities early.

At Newton, we use investment themes to identify long-term global trends and help us assess the future diversification potential of assets, rather than just relying on historical correlations. This helps us allocate capital into areas that we believe are more likely to generate attractive returns and avoid areas that may be more prone to risks. For example, with environmental factors and topics such as climate change high up the agenda, our Earth matters theme considers the investment implications of these developments.

Avoiding a catastrophe

One area that our Earth matters theme led us to avoid is the catastrophe bond market. There are clear attractions in an asset class where performance is dependent on something other than the economic cycle (in this case weather patterns). However, returns must be commensurate with the risk, and investors insuring catastrophic events risk losing all their capital under certain scenarios, such as multiple natural disasters in the same season. In this case, we believed that the catastrophe bond market’s reliance on historical data to price risk could be impaired as changing weather patterns result in certain regions becoming more prone to extreme weather events.

Conversely, Earth matters has also helped us identify areas of opportunity, such as operational renewable-energy assets. With fixed, inflation-linked revenues representing up to 50% of these businesses’ overall earnings, and power prices making up the rest, their sensitivity to the economic cycle is very limited. Unlike more speculative alternative assets, these are assets with ‘safe-haven’-like characteristics which investors seek out in times of uncertainty. This was reflected in 2018 when the renewable-energy sector made a strong positive return while equity markets saw considerable downside volatility and the return on 10-year US Treasuries was negative.

A renewable future?

Just five years ago, renewables were a nascent market, and investors continue to question the ability to access scale. However, to decarbonise the world’s power generation will require up to $50 trillion of capital over the next 30 years,[1] which in our view should provide support for the asset class as companies compete for access to that capital. Of course, careful analysis of the business models and structures of these companies remains essential.

While buying and selling wind and solar farms is not easy, investment-trust vehicles can make these assets liquid, allowing investors to gain access to the underlying characteristics in an affordable, transparent and tradeable manner. Although there has been much debate about having unlisted illiquid assets in daily-dealing funds, the investment-trust structure allows such assets to become liquid and accessible in small sizes, in much the same way as real-estate investment trusts (REITs) do for property. The other benefit that the listed space provides is the ability to adjust portfolio positioning quickly when more attractive opportunities present themselves.

Renewables are just one example of what I would define as liquid real assets, which can also include operational infrastructure, aviation financing and property.We have deployed liquid real assets in our multi-asset and absolute-return strategies for more than a decade, as we seek to achieve a more predictable risk and return profile. While liquid real assets are not without risk, they can provide uncorrelated returns, benefiting those pursuing fundamental diversification. Such attractive characteristics could be advantageous for pension schemes or other investors looking to inflation-proof their strategies against a backdrop that remains challenging for more traditional assets.

[1] Source: Bloomberg New Energy Finance.

Authors

Paul Flood

Head of Mixed Assets Investment