Matthew Roberts, Head of Fulcrum Alternative Solutions, Fulcrum Asset Management, writes that the potential impact of continued, disruptive inflation on asset prices is profound.
Whilst we can’t be assured this scenario will play out, it is seeming increasingly likely, so it is becoming more important to be prepared and to stress test the associated risks. If investors want to take profits from their traditional equity and bond portfolios to reinvest elsewhere, a natural path is to consider is that of alternative investments.
We believe there are three key aspects which are worthy of particular consideration for potential replacement investments when looking at how to deploy the freed-up capital: complementarity, accessibility (which includes costs and transparency) and, of course, sustainability.
Many asset classes or strategies that may be viewed as diversifying to traditional equities and bonds could well turn out to be much more correlated in a disruptive inflationary scenario. This includes many credit strategies (e.g. high yield bonds) and illiquid strategies such as private equity. Gauging the full historical context is a necessary condition for assessing the complementarity of an investment in a disruptive inflationary scenario. Even this may not be enough to make an appropriate judgement given the particular set of circumstances we face is, of course, unique. Identifying an investment that will perform the required role, with the associated inflationary protection, is easier said than done.
Consequently, being selective is paramount when choosing diversifying strategies. We would suggest that a thorough review on the underlying positioning of a strategy can help ascertain whether there is likely to be genuine complementarity/inflation protection. Furthermore, a detailed discussion with the manager on exactly what they are doing regarding inflation protection can help understand how central it is to their investment strategy.
There are several potential alternative investment strategies that could perform this key role and we believe that multi-asset absolute return is one of them, particularly for those investors that do not have the resources to select specialist investments directly themselves.
Historically, alternative investments have been plagued with accessibility challenges. These include costs, transparency, ESG integration and liquidity mismatches. It is possible to overcome these challenges, but many offerings do not adequately address them either individually or in aggregate. Identifying strategies or managers that take these issues seriously is a ‘must’.
Absolute return strategies have been evolving over recent years. Whilst they have been generally out of favour for some time and have understandably faced some criticism, they also have:
– Relatively modest associated costs compared with traditional hedge funds;
– Regular liquidity;
– The ability to be nimble and take advantage of big market dislocations (albeit case-by-case);
– An ever-evolving approach to ESG integration.
These strategies can be relatively complex, they are skill-based (and hence the choice of manager is critical) and they are very different from equities and bonds, which can take some getting used to. On this basis, we believe the decision on position sizing is critical, with some having perhaps been too over-zealous during their last phase of popularity.
Disruptive inflation leads to a conundrum when it comes to sustainability. Many of the asset classes that are naturally in scope when seeking to protect against inflation have big sustainability question marks. This requires an innovative response. Firstly, in the way that portfolios are structured and how the investments are selected. Secondly, and perhaps most importantly, is the commitment to ongoing engagement. One key reflection is that, to achieve maximum bang for buck, any engagement needs to fit with the nature of the business you sit within. There is no use plotting a large-scale corporate overhaul if you do not have the knowledge, skills and resources to do it well. Likewise, there are many fund management businesses that have the resources to do more. The absolute level of impact/change achieved is clearly important, but the quality of impact is crucial too. Similarly, perhaps we could even introduce the concept of ‘impact per $ of AUM’ to the discourse on the topic (recognising this is difficult to measure). More generally, we are supportive of collaborative engagement in many cases since the challenges we face are too large for any of us to solve individually.
Complementarity, accessibility and sustainability are key ingredients for success when it comes to identifying high quality diversifying investments in the face of a disruptive inflationary scenario. It is essential for portfolio managers to evolve how they approach ESG integration while maintaining a commitment to liquidity, transparency and being reasonably priced.