I have written that investors should consider new products through the lens of
the three primary colors of portfolio construction: capital preservation, income and growth. Most investor goals and objectives can be achieved through some combination of these “colors.” Once the right mix is determined, it is up to the adviser to create diversified exposures within each category.
Start with capital preservation and the potential benefits – and pitfalls – of using alternatives to diversify a capital preservation portfolio.
At first, this may be counter intuitive. Some investors hear “alternatives” and go straight to images of complicated, illiquid hedge fund strategies that are high-risk, high-reward. Yet they encompass far more. Certain alternatives, such as real estate and commodities, can help hedge against inflation. That may mean accepting greater volatility, but diversifying a capital preservation portfolio with and across alternatives can help investors preserve the capital they worked so hard to obtain.
(More insight: Visit Alts University for all you need to know about alternatives)
Why alternatives for capital preservation? They offer choices investors cannot get elsewhere: combinations of asset classes, strategies and successful active managers who are not available through ordinary mutual funds and fixed income investments. They can cost more in fees, true, but they can also deliver more, whether in inflation hedges, diversification, returns or income.
In the presence of risk, portfolio theory teaches that diversification is paramount to increase the probability of achieving investment goals. This applies to capital preservation in spades. Traditional hedges such as cash and Treasury bills face their own risks. Savvy investors – and financial advisers – incorporate non-traditional assets with unique risk profiles into their portfolios. This can balance overall exposure and reduce the negative impact of any one risk.
SOME RISK NECESSARY
The capital preservation component of client portfolios generally have the lowest overall risk, but to maintain the full value of their holdings, clients must accept some risk in their individual investments. It may be small, but it will not be zero.
The reason is simple: inflation, the classic risk. Loss of purchasing power is the single biggest threat to capital preservation. Clients can stuff their mattresses with cash, but even at today's historic lows, with each passing day, month and year, inflation will eat away at its value. Most market-watchers expect inflation to rise. The question is less whether than when.
Further, in a global environment of competitive currency devaluations by central banks, investors with large cash holdings face the additional risk of declining purchasing power through declining currency values.
Capital preservation investors traditionally have relied on short-term fixed income and inflation-linked instruments, which have risks too. During periods of financial repression, the Federal Reserve keeps short-term interest rates low; many cash investors do not keep pace with inflation.
Some turn to Treasury Inflation Protected Securities, which have high durations and negative sensitivity to rising interest rates; thus they carry interest rate risk. This is particularly unattractive now given the prospect for rising rates. TIPS also have had close to zero or negative yields, meaning investors may have to actually pay for inflation protection.
Fortunately alternatives can help. Because many have lower correlations to equities and fixed income, alternative strategies can offer excellent diversification. Defined as anything other than stocks and bonds and aimed to achieve inflation protection necessary for capital preservation, investors should consider in particular alternatives that are focused on real, tangible asset classes:
• Real Estate and REITs, the classic value-maintainers. Alternative strategies can give investors access to a broad range of real estate markets, domestic and international. Real estate's low correlation to other asset classes enhances diversification. When inflation goes up property values have historically kept pace, as has the rental income these funds can incorporate.
• Commodities: precious and industrial metals, energy and agriculture. Often seen as safe harbors during times of high market volatility, geopolitical uncertainty and inflationary cycles, commodities historically have outperformed other investments. More than just silver and gold, some alternative strategies let investors access diverse holdings and skilled active managers.
• Infrastructure funds invest in companies that own bridges, tunnels, highways, pipelines and water systems. Tolls and usage charges continue to be paid by consumers, in good times and bad, and revenues have kept pace with (or beat) inflation.
•Master Limited Partnerships, must distribute most of their income to qualify for special tax treatment, which can bring a substantial distribution, and they tend to have low correlations to equities. A big focus is energy exploration/services, which has boomed with U.S. shale oil and gas fracking, but they also invest in other low-risk investment categories, such as timber.
What these strategies have in common is they invest in real, tangible assets that investors and financial advisers expect to hold their value, if not appreciate. In that sense they are “safe.” They do, however, have exposure to loss. To beat inflation, investors simply must assume some risk.
We should not let investors stuff cash in their mattresses – not because we want their money, but because adding diversification to their cash (and short-duration bonds) can help them preserve its full value for the days when they need it most.
Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.
