How Risky are Specialist Funds?
Updated: May 18, 2022
So far in this series of quarterly blog posts on the subject of investment risk, I have covered risk in general, the risks of equities and the risks of bonds. In each case I attempted to look at risk from a longer term perspective. I also sought to convey the idea that it is more important to be concerned about permanent loss of capital that can result from business deterioration (in the case of equities) or negative yields (in the case of bonds) than price volatility.
"There is a general perception that ‘alternatives’ are higher risk"
In this final post I look at the risks associated with what we at Seneca call specialist assets.
What are specialist assets?
Until a year or ago, we used the term alternative investments for what we now call specialist assets. Whatever its origins, the term ‘alternative investments’ is nowadays used to refer to investments that do not fall under traditional asset classes such as bonds or equities.
It is therefore a very broad term that covers many different investment types.
However, since the term seems to be most closely associated with hedge funds, precious metals and esoteric investments such as art, wine, coins or stamps, there is a general perception that ‘alternatives’ are higher risk, either because of poor liquidity (hedge funds tend to deal only quarterly) or higher price volatility (precious metals exhibit high price volatility that is not generally rewarded with higher returns) or otherwise.
Although we do not as a rule invest in the aforementioned investment types, even where mandates and regulations allow, or indeed other ‘alternatives’ such as structured products and derivatives, we used the term because we liked the idea of identifying investments that offered something useful (or ‘alternative’) in relation to equities and bonds.
This meant looking for investments that had higher yields than bonds or equities, income streams that were more index-linked than bonds, or income streams that were more stable than those of equities. Examples include REITs that can have high yields, and income streams (rental income) that are both stable and as well as being index-linked. Or asset leasing vehicles that have similar characteristics. Or renewable energy infrastructure funds etc. Hedge funds, precious metals, art, wine, coins, stamps, structured products, and derivatives do not on the whole satisfy any of the requirements and thus we tend to avoid them.
So, although we liked the idea of looking for investments that offered something useful – or alternative – to bonds and equities, we disliked the association with higher risk. We thus abandoned use of the term ‘alternatives’ in favour of ‘specialist assets’.
There was never going to be a perfect solution, but we felt the term ‘specialist’ captured the focused nature of REITs, asset leasing, infrastructure and others that make up our investment universe in this area (most of our universe is made up of specialist investment trusts that are listed on the London Stock Exchange).
What is so great about ‘Specialist assets,’ particularly with respect to investment risk? As mentioned, we think that the more important risk to avoid is the risk of permanent loss of real capital rather than price volatility.
This can be easily understood in relation to gilts which will lose you real capital if bought today and held to maturity, but may well do so only gradually (think of the frog sitting in a pot of water that is slowly warmed up).
Measuring the scope for permanent loss of capital with respect to specialist assets is not as straightforward as it is for gilts. However, looking at the stability – and growth – of dividends provides a reasonable measure of business stability.
In the case of REITs, dividends over the last five years have grown by 5.9 per cent per annum, compared with 6.0 per cent for the broad equity market. However, dividends have been much more stable than those from equities: annualised standard deviation of 2.6 per cent versus 5.8 per cent.
As for share price behaviour, specialist assets display some attractive features. Returns have on the whole been higher and price volatility lower (calculated over the period since listing of the specialist asset in question) than the equity market. Furthermore, correlations with the equity market have either been low or in one case negative. Including them in our portfolios has thus had a beneficial effect on both the return side as well as the volatility side of the equation.
Published in Trustnet
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.