How to improve your portfolio by adding risk

Risk can be a dirty word for investors but it really shouldn't be, says Lonsec Chief Investment Officer Nathan Lim. After all, you need it in your portfolio to generate some returns and, in times like these, even keep pace with inflation.

Alternative strategies are intrinsically bound to the idea of risk. When used appropriately, Alternatives can enhance the risk adjusted returns for a portfolio than just relying purely on equities and fixed income. But what does this mean in practice for the average investor? Should you steer away due to its potential risks or lean in to enhance returns?

Lim points out that the alternatives space is not only broad but different strategies can be used for different reasons. Some offer growth, while others are defensive, and knowing where each sits is critical to how you allocate to them based on your own needs as well as the broader environment.

“Within our defensive portfolio, we’ll have around a 12% allocation to alternatives, for growth it’s around 19% and for balance, it’s around 17%. Within those allocations themselves, we then allocate or sub-allocate between defensive or growth allocations. 

So going back to those books, at the growth end, it will be 100% growth alternatives whereas, at the defensive end, only 17% of that allocation will be in growth alternatives,” says Lim.

In this interview for the Alternatives in Focus series, Lim shared all these insights, as well as his biggest concern about the alternatives space, as well as the strategies and fund managers he prefers in the current environment.

Timestamps

• 0:00 – Introduction
• 0:20 - The role of alternatives in a portfolio
• 0:44 - Biggest concerns with the asset class
• 1:32 - Optimal sizing in a portfolio
• 2:40 - What Lim sees in markets at the moment
• 4:01 - Preferred managers

Edited transcript:

Sara Allen: Hello and welcome to Livewire's Alternatives in Focus series. I'm Sara Allen and today, I'm joined by Lonsec’s Chief Investment Officer Nathan Lim. We're going to take a look at how investors can use alternatives in their portfolios.

To begin with, what role do alternatives play in portfolio construction?

At Lonsec, we like to look at alternatives in a slightly different way and what we mean by that is that alternatives are a very broad church. We allocate alternatives to both the defensive and the growth sides of our portfolio.

What is your biggest concern with this asset class?

The biggest concern that we have with this asset class right now is the disconnect that we're seeing between listed and unlisted asset valuations. Looking at the work that's coming out of Lonsec research, when you look at the valuations since the start of COVID-19 until now, listed assets are trading at about a 25% discount to unlisted assets, and that seems a bit odd to us. What we're concerned with the unlisted space is that perhaps this is setting up a period of persistent underperformance in the coming years for this asset class.

Anecdotally, when we speak to some of our managers that we engage with, especially around the infrastructure space, they're also observing this big disconnect between listed and unlisted valuations.

When it comes to sizing, there are a lot of different theories about what the optimal allocation for alternatives is in a portfolio. What do you recommend?

When it comes to our portfolios at Lonsec, we allocate to alternatives right through the whole spectrum, from conservative through to our growth allocation.

I've got some numbers here just to put these into context.

Within our defensive portfolio, we’ll have around a 12% allocation to alternatives, for growth it’s around 19% and for balance, it’s around 17%. Within those allocations themselves, we then allocate or sub-allocate between defensive or growth allocations. So going back to those books, at the growth end, it will be 100% growth alternatives whereas, at the defensive end, only 17% of that allocation will be in growth alternatives.

Do you shift that depending on the market?

Yes, that’s right. We will take advantage of market conditions to either dial up or dial down the mix of defensive and growth alts depending on market conditions.

What are you seeing at the moment?

We have a preference for multi-strategy hedge funds. These are a type of hedge fund that utilises a multitude of different investment strategies to try to generate a positive return. What we're talking about here is that they will go into equities, bonds, currencies, and volatility markets. They may take an absolute position or they may take a relative position. Basically, they have the freedom to go where they seem to find alpha.

What we like about these strategies over this current point in the cycle is that they've provided us with good steady returns in the portfolio set another way.

What they've been able to do for us is zig when the market zags right they are able to provide us with another form of diversification, but at the same time providing us positive returns, which helps drive a better Sharpe ratio in our portfolios.

I just want to touch on that point with Sharpe ratios.

Investors need to remember that you need to actually use risk in your portfolio and the Sharpe ratio is a very good indicator of manager skill. 

What alternatives do is that, by helping you smooth out your volatility, you actually can use alts to enhance your risk-adjusted returns in your portfolio, and this often comes through a high sharp ratio.

What managers do you prefer in this environment?

We have a preference for multi-strategy [managers] right now.

I would also add that another alternative investment that is very attractive to us right now is gold, especially during these troubled times.

Gold has acted as a great diversifier to help get a different source of alpha generation in the portfolio.

Are you using gold in your portfolio at the moment?

Yes, we do.