Consider stepping outside the box

Investors are likely to face greater challenges in generating strong returns in 2022 and beyond. Anthony Murphy, chief executive of Lucerne Investment Partners, puts forward the case for including alternative asset classes in portfolios as a solution to the headwinds on the horizon.

Global markets have started 2022 on shaky ground and investors, who have enjoyed strong market conditions for nearly two years, are taking stock and wondering where they go from here.

The ASX 200 Accumulation Index fell 6.13 per cent in January and was down 2.52 per cent for the 2022 financial year as at 31 January. This correction should not come as a surprise and is well overdue, particularly when considering the steep rise in global asset prices combined with the hubristic behaviour of many investors and markets in recent times. For context, 40 per cent of all US dollars in the system were printed in the past 20 months so markets have certainly had some assistance.

However, the market is now rationalising and investors need to follow suit. One must think forward when considering their portfolios, but too often we look in the rear-view mirror to repeat what has previously worked. This is completely normal behaviour and works in many facets of life. But the investment world is a different beast and it’s time to look through the windshield at that road ahead, which we believe is a windy one for years to come.

In 2021, central banks around the world continued to label inflation as transitory, but this has now changed. Inflation is here to stay and central banks will turn to their traditional playbook and commence raising interest rates. We are already witnessing this from our commercial banks in Australia, increasing interest rates before the Reserve Bank of Australia (RBA) has officially raised the cash rate. It seems they’re already looking through that windshield. We believe the cash rate will increase by 3 per cent to 5 per cent before the end of 2023.

At Lucerne Investment Partners, we have positioned investor portfolios to hold 15 per cent to 20 per cent exposure in listed long-only equities, with an even split between domestic and international markets. The balance of portfolios consists of a mix of alternatives, property, infrastructure and select credit, which is primarily private debt. We are less reliant on market conditions than ever and believe flexibility and control in investment mandates is critical for the years ahead.

Our flagship fund, the Lucerne Alternatives Investment Fund (LAIF) delivered 23.77 per cent for 2021 following 21.13 per cent for 2020 and is expected to deliver a positive return for January 2022. We are pleased with these results and the core focus of our investment committee, more than ever, is to preserve this performance while still being able to deliver attractive riskadjusted returns across all market cycles. LAIF has primarily delivered these returns by avoiding large drawdowns, particularly in bear markets. LAIF contracted 6 per cent during February and March 2020, a period that saw the ASX 200 Index decline by 27 per cent.

To combat inflation, we believe the RBA could increase the cash rate by as much as 5 per cent by the end of 2023. As interest rates rise, global asset prices should contract, and therefore prioritising investment strategies that can still deliver positive returns across all market conditions becomes an important consideration.

Alternatives as an asset class have always played a role in institutional and many family office portfolios. Yet, everyday investors have often under-allocated to this asset class, a trend that is now appearing to reverse. Established financial services firms are now dedicating greater resources to offering clients access to alternatives, which include private equity, long/short equity strategies, convertible notes, precious metals, resources, quantitative funds and digital assets. Previously, such strategies were primarily available to qualified wholesale investors only, but through vehicles such as LAIF and listed investment companies, retail investors can now also access these investments.

Allocating a portion of your portfolio to a diverse pool of alternative strategies can complement traditional asset class holdings. When considering a selection of alternatives, it’s important to ensure the different investments in the basket hold low levels of correlation with one another. For context, LAIF currently holds 14 different alternative strategies, which carry differing performance characteristics. To this end, it currently has no portfolio holdings in long-only listed equity funds. Over a threeto-five-year period we expect all strategies to generate positive performance, but this performance is captured from each strategy during different periods.

A good example of this is our allocation to the hard-closed Perennial Private to Public Fund II, which represents a 6 per cent weighting in LAIF. This fund targets revenue-generating unlisted companies in the private space that are seeking growth acceleration capital and are aiming to list or trade sale within two to three years. Given most of the fund’s investments are held privately until listing or sold, the fund carries very little correlation with the ASX 200 and has a great level of control over these investments and their liquidity timing. As these unlisted companies continue to grow, further capital raisings are completed often at higher valuations than Perennial’s entry point/initial cost. Perennial then revalues these companies to reflect the new valuation. The fund returned in excess of 10 per cent for January 2022 (following a significant uplift and revaluation in a key underlying holding), which is an exceptional result given the performance of equity markets and we expect further strong upside in 2022 and beyond as additional revaluing events occur across the maturing portfolio.

Outside of alternative fund strategies, we encourage investors to consider emerging trends in the market and how to best own these trends directly. In 2021, we researched corporate and consumer trends in the travel and accommodation industry and the growing bias toward private, apartment-style accommodation instead of hotels because of COVID – the world is changing. We acquired a convertible note investment in a company called Urban Rest Apartments, which provides high-quality and flexible terms on serviced accommodation. We secured an attractive double-digit interest rate and the ability to convert to equity in the business at an attractive valuation. Such an opportunity would not have existed in ordinary equity markets and many listed companies already had future earnings post COVID priced in.

Investors should also consider the private debt market and the quality riskadjusted returns that can be accessed in this space. For some time we have partnered capital with private debt managers that can secure equity-like returns with security over fixed assets such as property. Strategies in this space can deliver high single-digit and low doubledigit returns with very little volatility. Quality managers are selective in the types of transactions they support in this space. As interest rates rise, the returns in private debt can increase. When considering the long-term annualised return of the ASX 200 is 8 per cent, a similar or greater return can be achieved in private debt investments for much less risk.

The passive ‘buy and hold’ model has worked well over the past decade. Post the global financial crisis, passive investing has performed well and continued to do so following the market crash in early 2020 thanks to the enormous stimulus packages released by governments and central banks worldwide. This environment has seen record amounts of inflows into superannuation funds and exchangetraded funds, a rising tide that has floated all boats. The same period has witnessed record low returns in defensive asset classes, such as cash and bonds, resulting in many portfolios taking overweight positions to equities, increasing risk profiles across the board.

Declining interest rates to effectively zero has further fuelled price appreciation across equities and property and additional stimulus in the past two years has increased valuations further still.

Interestingly, the Future Fund is now also warning investors about the windy road ahead and is taking a bias toward active management. This approach is also supported by the fact more active managers are now outperforming passive and we expect this trend to continue for the 2022 income year and the years ahead. Also, some of the great investment names, such as Buffett and Dalio, have underperformed the market recently as they reduce equity exposure and build a war chest for when asset prices become attractive. This will happen.

So, how does one best prepare themselves to transfer from a passive to more active mandate to stay ahead of the broader market? Spending the time and effort to research and partner capital with independent tier-one investment managers is worthwhile and your portfolio will thank you for it.

There is a genuine skill set in selecting a good manager and knowing when to best hold that manager or, indeed, exit. As different themes emerge in the market, investors need to consider how to best own that theme and when considering which managers are deserving of their capital, which is a privilege, some key areas of focus for us include:

• Size does matter – is the manager committed to staying small and nimble relative to the size of their asset class? We like managers of private equity strategies who cap funds under management at $200 million.

• Alignment – how much is the manager (and their family) personally invested in their own strategy?

• Remuneration – is the manager better incentivised via performance as opposed to high management fees? This also assists with staying small and nimble.

• Performance attribution – how does the manager derive their performance and indeed outperformance against the relative benchmark? Can this be achieved consistently over time across different market cycles?

• Poor investments – how does the manager address poor investment outcomes and what have they learned to ensure this is minimised on a goforward basis? I

n summary, we encourage investors to take stock and review portfolios and consider how they are positioned for markets ahead. The attractive economic and stimulus conditions we have enjoyed since 2010 are behind us and that road is going to become windy. Going forward, investing and generating meaningful portfolio returns is going to become a lot harder. Investors should consider the addition of investments that can deliver sound absolute returns, which can include a mix of alternatives and private debt. We encourage investors to take a deeper understanding into their underlying investments, gain a greater level of control and ensure their portfolios are truly generating quality risk-adjusted returns. This approach will bode you well and we wish you every success for 2022 and the years ahead.