Cash offers little, so here's a deal. Loan the government money for ten years and earn about 1.25% per annum. Before inflation. The odds are investors will lock themselves into negative real yield for ten years.
Although we do hold government bonds - they are relatively safe, diversify risk from equities and were beneficial last year - it is obvious central banks, including the Bank of England, are more hawkish.
Potentially rising interest rates make the bond outlook a more challenging one, and with returns already low, the challenge is too great to ignore.
As such, we have looked to alternative strategy funds. Many investors are antipathetic - often classing them as hedge funds - but many alternative strategies have a long history of success and offer legitimate options to diversify a portfolio.
Rather than just looking to equity, interest rate and credit risk, alternative strategies generate returns through alternative risks. We look to three broad classes as outlined below:
• Merger arbitrage invests primarily in securities that are or may become subject to a tender offer, merger, liquidation, or other significant corporate action. In essence, taking ‘deal risk' and tending to be a low volatility strategy with low correlation to global equity markets.
• Equity long/short funds short stocks that are overvalued or secularly challenged and go long those the managers believe are undervalued yet exhibit secular growth. By investing both long and short, the strategy can exhibit a reduced (if not zero) net exposure to the overall directional risk of equity markets. It tends to deliver a modest return with low volatility and correlation to global equity markets.
• Finally, systematic trend-following seeks to identify trends - up or down - in a wide variety of asset classes and to profit from following those trends taking ‘trend risk'. By investing across numerous asset classes, the strategy tends to have a low correlation to global equity markets, offering attractive diversification characteristics.
None of the strategies look to shoot the lights out in terms of return.
The idea is to garner a single-digit return akin to that of the usual return of bonds, with much the same volatility, at a time when bonds fall short.
Nicholas Lowson is senior portfolio manager at Kleinwort Hambros
• Alternative strategy funds diversify the source of risk in a portfolio
• With cash and bonds offering little return, even a modest increase is welcome
• Client reaction is often negative to alternative strategy funds
• Low correlation does not equal no correlation and returns can fall in a significant sell-off