Regardless of the possible impact of the upcoming US election, markets will stay susceptible to volatility outbursts in the long run. The global economy remains fragile and sensitive to policy surprises, while risk-free rates are stuck near zero. Alternative assets address the resulting challenges for a wide range of investors, ranging from pension funds to family offices.
LGT Capital Partners has been allocating a substantial part of the Princely Strategy, Europe’s largest endowment of its kind, to alter-native assets for more than 17 years. The purpose of combining alternative and traditional assets is to diversify a portfolio by adding attractive risk premia across global markets, in order to achieve sustainable long-term returns with moderate volatility. The following three examples illustrate how alternatives can offer diversification, as well as sources of returns that differ from those typically associated with public markets.
ILS represent a key element of LGT’s asset allocation. Insurance-linked securities are similar to bonds, except that their risk/return drivers are largely not correlated with financial markets. Insurance companies use catastrophe bonds, known as cat bonds, or collateralized reinsurance contracts, to outsource some of the risks they hold when natural disasters occur. Investors in such securities earn a premium for holding that risk, as well as the money market return of the collateral assets. Policyholders will claim on the bond (or contract), if certain specified loss levels are triggered by a natural catastrophe (e.g. a large earthquake, hurricane, or flood). If this happens, the ILS will lose value. At the same time, major disasters can also offer good entry points into this market.
It is clear that most portfolios would have benefited from the inclusion of ILS, especially during the market turmoil of 2007/2008. Figure 1 shows how cat bonds achieved consistent returns with low correlation to a range of other assets. The outlook for the ILS market varies from time to time, and it is important to ensure that an ILS portfolio is well-diversified across regions and disaster types. But there is no doubt about its benefits in the context of a portfolio.
Note: The next LGT Beacon will be published on 26 October 2016.