Investors need to widen their search for uncorrelated assets to equities and bonds to avoid concentration risk in a handful of alternatives, according to Marc Syz, co-founder and managing partner at SYZ Capital.
With correlations rising between fixed income and equities, stock prices looking overheated, and fixed income investors starting to protect themselves against the potential of further spikes in inflation, Syz noted the rush to access uncorrelated returns is logical.
However, Syz argued that many investors are unfortunately confusing correlation with risk.
“Uncorrelated assets are not exposed to macroeconomic or market-induced volatility – meaning they are resistant to exogenous shocks and market cyclicality,” he said. “However, this does not also make them immune to other types of risk.”
Syz added that while adding to uncorrelated assets will ensure the performance of a portfolio avoids following that of traditional asset classes, holding too many of the same uncorrelated assets can also concentrate risk.
“Only by constructing a diversified portfolio, which contains a balance of traditional and uncorrelated asset classes, can investors truly reduce risk,” he said.
Three assets to look at
For Syz, with questions hanging in the balance around the longevity of government support, the impact on interest rates and inflation, investors should take advantage of emerging asset classes producing uncorrelated returns.
“Unearthing truly uncorrelated returns on listed markets is difficult, despite the flurry of solutions claiming to be,” he said.
“Instead, many investors have moved into alternatives to track down elusive uncorrelated returns,” he added. “But it is necessary to go further than your typical hedge funds or private equity solutions to find ‘true’ uncorrelated assets.”
So which asset classes should investors be turning to? Syz picks out three; litigation finance, royalties and life settlements.
“Litigation finance is an emerging asset class that bears no correlation to market or macro movements,” he said.
“By providing upfront funding for a litigation claim in return for a share of the settlement, the outcome of the case and, hence, the return expectations are dependent on a number of idiosyncratic factors – such as the type and resources of the defendant and the size of the case.”
In addition, given that most litigation funding is done on a case-by-case basis, Syz said this allows investors to gain exposure to different types of legal cases, claimants and defendants, as well as jurisdictions.
Royalties, whether pharmaceutical or music, are rapidly emerging as an attractive way to reap recurring revenues from intellectual property rights, he added.
“While these also bear different types of risk – related to changing music tastes or demand for drugs – the returns are entirely divorced from market volatility, Syz said.
Thirdly, he argued that life settlements also produces entirely uncorrelated returns.
“This is done by purchasing a life insurance policy from someone selling it on the open market to generate additional retirement income and realizing a return once they pass away,” he said.
Since many of these asset classes are still in their infancy, Syz noted that opportunities for deploying capital remain limited. However, as alternatives witness more take-up from mainstream investors and pension funds, he added that some of these uncorrelated strategies will make it into the mainstream.
“As investors continue to reach for protection in times of uncertainty, it is crucial they understand the nuances behind uncorrelated returns,” he said.
“Uncorrelated assets – to different degrees – are a useful tool for portfolio diversification, but to unearth truly uncorrelated returns, which are immune to market turbulence, investors need to be prepared to dig deeper into niche alternative investments, while remaining nimble and flexible.”