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Alternative asset allocation via ETPs

Commodities and currencies provide a potential source of diversification within portfolios and are easily accessed via ETPs, says Liz Wright, director UK intermediary distribution, ETF Securities (UK) Ltd

Rising correlations and falling asset prices initially triggered by the financial crisis in 2008 raised questions around the traditional ‘60/40’ portfolio model implemented by many advisers – 60% allocation to equities and 40% to high- grade corporate or corporate bonds.

Increasingly investors and advisers are considering alternative asset classes to achieve individual objectives – namely, manage investment portfolio risk, generate risk-adjusted returns, lower volatility, provide downside protection and secure broader diversification.

In this article we will consider commodities and currencies as alternative asset classes and consider the investment benefits of including such exposures alongside traditional equity and fixed income allocations. We will also briefly outline how exchange traded products (ETPs) can be a convenient means of accessing these asset classes.

Commodities as an inflation and risk hedge

ETF Sec 1Inflation can pose a significant risk to investors over time, however commodities can potentially provide a hedge against this risk. As demand for goods and services increases, prices often follow and so do the prices of commodities used in production. As a component of inflation, commodities can therefore potentially provide some degree of portfolio protection during periods of inflationary pressure. A number of North American pension funds, looking to protect returns against inflation, have incorporated commodity strategies as part of their broader asset allocation.

Commodities can also be used by investors as a potential source of diversification within portfolios. Research has demonstrated that price movements in commodities, particularly precious metals, have little relation to price movements in traditional asset classes such as equities and fixed income. Geo-political risks have historically tended to drive the divergence in commodity prices, as has weather, by causing supply shocks that can result in a spike in prices.

ETF Sec 2The chart left demonstrates the diversification benefits of precious metals, in particular gold, during some of the worst drawdowns in the S&P500, providing a much needed buffer to portfolios.

Currencies as a low volatility diversifier

Currencies go through cycles of appreciation and depreciation due to different macro-economic variables. These cycles generate potential opportunities for returns as investors can express either a positive or negative view on a currency depending on their outlook for their global economy. Investors can therefore generate returns over by taking broad views on major currencies like the US Dollar.

An investment in currencies can also be used to hedge against currency exposure risks. Where an investment is made in a foreign asset, it creates a risk that total returns could be reduced if the investor’s domestic currency rises in value against the foreign currency. A currency allocation within a portfolio could be used to mitigate this risk.

ETF SEc 3Generally, currencies have a low or negative correlation with most traditional and alternative asset classes and typically have a low level of volatility. An allocation to currencies can therefore potentially have a beneficial impact on the diversification of overall portfolio risk in a multi-asset portfolio.


Exchange traded commodities and currencies (ETCs)

The advent of commodity ETCs has provided a variety of investors with access to both physical spot and future commodity returns.

Physical commodity ETCs are backed by a specific quantity of commodity, typically precious metals, and provide exposure to movements in underlying spot prices.

Physical commodity ETCs are generally eligible for investment by UCITS and are generally deemed to be ‘non-complex’.

Synthetic commodity ETCs in contrast generally track indices comprised of underlying commodity futures contracts that continuously roll and provide exposure to the price movements of these contracts. Synthetic commodity ETPs will generally be fully collateralised but are deemed to be ‘complex’ instruments by the FCA.

Investors can access an individual commodity, sector baskets and/or broad- based all commodity exposures. The listing of commodity products on regulated stock exchanges has been a pioneering development, providing investors with an efficient new method of gaining exposure to changes in the price of commodities without having to take physical delivery.

Currency ETCs enable investors to gain long, short or leveraged exposure to foreign exchange (FX) rate movements by tracking currency indices comprising currency forward contracts, which roll on a daily basis. Currency indices are tradable benchmarks for daily FX rate performance between currency pairs and reflect the performance of one currency, or a basket of currencies, against another currency.

Investors can therefore access the foreign exchange market without needing to open foreign currency bank accounts or to trade in spot contracts, futures or other derivative contracts.

ETPs as the building blocks of multi-asset portfolios

ETPs are flexible instruments that can be used to build core positions to broad-based exposures like the FTSE 100, UK corporate debt, longer dated all commodities and multi-strategy currency baskets. The fact ETPs are traded on exchange also means that they are very accessible and can be used to easily add satellite positions traded on a tactical basis.

Exchange traded products offer private investors access to a whole universe of exposures, from traditional asset classes like equities and bonds to alternatives like commodities and currencies. Ultimately they have democratised the investment landscape allowing investors to choose from a number of cost-effective and transparent investment solutions.

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