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A risk-based approach to harnessing alternative sources of income

Optimizing outcomes through alternatives

The income-generating potential of alternatives seems to be largely underappreciated, despite the trend toward larger allocations to alternative asset classes and the need for yield. Investors can enhance their ability to capitalize on the yield and diversification benefits of alternatives by focusing on the risks that drive returns in each specific segment of the alternatives universe. Executing this, however, is no simple task. If done incorrectly, investors risk negating some of the diversification benefits that make alternatives such valuable contributors to stronger, more resilient portfolios.

Nuveen experts explore risk analysis across income-generating asset classes, including key considerations related to the coronavirus pandemic and offer a distinct framework for risk factor-based portfolio construction.

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  • Alternative asset classes such as private credit, real assets (farmland, timberland and private equity infrastructure investments) as well as non-traditional sectors of fixed income (preferred securities, emerging markets debt, high yield corporate debt and leveraged loans) present attractive income-generating potential.
  • Idiosyncratic risks play a vital role in driving returns in each of these asset classes — and these risks are what institutional investors should be trying to harness in an income-generating multi-asset portfolio. But it is important to note that each of these asset classes has significant exposure, in varying degrees, to the core, broad-based risk factors: equity, credit spread and rate duration.
  • As the chart below illustrates, idiosyncratic risks account for less than 60% of the contribution to total risk in most of the alternative asset classes included in the chart. With emerging markets debt, for example, equity risk accounts for 36% of the total risk and credit risk accounts for an additional 33%.
  • Preferreds are also an interesting case. Some investors consider them to be more like an equity instrument while others consider them to be more like fixed income. This debate is easily settled when viewed through a risk decomposition lens, which shows that equity risk and idiosyncratic risk account for the totality of risk for preferreds.

Decomposing risks across asset classes 

Fixed income

The non-traditional, or “plus,” sectors of fixed income present attractive yields for investors seeking enhanced income. Opportunities in these sectors are continuously shifting, emphasizing the need to take a diversified and dynamic investment approach. We examine several nuances of the return drivers in these sectors that investors should consider.

Private credit

U.S. senior middle market loans have typically yielded between 6% and 8% since 2010 and the illiquidity premium has averaged 1.8% during the period, according to LC/S&P Global. This has provided a boost to yields, making middle market loans an effective alternative source of income. We explore their risk profile, which varies significantly from other types of debt.

Real assets

Real assets have proven to be exceptional stores of value and defensive income generators because they provide products or services that are essential to the global economy. We explore the risk factors that drive the value of these assets, which are highly idiosyncratic, and other factors that vary from asset to asset.

Real estate

Investors often cite diversification as the primary reason to invest in real estate. But the diversification benefit of real estate is largely the result of the quality and security of the income stream associated with real estate investments. We explore the megatrends driving risk considerations and our current assessment of risk across real estate markets.

Risk-based approach

Based on our extensive research, and our work with institutional investors globally, we share our recommendations for how institutions can optimize their ability to harness the income-generating potential of alternatives by using a risk factor-based approach to portfolio construction.
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Dimitri Stathopoulos
United States
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