Alternative Investments can help you pursue your goals across market cycles

Volatility in the financial markets and macroeconomic uncertainty have left many investors feeling paralyzed. Many investors are questioning whether now is an opportune time to invest in Alternative Investments strategies given their less liquid nature. However, history has shown that when investing in Alternatives, the most critical thing is to allocate throughout a full cycle—including downturns—to help realize the powerful return premiums and diversification benefits of this asset class.

Effectively timing the markets is difficult and the opportunity costs of missing out on performance rallies can hinder long-term performance. Our Chief Investment Office has shown that an investor’s returns in public equity markets can be significantly eroded by not participating in its best performing days.

Staying Invested Matters For Private Markets Too

The benefits of staying invested and the difficulties of market timing also apply to Alternative Investments. And the less liquid nature of the strategies only raises the hurdle to trying to time one’s investments. For instance, within Private Equity (PE), the illiquidity and contractual obligations of multi-year investment periods limit an investor’s ability to tactically enter and exit the market. While investors can time when they make commitments, they do not control when that capital is invested by the Private Equity fund manager or when that manager exits an investment.¹ Despite that, a fund manager’s ability to be patient and discerning with respect to capital deployment is a key element of the value he or she delivers.

A Disciplined Approach Is Key

These factors underscore the importance of investing for the long-term, which underpins the Chief Investment Office’s Strategic Asset Allocation (SAA) framework. This asset allocation guidance recommends a diversified approach that invests across asset classes, including Alternative Investments. Maintaining allocations to Hedge Funds, Private Equity and Real Assets—in alignment with one’s risk profile and liquidity needs—should, over the long term, shift a portfolio’s efficient frontier to deliver greater return per unit of risk. Even in an environment like the current one, constructing a portfolio to include an appropriate allocation to Alternative Investments is a valuable exercise for qualified investors.

While building their exposures, investors should seek to achieve diversification including by manager, strategy and vintage. To the extent investors may want to include opportunistic investments, there are several Alternative Investment strategies with favorable outlooks even in a market regime characterized by equity and Fixed Income volatility, higher inflation and interest rates, and greater uncertainty.

Private Markets Deliver Compelling Returns

Private Market strategies have, over multiple decades, delivered competitive returns relative to public equities and fixed income strategies. Spanning Private Equity, Venture Capital (VC), Private Credit and Real Estate, these strategies exceeded the S&P 500 in terms of performance, with the exception of Real Estate, which trailed only slightly over the twenty-year period from Q2 2002 to Q2 2022. The outperformance of Private Market strategies was also achieved with lower volatility, thereby making the relative risk-adjusted returns even more compelling.

Private Market strategies have outperformed public equity strategies during both Federal Reserve interest rate hiking and cutting cycles, which is pertinent to today’s markets. The current Fed hiking cycle that began in Q1 2022 has not officially ended, however, early performance indications suggest the pattern of Private Markets outperformance may hold once again.

Certain private markets strategies display relatively strong performance from funds originated during economic downturns. For example, U.S. buyout fund vintages from periods in and around recessions have historically delivered competitive returns. While past performance is no guarantee of future results, this data bolster the case for vintage year diversification, including committing to Private Equity strategies during periods of economic and financial volatility.

Hedge Funds May Also Benefit From Higher Rates

The decade following the Global Financial Crisis (GFC) proved challenging for Hedge Funds. And yet, today’s macroeconomic environment may present an improved investment environment for this asset class: Historical data shows that higher interest rates may create a better opportunity set for Hedge Fund returns and alpha generation.

Recent data backs this up. Amid a challenging backdrop, Hedge Funds on the whole generated returns of approximately -4% in 2022.² This margin of outperformance relative to a traditional 60/40 portfolio was greater than during the GFC. Looking forward, Hedge Funds may be well positioned coming off strong relative performance in 2022. Many investors believe the asset class’s diversifying characteristics were validated in the past year and intend to continue using Hedge Funds to improve portfolio outcomes.

Potential Opportunities And Risk Considerations For Qualified Investors

Despite the macro uncertainty of today’s world, several Alternative Investment strategies across Private Markets and Hedge Funds currently have favorable outlooks. For one, Private Market funds in aggregate have a sizable amount of dry powder—available cash on hand—allowing them to capitalize on emerging opportunities. With patient capital at their disposal, Private Markets fund managers can act as liquidity providers and potentially take advantage of discounted valuations.

In addition, the recent environment of higher interest rates and inflation, geopolitical uncertainty, and increased volatility in equity and fixed income markets has favored various Alternative Investment strategies, particularly those that typically display low correlations to traditional asset classes. To the extent that the environment shifts, a sizable opportunity set could unfold across asset classes, as noted below.

Private Credit

Potential Opportunity: Rising short-term interest rates have significantly increased return expectations, with the added benefit of lower durations relative to traditional fixed income strategies. By year end 2022, new private credit transaction yields had risen to low to mid-teens levels. Due to structural factors, direct lenders have become the de facto lenders of choice for many companies and Private Equity sponsors. Interest coverage has declined with rising rates though overall remains at manageable levels, and defaults continue to remain low. Existing Private Credit portfolios, as always, will have to contend with legacy issues; however, fresh pools of capital could find compelling opportunities given the backdrop.

Risk Considerations: Greater-than-expected deterioration of interest coverage; a severe economic recession that creates a spike in default rates, even for private middle market borrowers.

Special Situations and Distressed

Potential Opportunity: The opportunity set for Special Situations and Distressed was historically sparse in 2021-2022 due to historic fiscal and monetary stimulus. As this government intervention wanes, default rates have begun to rise and are expected to reach long-term averages. In addition, if the credit environment remains challenged for longer than expected (e.g., inflation and rates surprising to the upside or a more severe-than-expected recession), then distressed assets could quickly metastasize. Given that companies largely extended maturities during the forgiving environment of 2021, we expect the opportunity set to unfold at a slower pace than recent cycles.

Risk Considerations: Interest rates revert to a lower-for-longer dynamic; reduced/weakened covenant packages in the syndicated leveraged loan market make it difficult to initiate debt restructurings.

Private Equity

Potential Opportunity: Rising inflation and interest rates presented a challenging environment for Private Equity in 2022—similar to public equities. This led to slowing deal activity and reduced exit opportunities. Despite that, the strategy has had several levers to pull to adjust to the shifting landscape, including focusing on more economically resilient sectors or businesses with hard assets. The rise of Private Credit has also kept open an important source of financing for sponsors. Going forward, with the pace of Fed tightening likely slowing, bond yields declining at the start the year and the valuation gap between public and private markets narrowing, 2023 could see a more favorable backdrop for the strategy. In addition to potentially improved sentiment, structural forces will continue to propel Private Equity to new heights.

Risk Considerations: A slowdown in Private Credit availability to hamper an important source of financing for the strategy; higher financing costs can potentially challenge equity returns and/or require larger equity checks in deals; a severe economic recession could affect existing portfolio companies.

Venture Capital

Potential Opportunity: The pendulum has quickly swung back to favoring limited partners (LP) compared to the frothy environment of 2021, which significantly favored founders. Deals today are expected to be struck with better terms and more compelling entry valuations. In the near term, investors expect an increase in Structured Equity and Venture Debt strategies. Likely unfolding over the course of 2023-2024, the opportunity set for VC vintages during this period of reset for the strategy could be historic, as animal spirits are revived and deal-making resumes.

Risk Considerations: High valuations paid in 2020-2021 could weigh on the market for some time, lengthening the market’s process of adjustment; if interest rates continue to rise that could challenge valuations and keep the initial public offering market closed.

Hedge Funds – Global Macro

Potential Opportunity: Global Macro strategies have benefited throughout this new market paradigm that has characterized the post-pandemic period. The opportunity set is expected to remain fruitful on the back of elevated volatility across asset classes, continued factor reversals, shifts in global monetary policy, and volatile inflation dynamics. Most importantly, Global Macro has historically exhibited low correlations to traditional equity and fixed income strategies while trading in relatively liquid asset classes, thereby providing significant portfolio utility.

Risk Considerations: Reemergence of low-volatility with little to no trends in rates or currencies could diminish return expectations.

Hedge Funds – Equity Hedge

Potential Opportunity: High macro uncertainty and expected dispersion are expected to drive an attractive opportunity set. Equity market neutral strategies in particular may be best positioned in this environment. From a portfolio construction standpoint, an allocation to these funds sourced from traditional long-only investments can help reduce portfolio beta and potentially increase alpha, thus helping to provide differentiated equity risk.

Risk Considerations: Significant rise in equity correlation; lower single-stock dispersion; exogenous shocks to the financial system.

Selecting The Right Alternative Investments

As with all investment decisions, the right investment depends on a range of factors, including your risk tolerance, time horizon, tax sensitivity and liquidity needs. The Chief Investment Office recommends an allocation to Alternative Investments of 20%-30% for many investors. It also encourages clients to understand how each individual investment supports an investor’s overall goals and to take a diversified approach when adding Alternative Investments to a traditional portfolio approach.

Talk to your advisor about how allocating to alternatives may make sense for your overall investment strategy.