What does all this mean? In short, it means that we’re at a critical decision point in portfolio construction and that additional asset classes may need to be considered.
For advisers looking to use alternatives in client portfolios, there are two paths:
Choice #1: Incorporate alternatives that are considered return enhancers.
Those who choose this path want to outpace inflation by incorporating an option like private equity or real assets into their portfolios. Real estate (REITs) as an asset class has been a strong performer in 2021 and 2022 year-to-date and rents can escalate quickly with multifamily investments.
Thanks to its macro-tail winds, infrastructure could improve revenue numbers faster than cap rate expansion, resulting in total returns that exceed inflation. Private equity is also a good choice as it tends to outperform when public markets falter. According to iCapital, six months following an initial rate hike, stock returns are on average flat to slightly negative and 12 months after the first hike only see modest gains of 3 to 6 per cent.
Meanwhile, when public markets returned between -5 per cent and 5 per cent, all private equity funds outperformed the public index by 6.5 to 8.2 per cent. Many investors may choose to outpace inflation as well as returns of traditional asset classes by incorporating return-enhancing alternatives into their portfolios.
If current valuations are a concern, perhaps choice #2 is more attractive…
Choice #2: Hunker down and manage volatility.
Since the beginning of the last bull market a decade ago, hedge strategies have struggled to achieve market returns. But with the 60 per cent equity/40 per cent fixed income asset allocation strategy and duration-sensitive bonds losing nearly 10 per cent in the first quarter of 2022, advisers may be seeking alternatives.
Within this choice, there are number of options that haven’t been as attractive in recent years as they are today. Advisers may choose to look at the hedged strategy space for the first time in years.
Strategies like market neutral or long-short equity are also options, aiming to isolate factors that are not correlated to inflation or rising interest rates.
Turning to private markets once again, private credit is a space with which many investors are comfortable. While investments can range in credit quality, it’s possible to find senior secured investments. Often, these have underlying notes that are variable in nature and carry inherit protection against interest rate increases.
Advisers will need to understand the nuances of these investments, such as underlying leverage and where an investment stands in the capital stack.
Being over-leveraged or allocated too heavily to subordinate debt could lead to exposure to undesired idiosyncratic risk characteristics.
Advisers and their clients can also choose to blend several strategies to take an objective/risk replacement approach, especially if they’re underweight relative to alternatives.
As we head into this new adventure of weaker bonds and equities, more diversification could be the optimal path to choose – with private markets and private credit being such options.
James Martin is head of International Client Solutions at Hamilton Lane
