How alternative investments may benefit your portfolio

After a decades-long period of low inflation, low interest rates and solid economic growth, investors have learned to live with volatile market conditions characterized by persistent inflation and high interest rates. Traditional equity returns are now projected to be closer to longer-term averages around 8%, which would be a significant departure from the mid-teen average returns of the post-Global Financial Crisis (GFC) to COVID period.

The snapback in fixed income yields after compressing in the low-rate post-GFC era also heightens the possibility of a more volatile bond market, which can dampen the diversifying benefits that investors tend to expect from fixed income. In response to these evolving expectations, investors may want to consider broadening their investment horizons beyond the traditional 60/40 stock/bond portfolio.

The importance of low correlation in a portfolio

Over most of the past 30-plus years, stocks and bonds exhibited low correlation to one another, providing investors some degree of diversification. The 60/40 portfolio is based on the view that stocks tend to zig when bonds zag—low correlation—and vice versa. The expectation is that the 60% allocated to equities delivers portfolio growth. In turn, the 40% allocation to fixed income provides income, stability, and diversification.

Yet the relationship between bonds and equities—known as correlation—looks more dynamic when we examine other timeframes. For example, during the 1970s and into the 1980s—a period also characterized by volatility, high levels of inflation, and rising interest rates—investors experienced elevated correlation between equities and fixed income, meaning they moved more in tandem. Similarly, during 2022’s selloff and several shorter periods since, stocks and bonds have been highly correlated in response to the market’s higher volatility and increased inflationary pressures. Returns across stocks and bonds may remain highly correlated as the Federal Reserve holds rates near the highest level in two decades to tamp down persistent inflation.

Exhibit 1: Stocks and bonds show increased performance correlation

Source: FactSet, as of December 29, 2023. Important data provider notices and terms are available at www.franklintempletondatasources.com.

How alternative investments differ

Alternative investments are financial assets that do not fall into one of the conventional asset classes, such as stocks, bonds and cash. Over long time periods, alternative investments—including private equity, private real estate, and hedge funds—have demonstrated attractive historical returns with lower volatility than stocks.² When used judiciously, we believe alternative investments can provide exposure to unique return drivers for the overall portfolio, thereby minimizing correlations to the performance of traditional equity and fixed-income asset classes. We believe this can offer portfolios improved diversification, reduced volatility and potentially enhanced yield or return, depending on each investor’s goals and objectives.

Exhibit 2: Alternatives may provide enhanced return potential with lower volatility³

Source: Optica, FactSet. All return and volatility measurements use data from Jan 1, 1990 through March 31, 2023. Important data provider notices and terms available at www.franklintempletondataresources.com 

The historical diversification benefit of alternatives can be seen in Exhibit 3. It shows how the introduction of alternatives to various portfolio allocations may aid in reducing overall portfolio volatility and enhancing potential return. Total allocations to alternatives and their composition in portfolios will vary depending on each investor’s return/risk objectives and the ability to assume illiquidity.

Exhibit 3: Rethinking the 60/40 stock/bond portfolio

Source: Fiduciary Trust International, using data from FactSet. All return and volatility measurements use data from Jan 1, 1991 through September 30, 2023. Important data provider notices and terms available at www.franklintempletondataresources.com

Incorporating alternatives into portfolios

Portfolio construction is more critical and complex with the addition of alternatives. There are also additional risks, including leverage, longer lock-up periods (illiquidity), and increased complexity, which must be closely analyzed and monitored.

We also believe it’s beneficial to set clear objectives for each asset class at the outset. Each potential investment should have a unique purpose in the portfolio and contribute to an investor’s portfolio via strategy/source of return, geography, sector, or other differentiating factors. For example:

• Private equity. We look across private market strategies from early-stage venture to distressed to deliver unique risk-adjusted returns typically above that of public equity. We also look at how a private equity strategy may improve overall diversification.
• Hedge funds. We endeavor to access strategies that are constructed to have limited sensitivity to equities and bonds, including merger arbitrage, convertible arbitrage, and fixed income relative value.
• Real estate and real assets. Through durable cashflows and hard assets, this asset class may offer portfolios a unique source of yield, growth, and potentially inflation protection.

The value of manager selection

Manager selection is also a critical component of the risk management process. Our robust due-diligence process reflects decades of institutional knowledge and experience in alternatives investing. Having clear expectations aids in filtering the disparate and voluminous manager opportunities across alternatives. There are more than 3,000 hedge funds and 6,000 private equity managers⁵, so having a clear filter helps to winnow the list.

Our process proceeds in deliberate stages and includes, but is not limited to, evaluating management team structure and longevity, key investment terms, and operational practices to understand process, rather than just historical outcomes/performance. We also review all manager and strategy materials; research specific market opportunities and landscape of peers; detailed performance and attribution analysis; reference interviews; and operational and legal diligence.

Manager selection is critical to the entire process, as depicted in Exhibit 4. It shows the range of returns between the bottom quartile and top quartile of private alternative managers by strategy and compares that to the range of returns for U.S. large-cap public equity managers.

For example, the dispersion of returns for private equity buyout managers ranged from over 40% annualized return at the top to nearly -10% annualized return at the bottom. This compares to the relatively tight dispersion of U.S. large-cap managers shown on the far right. Thus, the outcome for an investor in buyout, venture capital or these other private strategies could vary greatly depending on manager selection.

Exhibit 4: Manager selection and performance

Range between top quartile and bottom quartile private alternative managers compared to range of returns for U.S. large-cap public equity managers

Source: Cambridge Associates, FactSet, as of December 31, 1996 to September 30, 2023. Important data provider notices and terms available www.franklintempletondatasources.com.

Alternatives moving into the mainstream

Historically, alternative asset classes were the purview of large endowments, foundations, pensions, and select family offices of significant means. The diversified approach for these investors was exemplified by the former CIO of Yale’s endowment, David Swensen, who wrote the book on diversified portfolios, Pioneering Portfolio Management, first published in the year 2000.

Since then, the financial world has continued to push to bring these capabilities to the broader investing public via mutual funds and other more liquid structures. These advances have lowered minimum investment thresholds and fees, and increased liquidity for strategies that otherwise would be unattainable for the broader investing public.

An investor may now be able to gain exposure to hedge fund strategies such as merger arbitrage and convertible bond arbitrage through mutual funds that offer favorable fees (typically 1.2 to 1.5%) and daily liquidity. This is in stark contrast to the typical 2% management fee/20% performance fee and limited liquidity typically offered by private hedge funds. Additionally, investors may now have access to private real estate through interval funds. We believe they provide a better reflection and exposure of the asset class than publicly traded REITs but with greater liquidity and lower fees than a typical private real estate fund.

In addition, these more liquid fund structures have made tax reporting simpler. Many funds are providing 1099s, rather than partnership K-1s, which are often multi-page, relatively complex tax documents.

An experienced advisor

We believe in alternatives because they may increase portfolio resiliency. In our opinion, an all-weather portfolio is better able to withstand various economic scenarios, as opposed to a two-asset class portfolio of just stocks and bonds. This belief has been reinforced by the challenging, highly correlated environment for stocks and bonds since 2022 versus the relatively stable uncorrelated returns provided by alternatives.

At Fiduciary Trust International, we are committed to delivering innovative, differentiated, and personalized investment solutions. It’s our belief that prudent, risk-managed investing in alternative asset classes requires specific knowledge and expertise honed over many years through various market cycles. Our alternatives platform extends beyond traditional investments and offers an expansive footprint and specialized capabilities across a range of asset classes, structures and investment outcomes.

As alternatives become more widely available to investors, we believe having experience and an institutional framework in diligence and selection will prove highly valuable to investors. For more information on the role of alternatives in your portfolio, please contact your Fiduciary Trust portfolio manager.

 

 

 

Alternative investments are private investments that may only be suitable for sophisticated investors and are subject to special risks. Alternative investments may engage in leveraging and other speculative investment practices that may increase the risk of investment loss. These investments may be highly illiquid with capital locked-up for extended periods of time and little to no secondary market. They are not required to provide periodic pricing or valuation information to investors and may involve higher fees, complex tax structures and delays in distributing important tax information.