MARKET COMMENTARY

A Role for Alternative Investments in 2022: Diversification Offers Portfolio Benefits

12.28.2021 - Kate Huntington, Head of Advisory Solutions Group

The current market environment features elevated equity valuations, low-to-negative yields and tight credit spreads. Will these trends continue? As the investing adage goes, “we cannot predict the future, but we can prepare for it.” Diversification is one way to prepare for the future and this is especially true today. We believe portfolios positioned for a variety of future economic and market outcomes are more likely to deliver long-term value.

Alternatives as a Diversification Tool

Alternative investments are an important diversification tool that have the potential to enhance a portfolio’s long-term risk-adjusted returns. (1) They can provide exposure to unique return drivers for the overall portfolio, minimizing correlations to the performance of traditional equity and fixed income asset classes.

But portfolio construction and risk management become more critical and complex with the addition of alternatives. A proper framework, therefore, is needed. It starts with understanding the purpose of each type of alternative investment and the role each can play within a multi-asset class portfolio. There are also risks, including leverage, illiquidity and increased complexity, which must be closely analyzed and monitored.

Private Equity Offers Unique Exposure

Private equity offers exposure to sources of equity and equity-like returns not easily accessed via public markets. For example, early-stage investing in technology and life sciences, including enterprise software, biotech and digital applications, has benefited from a growing and evolving economy as well as company-specific milestones such as speed of product creation, first financing and market testing. Advances in technology and medical breakthroughs over the past decade have also led to lower capital requirements and shorter timeframes for new business models to be proven and adopted.

But in the current environment there is reason to remain cautious and highly selective in private equity investing. Investment volume and capital raising in late-stage venture/growth equity has been expanding rapidly (2)and private equity firms are navigating a highly competitive landscape. We expect (hopefully) isolated bubbles and seek strategies that are ideally selling into this current frenzy. As a counterbalance to market uncertainty, we believe a well-constructed private equity portfolio should include distressed debt and special situations strategies.

The Benefits of Absolute Return’s Low Correlation

Absolute return strategies seek to deliver returns that are both consistent across market cycles and above that of fixed income. A high-quality portfolio of absolute return managers with limited sensitivity to traditional asset classes may enhance the risk-adjusted return of a portfolio. With a challenging yield curve, increased value in these strategies may be achieved as both a fixed income alternative and a complement. However, we caution against “hedge fund” strategies that provide minimal excess returns or downside protection relative to a portfolio’s benchmark, and managers who charge higher than average fees.

The Upside of Real Assets

Real assets, such as real estate, farmland, and infrastructure, have the potential to provide a source of yield and downside protection. They can also serve as a defense against the uncertainty of inflation as they are supply constrained and often appreciate in value due to rising input prices, replacement value, and rents during periods of heightened inflation. But certain sectors within commercial real estate, such as office, retail and hospitality, are undergoing an evolution due to the global pandemic and continue to present a number of unknowns. We see opportunities today outside of the typical property segments that have been supported by a variety of long-term demand drivers, including:

  • Agriculture – global imbalance in food supply/demand
  • Digital Infrastructure—rapid increase in digital applications and data use
  • Industrial – ecommerce expansion and lack of infrastructure
  • Renewables – transition to low carbon economy
Rethinking the Traditional Client Portfolio

The traditional 60% equities/40% fixed income asset allocation is by no means going away completely. We continue to believe in portfolios that lean more towards equities will benefit from compounding stock returns over the long-term. Fixed income can add stability to a portfolio, although with less yield today. To meet long-term risk-adjusted return goals, adding a mix of alternative investments to a traditional portfolio offers differentiated drivers of risk and return, increasing diversification and portfolio robustness.

 

 

 

Source: Preqin: “Why Invest in Alternatives”
Source: Pitchbook, as of 9/30/2021


 



This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

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