Alternative Investments: When Diversification Is a “No-Show”

After a challenging year, investors are approaching 2023 with eyes wide open, soberly appraising several potential risks, including a recession, rising interest rates, currency moves, and the debt ceiling showdown. But they’re doing so with a renewed appreciation for one of the core principles of investing—diversification.

When Diversification Skips Town

A truly exceptional year, 2022 was dominated by historically high inflation, sharply rising interest rates, and a surge in bond yields. The combination pummeled markets, and the diversification benefits typically associated with stocks and bonds failed to materialize. In fact, last year stands out as the only calendar year since the Great Financial Crisis when returns on both global stocks and municipal bonds both hit negative territory (Display).

While we still consider stocks and bonds the pillars of most asset allocations, we have long recommended that investors look further afield. Alternative investments like private equity, private credit, commercial real estate debt, and multi-manager hedge funds may enhance income, stability, and capital appreciation, while diversifying exposure to a range of economic and geopolitical risk factors.

Given last year’s anomalous results, perhaps it’s time to take a second look.

Take It Private

When it comes to growth strategies, publicly traded stocks understandably command the lion’s share of investors’ attention. But not all companies are publicly traded—by number, the vast majority are held in private hands.

Like public companies, these businesses earn profits that they use to reinvest and grow, generating long-term capital gains for their owners. Yet, unlike public companies, the market for buying and selling private companies remains less liquid and less efficient. What’s more, private market investors use different strategies to unlock shareholder value. Some enhance operations through improved management techniques while others combine smaller entities to generate scale before selling a larger “roll-up” to a strategic or financial buyer. Finding partners who succeed in this space gives investors the chance to earn attractive premiums—not only to public markets, but also to other private market investors—over multi-year economic cycles.

Those cycles needn’t all be benign. Some private market investors benefit from a weaker economy or market stress. Through so-called “secondary investments,” these players essentially provide liquidity to financial counterparts who are forced to sell all or part of their stakes. By providing an exit for those sellers—and alleviating whatever pain they are enduring—secondary investors can earn a compelling premium over time. This holds especially true for secondary investors who are highly selective, targeting solid assets at discounted prices.

Yield Your Way Through It

As investors widen their net beyond traditional stocks and bonds, alternative investments that enhance yield also deserve further scrutiny. In difficult markets, earning a high yield can backstop returns while buffering temporary declines in asset values. And while there are many ways to generate income, there’s a simplicity to sourcing it directly from cash-yielding assets.

Take private credit and commercial real estate debt, which both offer attractive yields at present. Since each tends to have floating rate debt, they’ve benefited from the Fed’s hiking cycle relative to other fixed income markets. Plus, underlying market dynamics have created enough stress in both asset classes to create enticing opportunities to deploy capital.

Let’s start with private credit, which has grown in recent years. As regulatory requirements have made middle market lending less attractive, private capital has increasingly filled the gap in the wake of banks’ retreat. Now, rising rates have created a cash crunch for borrowers and, in turn, for lenders who underwrote loans in a low interest rate environment, which continues to fade away. In our view, for select private credit investors, deploying incremental capital could be particularly rewarding for the foreseeable future.

A similar dynamic has emerged in the world of commercial real estate. Unlike household mortgages, which are typically 30-year fixed rate debt in the US, commercial real estate debt generally carries a floating rate. Accordingly, the Fed’s hiking cycle in 2022 has created a cash crunch—especially for borrowers who overleveraged to generate higher returns on equity or to justify overpaying to win properties in recent years. We expect that over the next year or two, a wave of transactions will clear the market as fragile capital structures need to be replaced with more conservative ones. Investors who ride this wave could earn handsome rewards.

Expand Your Exposure

The final category of alternative investments worth revisiting offers uncorrelated return streams that are designed to improve risk-adjusted returns. For instance, multi-manager hedge fund strategies combine exposures to hedge funds focused on different asset classes and approaches. The goal? To “stack” individual excess return streams into one larger one.

Within each of these funds is a host of underlying return sources, which respond to markets in different ways. Take global macro funds, which focus on broad economic and geopolitical themes and tend to perform well in trending markets. They were a standout in 2022 and continue to dominate, making exposure to them attractive in the current environment, in our view.

Then there are “long/short” strategies, where managers adopt both long and short positions in global equities. Here the aim is to minimize exposure to the market’s overall direction while adding value by picking winners and losers in the same sectors. For investors looking for solutions that can potentially contribute to portfolio returns—even in a down market—these strategies stand out.

The Recipe for Success

Much like a food recipe, your portfolio should aim to combine different ingredients into one delectable whole. Each element should contribute something unique and work well with the others. This year, investors seem to be looking for a hearty soup—if stocks and bonds are the meat and potatoes, these other strategies are the vegetables and seasonings. Combined, they result in a much better-balanced creation.