Alternatives: How are alternatives continuing their transition to an essential portfolio allocation?
The reality is that neither the level of rates nor the outlook for equity returns will be sufficient in meeting investors’ needs for income and return.
David M. Lebovitz
Global Market Strategist
The first quarter of the year saw stocks and bonds sell off in lock-step, as fears of inflation and a hawkish pivot by the Fed sent yields higher and equity valuations lower. Taking a step back, however, interest rates have risen but remain low by historical standards, and the re-rating of equity valuations has only marginally improved the prospect for future equity returns. The reality is that neither the level of rates nor the outlook for equity returns will be sufficient in meeting investors’ needs for income and return. As such, alternatives will continue their transition from an optional portfolio allocation to an essential one.
Exhibit 12: Stock-bond correlations are unstable over time
S&P composite, 10-year UST yield, 12-month rolling correlations, 1900 - present
Source: Robert Shiller, Yale University, J.P. Morgan Asset Management. Data are as of May 31, 2022.
Core real assets are in focus, as real estate, infrastructure, timberland and transportation assets have all historically provided investors with both inflation protection and income. While there are lingering concerns about some parts of the real estate market – particularly the office sector – activity has been resilient. Importantly, when it comes to the real estate market more broadly, tenants are not shying away from higher rents. For clients who cannot or are unwilling to hold illiquid assets in their portfolios, we have seen significant growth in the semiliquid opportunity set and believe that this improving access will continue, thereby democratizing alternatives as an asset class.
Private equity activity has cooled against an uncertain macro backdrop, with general partners focusing less on traditional buyouts and more on add-ons, platform creation and growth equity. Furthermore, we have seen an increasing focus on the middle market, as well as on the old economy sectors that stand to perform well in an environment characterized by a tight labor market and elevated inflation. In private credit, direct lending and mezzanine debt strategies remain attractive. At the same time, we are increasingly seeing investors discuss committing to distressed or special situation funds, as there is an expectation that a backdrop of slower growth and higher interest rates may lead to an expansion of this opportunity set.
Finally, hedge fund performance should continue to improve, especially macro funds and those strategies that are agnostic to the direction of markets. Macro strategies in particular have proven to be a port in the storm given they tend to traffic less in traditional stocks and bonds, while relative value credit and equity long/short strategies have been able to take advantage of lower correlations and elevated return dispersion. In general, our work has shown that environments of greater macroeconomic volatility tend to translate into elevated capital market volatility; in these types of environments, hedge funds tend to outperform traditional long-only equity and fixed income strategies.
Exhibit 13: Hedge funds tend to outperform in environments of elevated rate volatility
Hedge fund performance by MOVE quartile
Bloomberg, FactSet, HFRI, Merrill Lynch, MSCI, J.P. Morgan Asset Management. Data are as of May 31, 2022.
At the end of the day, however, we still believe that alternatives require an outcome-oriented approach. Furthermore, we recognize the ability for manager selection to make or break an allocation to alternatives. As a result, we believe that having a framework for allocating to these assets and strategies is imperative, as traditional portfolio construction methods may not be an optimal approach when constructing portfolios of alternative assets.