Principles for Alternatives

1

Why Alts: Elevated valuations in public markets

point to muted future returns

Since 1950, the classic 60/40 stock-bond portfolio has delivered strong annualized returns. Currently, however, the 60/40 has three issues, which --if left unaddressed-- could cause investors to fall short of their long term goals.
We measure the valuation of a 60/40 by adding the earnings yield on stocks multiplied by 0.6 to the yield-to-worst on bonds multiplied by 0.4. This earnings/coupon yield tells us the 60/40 is getting more expensive, which historically has led to weaker long-term returns.

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"While 60/40 portfolios have provided very strong returns for many decades, this has come with a cost measured in higher valuations, less diversification and diminishing portfolio yields."

Dr. David Kelly

Chief Global Strategist

2

Why Alts: Stock-bond correlation doesn’t sufficiently diversify

when inflation is a threat

When equities zig, bonds are supposed to zag. This worked from 2000 to 2021 when growth rather than inflation was the risk. But, for the almost four decades prior when inflation risk was elevated, the average stock-bond correlation was positive.
Now that we’ve returned to a normal inflation and interest rate environment, correlation is once again positive, meaning bonds may struggle to provide sufficient diversification.

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Regime vs. Average correlation

1963 - 2024

3

Why Alts: The income on a 60/40 portfolio is low

relative to history

Rates are higher relative to the past 10 years but still low relative to the past 50, inflation is once again meaningful and the dividend yield on the S&P 500 is unimpressive. Consequently, the real yield on a 60/40 portfolio is currently negative.

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Yields

As of August 31, 2024

4

Why Alts: Alternatives can

improve portfolio risk and return

For those willing to venture outside of the classic 60/40, adding a sleeve of alternatives to portfolios can help address the current headwinds by enhancing returns, diversification or income.
In the Guide we show a 30% allocation improves the risk / reward tradeoff. However, investors should not add to alternatives indiscriminately. Alternatives is one word used to describe many different asset classes, everything from owning a building to a share in a hedge fund, each of which plays a unique role in portfolios.

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"Adding a diversified sleeve of alternatives to traditional stock/bond portfolios can help manage risk and improve return."

Katie Korngiebel

Research Analyst

5

Which Alts: Different alternatives can enhance

different portfolio atttributes

In general, investors’ approach to allocating to alternatives should be outcome oriented - in other words, step one is identifying the goal you’re trying to accomplish, and step two is allocating to the asset that will provide the desired outcome.
The new alternative allocation should then be funded from the part of the portfolio that was previously trying to accomplish this goal. For example, if investors want to enhance income, they might consider an allocation to private credit funded from their current core fixed income position.

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Correlations, returns and yields

10-year correlations and 10-year annualized total returns

6

Which Alts: Private markets are growing

and dominated by growth companies

As more companies balk at going public, private equity is expanding in the fastest-growing sectors of U.S. markets, especially Technology.
Companies are now spending more of their early stage, the fastest growing part of their lifecycle, in private markets, so investors looking for strong capital appreciation should look beyond publics. A slower IPO market over the past few years has accentuated this trend.

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Median age at IPO

1980 - 2023

7

Which Alts: Private credit is providing

a growing proportion of financing

After the Great Financial Crisis, increased regulatory scrutiny led banks to greatly reduce their exposure to higher risk lending opportunities.
Private credit firms, which are not held to the same regulatory standards, have stepped in to fill this gap.

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Primary market sources of financing

New-issue market for broadly syndicated loans

8

Which Alts: Hedge funds can diversify

traditional stock/bond portfolios

Hedge funds have provided downside protection during most of the periods of acute market stress over the last thirty years. During the distress, macro hedge fund correlation to a 60/40 stock-bond portfolio has typically fallen to zero or below.
Correlations came down in 2020, although not as far as during other periods of volatility, likely because market volatility during COVID was so brief relative to past downturns.

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30

years of downside protection provided by Hedge funds during periods of acute market stress

9

Which Alts: Real assets offer

attractive levels of income

Though bond yields have risen, they are still low relative to history, forcing investors to take on more risk to generate the income they need.
However, alternatives, particularly core real assets, can provide investors with credit-like yields without the elevated correlation to equities.

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Asset Class Yields

Percent

10

Which Alts: Diversification within alternatives

can improve the risk/return tradeoff

Though each alternative asset class plays a different role in portfolio construction, investing in multiple with different properties can improve portfolio outcomes.
A balanced exposure to alternatives, as illustrated by the “Asset Allocation” portfolio, would generate an annualized return of 9.6%. While this is lower than the highest returning asset classes like venture capital and private equity, the “Asset Allocation” portfolio achieved this return with significantly lower volatility.

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9.6%

annualized return that could be generated with a balanced exposure to alternatives, as illustrated by the "Asset Allocation" portfolio

11

Who Alts: Manager selection matters a lot more

in private markets

Manager selection is critical to strong returns, perhaps even more so in alternative investments. Alternatives are newer and less efficient than public markets, leading to wider performance dispersion among managers.
This dispersion is pronounced in non-core real estate, private equity, venture capital and hedge funds, underscoring the importance of choosing an effective manager to unlock the return-enhancing potential of alternatives.

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"Manager dispersion is particularly wide in private markets, making investing with a good manager a key element of the allocation process."

Brandon Hall

Research Analyst

Principles of Alternatives Investing

Principles of Alternatives Investing

Why Alts: Elevated valuations in public markets

point to muted future returns

"While 60/40 portfolios have provided very strong returns for many decades, this has come with a cost measured in higher valuations, less diversification and diminishing portfolio yields."

Dr. David Kelly

Why Alts: Stock-bond correlation doesn’t sufficiently diversify

when inflation is a threat

Regime vs. Average correlation

Chart

Why Alts: The income on a 60/40 portfolio is low

relative to history

Yields

Chart

Why Alts: Alternatives can

improve portfolio risk and return

"Adding a diversified sleeve of alternatives to traditional stock/bond portfolios can help manage risk and improve return."

Katie Korngiebel

Which Alts: Different alternatives can enhance

different portfolio atttributes

Correlations, returns and yields

Chart

Which Alts: Private markets are growing

and dominated by growth companies

Median age at IPO

Chart

Which Alts: Private credit is providing

a growing proportion of financing

Primary market sources of financing

Chart

Which Alts: Hedge funds can diversify

traditional stock/bond portfolios

Which Alts: Real assets offer

attractive levels of income

Asset Class Yields

Chart

Which Alts: Diversification within alternatives

can improve the risk/return tradeoff

Who Alts: Manager selection matters a lot more

in private markets

"Manager dispersion is particularly wide in private markets, making investing with a good manager a key element of the allocation process."

Brandon Hall

Dive deeper into the data. Explore the charts.