2022 saw stock/bond correlations turn positive, leaving many investors with nowhere to hide. However, hedge funds demonstrated an ability to zig when other markets zagged.
The onset of higher interest rates and reset in equity valuations last year have left some questioning the wisdom of owning alternative assets. While we recognize that there is a near-term opportunity in traditional assets, this opportunity will likely be fleeting – regardless of one’s precise view on Fed policy and the contours of growth going forward, lower rates and a more challenging environment for equity returns seem to be on the horizon.
As such, we still see room for alternatives to enhance returns, generate income and provide diversification. Private equity buyout valuations have been far more resilient than their venture counterparts, mostly because these businesses were able to generate decent earnings growth in 2022. While there may be further downside ahead, it is important to remember that some of the best private equity vintages were ones that coincided with economic slowdowns and recessions. Furthermore, as growth slows this year we do expect default rates to rise, creating an opportunity for distressed and special situations investors.
We also continue to see value in core real assets, even in an environment where capital values decline. Real estate markets are characterized by significant dispersion, as the industrial sector has the wind at its back, while office continues to struggle. Meanwhile, infrastructure assets seek similar income streams and inflation protection, serving as a hedge against an inflation revival. Finally, direct lending may soften as growth slows and financial conditions tighten, but the flexibility and higher quality nature of these loans leave the asset class looking favorable from a structural perspective.
Finally, hedge funds can provide diversification benefits over and above traditional fixed income. 2022 saw stock/bond correlations turn positive, leaving many investors with nowhere to hide. However, hedge funds demonstrated an ability to zig when other markets zagged; this dynamic, in conjunction with higher base rates and volatility, should support performance during the back half of the year.
As always, however, we believe that allocating to alternatives is a multi-step process. First, an investor needs to identify the problem they are looking to solve, and subsequently back into the appropriate type of alternative investment. From there, manager selection takes on an outsized role, as dispersion in private market returns tends to be far wider than is observed in public markets.