April 2023
This was a guest article for Hottinger Group.
2022 may prove to be a watershed year in markets, not just because it was the worst year in decades for fixed income. It was the year that demonstrated the limitations of the 60-40 model. The experience of seeing bonds and equities decline concurrently encouraged many investors to seek a more diversified asset allocation model with higher allocations to alternatives[i].
The Shifting Macro Landscape
A key reason for now considering alternative investments is the changed macro backdrop. Not only have we witnessed the highest level of inflation in decades and the fastest adjustment in US interest rates, COVID-19 and rising geopolitical tensions have raised the possibility of deglobalization and a realignment of global trade.
These shifts in geopolitics and capital market trends and in demographics, technology and resource utilisation, have prompted McKinsey to suggest that the global economy may be on the cusp of a New Era[ii], replacing what they call the Era of Markets of the last 40 years.
From an economic perspective the transition has been from a demand-constrained economy with disinflationary tailwinds to a supply-constrained economy with inflationary headwinds. That points to less palatable policy trade-offs for central bankers going forward and the potential for a new era of Great Volatility[iii] as Isabel Schnabel of the ECB has called it.
Building Robust Portfolios
A more volatile macro back drop supports the case for building a more robust portfolio with assets and strategies that can deliver returns in different environments. Maintaining a good balance between liquid and illiquid exposures may also be critical in managing capital and taking advantage of opportunities in a more volatile environment
The trend in recent years has been for private markets to be the first port of call when building alternatives allocations. Certainly, private equity, private credit, real estate, VC and infrastructure all have a place in a diversified portfolio.
However, when constructing portfolios it is important to look through to the underlying economic risks. A portfolio may look diversified with allocations to a range of different “buckets”, but economically it may be less diversified. Research from Bridgewater[iv] has shown that the typical institutional portfolio has a heavy bias to positive growth and low inflation.
Furthermore, as Sebastian Page highlights in “Beyond Diversification”[v] some seemingly diversifying assets and strategies may have a low correlation to equities in an equity bull market but become more positively correlated in times of stress when the economy turns down and liquidity dries up.
The Opportunity in Liquid Alternatives
The need to maintain liquidity while diversifying equity and duration risk point to liquid alternative investments as a particularly interesting option at the current juncture.
The range of liquid alternatives spans alternative assets such as gold and REITs to the range of trading and hedge fund strategies which are available with daily, weekly or monthly liquidity. Broadly speaking that includes much of the global macro trading universe, managed futures, market neutral strategies, volatility and tail risk strategies.
An important attraction of liquid alternatives is the potential to deliver returns in periods when traditional assets underperform such as in 2022.
Certain features of these strategies equip them to do that, specifically:
they are tactical (change positions in response to market and economic developments),
unbiased and opportunistic (can be long or short),
diversified (seek opportunities across many markets) and
trade liquid markets.
Diversifying Equity Risk
Within liquid alternatives it is important to evaluate strategies not only on their risk-adjusted returns but also in terms of their ability to deliver a convex return profile in times of equity drawdown.
Some hedge fund strategies may have attractive risk adjusted returns but a high correlation to equity, such as currency or credit strategies, and so are less diversifying to equities. Other strategies such as equity market neutral can be uncorrelated to equities but won’t necessarily deliver positive performance in times of stress.
Strategies like global macro and managed futures may have lower risk adjusted returns than other hedge funds but have historically delivered positive returns in major equity drawdowns which can justify a higher allocation from a portfolio perspective.
Performance of Various Hedge Fund Strategies in Major Equity Drawdowns, 2000-2022
Source HFRI/Archive Capital
That said, global macro and managed futures strategies are diversifiers rather than insurance strategies and investors need to be clear on whether absolute return, uncorrelated returns or tail risk protection is the objective for any allocation.
Inflation Protection
In the last two decades investors could rely on government bonds to generate returns in times of equity stress. However, in 2022 we saw how that relationship is contingent on inflation being well behaved. Although the consensus is that inflation has peaked for now, it is conceivable that we may see renewed inflationary upswings and diversifying inflation risk is likely to continue to be a consideration.
Over the long term equities and real assets should provide inflation protection but these assets can be marked down if interest rates rise in response to higher inflation. Again, some liquid alternatives can serve as potential diversifiers for inflation risk. In a paper in 2021 researchers at Man AHL[vi] examined which assets and strategies performed best in inflationary periods. They found that within equities, Quality outperformed, and elsewhere gold, commodities and trend following strategies did well. The research proved timely because Commodity Trading Accounts, or CTA’s, performed strongly in 2022.
Summary
In sum, the changed macro environment suggests the era of beta investing of the 2010s may be over and the traditional negative correlation between bonds and equities may be less stable.
A more volatile macro backdrop argues in favour of building more robust, resilient portfolios with greater use of alternatives.
While private markets may offer interesting opportunities to enhance equity and growth risk in portfolios, adding liquid alternatives can add diversifying sources of return, particularly in a more volatile macroeconomic environment.
[i] Move Over, 60/40 Portfolio. You’re Out of Date Now, Lauren Foster, Barrons, May 2022 [ii] On the Cusp of a New Era, McKinsey Global Institute, October 2022 [iii] Monetary Policy and the Great Volatility, Isabel Schnabel, Speech at Jackson Hole, August 2022 [iv] Building A Beta Portfolio in an Environment That Looks Difficult for Assets, Gordon et al, Bridgewater Associates, May 2022 [v] Beyond Diversification: What Every Investor Needs To Know About Asset Allocation, Sebastian Page, 2020 [vi] The Best of Strategies for Inflationary Times, Neville et al, The Journal of Portfolio Management, August 2021
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