Diversify with alternatives

Infrastructure is a key element of the alternative investment universe. Many of the trends highlighted in our Decade Ahead-including demobilization, digitalization, decarbonization, and high government debt burdens-will need increased private investment in infrastructure. For example, we currently see significant focus on areas such as data centers to support digitalization and AI developments, as well as green energy.

For investors, the consistent inflation-linked cash flows provided by private infrastructure assets may appeal to both those seeking income and capital gains with long time horizons. At the same time, infrastructure assets can help diversify portfolios. Between 2005 and 2022, they had correlations of between –0.2 and 0.6 to other investments, according to Cambridge Infrastructure Index data.

Credit hedge funds. Specialist credit hedge funds, which aim to take advantage of the differences in creditworthiness and spreads between various borrowers, rallied around 4.6% in the first quarter of the year. TWe see continued scope for this strategy to enhance portfolio returns in 2024 given spread dispersion: The difference between the strongest and weakest CCC borrowers remains elevated, in the 65th percentile over the past 25 years’ data.

Equity long/short with low net exposure is another preferred strategy. Equity long/short strategies have historically delivered excess returns over the S&P 500 (alpha) of 5.2% a year in periods where correlation between stocks is low and dispersion of stock returns is above average as it is today. Global equity long/short funds benefited from this trend in the first quarter, with the spread in performance between long and short positions standing at 6.3% through the end of March, the best start to a year we’ve observed since 2010.

We also like macro hedge funds, which should be well positioned to capitalize on a turn in the interest rate cycle and help investors navigate geopolitical shifts. Meanwhile, multi-strategy funds that can shift investments between different trading strategies to manage risk and seek returns across various scenarios can help investors build alternatives exposure, given lower minimum investment requirements.

Investors should note that hedge funds can carry unique risks, including reduced liquidity, higher fees, and added complexity.

Value-oriented buyout. We like strategies where managers identify appealing middle-market companies, buy them, and use their skills to add operational value. Buying middle-market companies requires less borrowing, and, according to Pitchbook, buyout valuations have fallen. The median North American and European EV/EBITDA has declined more than 12% on a 12-month-trailing basis.

Secondaries. We also like strategies that buy private equity assets in secondary markets. They allow investors to build positions in existing assets quickly, and prices remain discounted. Discounts to net asset value were 15% on average at the end of 2023. We expect volumes to build on last year’s USD 112 billion (the highest since 2021), with greater diversity of assets coming to market.

Thematic equity. This strategy also represents an opportunity for investors who want to capture long-term growth in their portfolio, particularly those exposed to long-term trends like digitalization, healthcare, sustainability, and the energy transition. We expect private equity managers to use their long-term investment horizons and active ownership to deliver 10–12% annual returns throughout the market cycle.

Private credit. We continue to see a place for private credit and direct lending strategies in portfolios as a strategic source of income, diversifier of returns, and potential improver of risk-return characteristics.

While we are closely watching for signs of financial stress, such as rising non-accruals (loans that have ceased to make interest payments and are deemed non-performing) among smaller borrowers, we believe that experienced private credit investors in well-diversified funds focused on larger companies in the most economically resilient sectors are likely to be fairly compensated for the risks inherent in the asset class.

We also see signs of growing prudence among private credit managers. Recently originated private loan data from JPMorgan shows that the median net leverage for transactions closed in January was at 4.5 times, compared to a median leverage of 4.9 times for all of 2023. Sponsors are putting in more equity in leveraged buyout transactions than at any time since 1997. And loan documents indicate that borrowing terms have become stricter in what should be a further comfort for investors.

Investors should understand the risks inherent to private markets. These include illiquidity, long lockup periods, leverage, concentration risks, and limited control and transparency of underlying holdings. Allocations to private markets should form part of a well-diversified portfolio and be regularly reviewed as personal and market circumstances evolve.