Alternative investments: Asset allocation strategies in a changing environment
Highlights from the “An asset allocation solution for public and private markets” session at the Asia Investment Conference 2024
Over the past two decades, investors have increasingly adopted alternative investment strategies – ranging from hedge funds to private equity and debt as well as real estate and infrastructure – in order to increase portfolio diversification, mitigate risk and deliver more consistent income and returns.
The popularity of alternatives among the likes of institutional investors and sovereigns was driven to a significant extent by the low yield environment.
As Massimiliano Castelli, Head Global Sovereign Markets Strategy and Advice, UBS Asset Management, explains, “The popularity of alternatives among the likes of institutional investors and sovereigns was driven to a significant extent by the low yield environment.” It ran from 2009, at the close of the global financial crisis, to 2021. During this period, the higher yields and wider opportunity set offered by alternatives became particularly compelling, as did their low correlation with public markets.
Since 2021, however, the picture has changed. The rise in global inflation that followed the end of the COVID pandemic led central banks in North America and Europe to raise interest rates, abruptly concluding over a decade of near-zero rates. At the same time, Russia’s invasion of Ukraine in February 2022, along with renewed hostilities between Israel and Hamas in late 2023, have led to heightened geopolitical tensions and further market volatility.
From the point of view of portfolio construction in particular, 2022 was a year when the negative correlation between equities and bonds broke down, with losses seen in both asset classes. The question facing investors today, therefore, is: how do alternatives fit into this new economic and financial environment?
How market developments have affected hedge funds
How market developments have affected hedge funds
“To look at one example, hedge funds have always been considered as a source of diversification and uncorrelated returns in investors’ portfolios,” explains Adolfo Oliete, Head of Research and Head of APAC Investments, UBS Hedge Fund Solutions, a distinct business unit of UBS Asset Management (Americas) LLC. “But they are even more timely now as a result of the well-advertised challenges of the traditional 60/40 portfolio: given the inflationary environment we're in, bonds may no longer provide the correlation benefit that they have historically.”
Oliete says that the role of hedge funds within portfolios has generally been to reduce the overall volatility profile without affecting returns. “Hedge funds are even better placed to do this in the current environment,” he adds. “In the low rate regime of the past decade, returns were more challenging to harvest for hedge funds: it was difficult to keep up with an environment where risk assets were essentially going up in a straight line unless you overreached for risk.”
Prior to 2021, that sort of dislocation and volatility was harder to find and harvest. Fast forward to today, to a higher rate environment, however, and it is possible for managers to capture much of the upside of the market – to capture that dispersion from both the winners and the losers – without reaching outside of the risk profile.
He explains that the type of hedge fund strategies trying to capture spreads, dispersion and/or market volatility were historically less effective as a result of a low or negative rate environment. “Prior to 2021, that sort of dislocation and volatility was harder to find and harvest. Fast forward to today, to a higher rate environment, however, and it is possible for managers to capture much of the upside of the market – to capture that dispersion from both the winners and the losers – without reaching outside of the risk profile.”
In terms of the current outlook, Oliete says that higher interest rates typically lead to elevated levels of volatility – and greater volatility increases the range of potential investment opportunities. “We have already seen over the last six to eight months that returns are starting to rise, so you now have the dual benefit of returns that are not just higher but also relatively uncorrelated to public markets,” he adds.
Private credit goes from strength to strength
Private credit goes from strength to strength
Recent macroeconomic developments are unlikely to dim the appeal of private credit, says John Popp, Global Head and Chief Investment Officer, Credit Investments Group, UBS Asset Management.
“There are fewer publicly listed companies in the US today than there were a decade ago,” he points out. “There are 17,000 companies overall in the US that have revenues over USD 100 million, and just 2,600 of those companies are public. So alternatives provide an opportunity to increase risk-adjusted returns largely by increasing the opportunity set – and this is equally true on the debt side.”
The growth of private credit as an alternative investment strategy was driven by the withdrawal of larger banks from the direct lending market in the wake of the global financial crisis, Popp adds. “The next shift was driven by private equity as those firms developed their own capital markets capabilities,” he explains.
Popp says he and his team are primarily looking for inefficiencies in credit markets. “This is where you can get the incremental premium: it is not just down to illiquidity; it is also based on the complexity around the transactions, the negotiated nature, the heavy paperwork and the pickup over time. For a strategy that is focused on enterprise value companies, with annual revenues of USD 400 million and above, that premium could be anywhere from 50 to 300 basis points.”
But I don't think it's just the pickup in yield that appeals to investors... It is also the pickup in diversification, by which I mean getting access to opportunities that would not otherwise be available, as well as structural benefits. These deals can be more tightly managed around protecting your asset value.
Recent rises in interest rates have clearly resulted in higher returns for this asset class. “But I don't think it's just the pickup in yield that appeals to investors,” Popp adds. “It is also the pickup in diversification, by which I mean getting access to opportunities that would not otherwise be available, as well as structural benefits. These deals can be more tightly managed around protecting your asset value.”
Lock-up periods and illiquidity considerations
Lock-up periods and illiquidity considerations
Although interest rates have risen since 2021, alternatives assets with lock-up periods are still generating bigger returns than public markets.
Investment managers have created semi-liquid solutions in recent years to provide investors with redemption rights and periodic liquidity windows. These are designed as a way to balance illiquidity risk. As interest rates have risen, so too have liquidity premiums – and demand for semi-liquid investments.
Oliete adds: “I think also within the hedge fund world, you need to be mindful of what you are buying when going more liquid: It is possible that you either might not be buying the right liquidity, or not buying the same return profile because you don't have the same illiquidity premium.”
A public and private solution
A public and private solution
In the end, evolving market dynamics have changed the outlook for traditional approaches to asset allocation, but we believe an evolved, blended solution that includes alternatives can help generate consistent income and returns and deliver a diversified portfolio to meet the different long-term goals for investors.
