Diversify with alternatives

Investing in private infrastructure can enhance the income potential and bring diversification benefits to a private market portfolio.

• Infrastructure has return potential. Over the decade through 2023, infrastructure investments (as measured by the Cambridge Associates Infrastructure Index) on average returned 10.8% annually compared to 5.9% from global equities (MSCI ACWI) and 0.4% from global aggregate bonds (Bloomberg Global Aggregate Index). We believe more resilient US growth, government spending, and constrained fiscal positions bode well for private infrastructure returns in the months and years ahead.
• Infrastructure can be a tool for portfolio resilience. High barriers to entry, monopolistic positioning, and the high degree of cost passthrough of many of these assets mean infrastructure can provide portfolio resilience through the business cycle. Infrastructure assets have shown correlations ranging from -0.2 to +0.6 with other investments between 2005 and 2022, according to Cambridge Infrastructure Index data. This low correlation can help reduce overall portfolio volatility and enhance risk-adjusted returns.
• Infrastructure underpins many transformational innovations. We maintain a positive view on the asset class. Infrastructure sits at the heart of powerful structural trends—including greater spending on data centers and power generation as part of the AI revolution.

While the private equity (PE) industry continues to lag public stocks as the global rate-cutting cycle takes longer to impact unlisted assets, we see signs of improvement for PE assets.

• Deal-making is accelerating and valuations are stabilizing. Transaction activity is improving and exits are gaining traction. Higher public valuations have made public listings more attractive again, and strategic buyers have cash on hand, as well as interest in mergers and acquisitions. Leveraged buyout (LBO) entry multiples have fallen 5% below their 2022 peaks and stood at around 11x EV/EBITDA at the end of the first quarter, according to the latest Burgiss data. Now may be a good time to complement public equities with private equity, albeit focused on lower entry multiples for PE to offset the impact of still-high interest borrowing costs.
• In the current environment, we prefer fund managers with strong track records in operational value-creation and in identifying large or midsized companies with appealing valuations. We expect continued middle-market buyouts, carveouts, and divestitures over the coming quarters. 
• We still like secondaries, which present solid fundamentals driven by LP and GP needs for liquidity. Investors can access quality secondary assets at attractive entry points with current discounts to NAV averaging 12% across strategies.

Private credit remains a potentially attractive addition to long-term portfolios. While default rates in aggregate rose to 2.7% in the second quarter, according to Proskauer, financial distress is concentrated in lower-middle-market and smaller borrowers, where we are more cautious.

• The income on offer looks appealing. The overall asset class offers yields of around 11%, based on JPMorgan data, a spread of 130bps and 310bps to US leveraged loans and high yield (as of 30 June 2024), respectively. While Fed rate cuts will partly erode returns, they could ease funding costs and temper credit losses. We expect high-single-digit to low-double-digit returns this year and next.
• Private credit may help lower portfolio swings. The asset class has historically exhibited lower volatility than conventional credit. Additionally, the sector benefits from strong covenants and diversified borrower bases, which can help mitigate risks.
• Focus on senior upper-middle-market and sponsor-backed loans. Doing so—while also focusing on newer loan vintages and less cyclical sectors —should mitigate losses and take advantage of appealing prospective returns. Investors in private credit should be mindful of the risks, including credit risks, illiquidity, and leverage, and should focus on experienced managers to navigate today’s complex environment.

We believe hedge funds are well positioned to navigate falling interest rates, divergent monetary policies, and political uncertainty. Historically, hedge funds have done well ahead and after US elections, with HFRI Fund Weighted Index outperforming a 60/40 portfolio on five out of the eight past occasions since 1992.

• Seek return generation in equity-market neutral funds. Market swings and stock dispersion can create mispricing opportunities and increase alpha potential for equity long/short strategies. Equity market neutral (EMN) managers are on track for a record year, with the HFRI EMN index up 7.5% through September. CIO analysis shows that adding around 10% of equity market neutral (EMN) hedge funds to a global 60% equity/40% bond portfolio can deliver comparable expected annual returns, but lower expected annual volatility by roughly 1-3 percentage points, based on Bloomberg data since 1990.
• Look for diversifier strategies to smooth returns. Macro funds should be well positioned to exploit market dislocations, potentially offering valuable diversification in more uncertain market environments. Multi-strategy platforms, in particular, offer the flexibility to adapt to changing market dynamics and for managers to allocate capital across different strategies
• Be selective in credit hedge funds. We recommend more diversification and selectivity in alternative credit. We prefer tactical managers who can capitalize on dispersion across sectors or regions. Convertible arbitrage remains attractive, in our view—the segment provides long-dated optionality, event-driven alpha, and can capture relative value in overlooked credit areas.