Diversification is the Only Free Lunch: Alternatives in a Volatile Market
Prashant BHAYANI CIO Asia, Grace TAM Chief Investment Advisor, Hong Kong & Dannel LOW Investment Specialist at BNP Paribas Wealth Management
Key summary
- We expect market volatility to stay high. Instead of holding too much cash which offers negative real returns, investors should consider alternatives such as private equity, real estate, hedge funds, direct investments and structured products as satellite allocations to diversify and reduce overall portfolio volatility.
- We have seen the worst year-to-date performance for a 60% stock/40% bond portfolio since 1976. Alternatives generally show lower correlation with other asset classes. Investors can also take advantage of the current high volatility to invest in structured solutions with principal returned at maturity while capturing the upside potential.
- Most of the alternative investments require a longer-term horizon to benefit from market dislocations. They offer a premium over public securities at the expense of liquidity, and therefore, enhance investors’ risk-adjusted portfolio returns in the long run.
Too many risks
The Russia/Ukraine conflicts, energy shock, high inflation, the hawkish Fed and potential aggressive tightening, China lockdowns and insufficient easing, supply chains disruptions, as well as rising stagflation and recession risks are the key investor concerns at present. Current volatility levels for different asset classes are much higher than their historic average (chart 1).
A US recession is NOT our base case scenario. Our forecasts for US GDP growth are 3.7% in 2022 and 2.5% in 2023. However, there is no quick fix to the issues mentioned above, and hence, we expect market volatility to stay high in the near term.
Why not holding large cash positions in times of uncertainty?
With deposit rates remain low while inflation is rising, cash is not king but a drag to long-term portfolio performance. Holding cash is an opportunity cost not even be able to beat inflation and keep the purchasing power, and hence, investors get a very negative return after inflation.
Alternatives as satellite allocations
We currently have an overall neutral stance on equities (downgraded from positive since February versus consensus) and fixed income (upgraded from negative recently) amid higher volatility and uncertainty. Therefore, it is important to build satellite allocations to alternative investments in order to diversify and lower overall portfolio volatility.
Some examples of alternative investments:
• Commodities
• Private equity
• Private real estate & REITs
• Hedge funds (long-short equity, global macro, event-driven, relative value strategies)
• Structured products
• Direct private investments
Why alternatives?
(1) Low correlation with traditional asset classes: Alternative investments tend to have lower correlation with traditional equity and fixed income asset classes (chart 2). Therefore, they are good diversification tools in a volatile market.
(2) Benefit from market dislocations: With a large cash pile and the ability to invest, improve and reposition companies, private equity and real estate funds can benefit from market dislocations with better valuations and points of entry.
They can also improve the companies’ operations outside the eye of public markets with a longer-term time horizon. Investing in commercial real estate also offers inflation hedge as rents normally rise with inflation. Furthermore, private equity firms are active in themes including health-care, infrastructure, ESG and technology/metaverse that we favour.
Hedge funds are one of the tools that can be used to target market dislocations and hedge market risks. Post-pandemic recovery is providing numerous event-driven opportunities around corporate restructurings as well as other credit and corporate events. Furthermore, macro hedge fund strategies are benefiting from trends in currencies, rates and commodities. For many years, all central banks had the same monetary policy and were stuck at the zero or negative yields. Now, we have divergent trends with China easing while US and Europe tightening but at a different pace.
Read Investment Navigator April 2022 - Yield Curve: What Is It Telling US?
(3) Enhanced long-term portfolio risk-adjusted returns: Alternative investments help enhance investors’ long-term risk and reward profile of their portfolios (chart 3). The potential premium that investors earn from alternatives over public stocks and bonds is the sacrifice of liquidity as many alternatives require a longer-term investment horizon.
(4) Monetize the volatility: We expect higher volatility to continue given the uncertainties of peak yields and inflation as well as their impact on growth. Investors can take advantage of periods of higher cross-asset volatility in bonds, equities, currencies and commodities to construct structured product solutions, such as principal returned at maturity solutions that limit the downside with upside potential.
CONCLUSION / STRATEGY
- We expect market volatility to stay high in the short term given uncertainties over the Russia/Ukraine conflicts, energy shock, high inflation, the Fed’s tightening path, pro-longed China lockdowns, supply chains disruptions, as well as rising stagflation and recession concerns.
- Instead of holding too much cash which offers negative real returns (after inflation), investors should consider alternatives such as private equity, private real estate, REITs, hedge funds, commodities, direct investments and structured products as satellite allocations in order to diversify and reduce overall portfolio volatility .
- Alternatives in general have lower correlation with traditional asset classes. Most of them require a longer-term investment horizon to benefit from market dislocations and offer a premium over public securities at the expense of liquidity. Therefore, they help enhance investors’ risk-adjusted portfolio returns in the long run.
