By Amit Sinha
The role of alternative investments in a portfolio has become more and more critical than ever before. In fact, the market for these products is only getting bigger.
Hedge funds, private credit, private equity and others— once the providence only of the large institutional investors, endowments, and the wealthy, have now been democratized to where the average investor can access these products and join what had once been an elite club.
In part, easier access and increased interest in alternatives has been brought about by dramatic improvements in investment technology, bringing greater transparency, knowledge and access to various investment products with the potential for additional alpha generation (earning returns that are in excess of a traditional market index).
At the same time, the macro environment in 2021 also is different than in the past. Zero interest rates have encouraged investor risk-taking; with government bonds yielding close to nothing, investors are forced to look elsewhere to earn positive real returns. Combined with quantitative easing, fiscal stimulus and pent-up demand as we emerge from the greatest pandemic in a century, macroeconomic risk is shifting for the first time in decades from a risk of deflation to a risk of reflation.
Yet, the needs of long-term investors remain the same. Individuals saving for retirement need a higher investment return to increase their likelihood of supporting a healthy lifestyle in retirement.
For those individuals who are fortunate enough to work for a company that offers a retirement pension, underfunded pension funds still need to earn a premium over their potential liabilities to reduce the risk of a future funding gap.
For example, to meet their liabilities or commitments, the typical public pension fund or endowment still needs to generate annual returns somewhere between 6–8%. Said differently, there is a need to generate more than 300 basis points (bp) of alpha over a “typical” balanced portfolio — 60% equity, 40% fixed income — while being prudent with the risks taken and fees paid to generate those returns. Meeting these needs may appear daunting, but doesn’t have to be.
Refreshing the Approach to Alternatives
The current investment environment, with its complexity and uncertainty, offers investors an opportunity to hit refresh on their investment playbooks. There are four key themes around which a successful alternative investment portfolio can be designed.
Seek Absolute Return in Specialty Areas
The lower cost of corporate borrowing creates a potential opportunity to earn higher absolute returns from investment strategies where the underlying assets can be leveraged while managing principal risk. This makes those products that invest in direct lending, collateralized mortgages and securitized strategies appealing as sources of higher absolute return for investors with longer time horizons.
Short-term risk aversion and market behavior also provide long-term sources of absolute return. A specialized opportunity for such a return can be found in volatility markets, where an investor can earn a premium between higher implied volatility versus realized volatility, provided the manager can manage the downside well. Certain volatility strategies proved resilient in 2020 and may be attractive sources of absolute return.
Diversify and Mitigate Macro Risk
Most return generating assets — public and private equities, credit, real estate or infrastructure — are essentially leveraged bets on a healthy and growing economy. During periods of economic weakness and heightened macro volatility, these assets may stumble in tandem. There is therefore a need for strategies that are either less correlated or negatively correlated to the economic cycle.
Certain hedge fund styles and alternative risk premium approaches are explicitly constructed to generate returns from factors that are distinct from and uncorrelated to traditional markets. An allocation to these approaches potentially can be diversification.
Don’t Pay for Beta
A frustrating experience for some investors has been locking up capital for a decade, only to find that the desired returns might have been obtained by investing in lower-cost, market-indexed investments. This risk gets amplified with increased access and democratization of alternative strategies, making it essential that an investor and their advisor are able to invest in products that offer truly alternative returns at reasonable fees.
Fortunately, investment technology has advanced, making it possible for investors to separate alpha and beta sources of return. For example, “portable alpha” strategies overlay market beta exposure over uncorrelated alpha sources, offering investors the potential to pay for alpha while obtaining beta at a lower cost.
Another promising development is in the area of replicating private equity investment styles in public markets. With return dispersion between top- and bottom-quartile private equity managers measured in thousands of basis points, this innovation places a valuable tool in the hands of investors and advisors. Diversified private equity portfolios now can be created using a combination of high conviction managers and comparatively lower cost replication strategies.
Make Bold Bets but Size Them as Call Options
The future is exciting — in response to environmental, demographic and social change, innovation in areas of data, AI, technology, healthcare, sustainability, governance, inclusion and infrastructure will have a transformational impact. Invest in these themes of the future, but size them as call options — assume you could lose a significant amount of your invested capital, but the payoff potentially could be several times the premium paid.
So…What Does a Refreshed Alternative Portfolio Look Like?
Based on the above approach, we can categorize strategies into absolute return, skill premium, diversification, low cost, and innovation.
Designing a portfolio using these components, we start by defining an investment objective based on an investor’s needs and utility function; for example, maximize return subject to balancing risks across macroeconomic regimes at a reasonable cost.
The need for higher return potential is met through absolute return, equity and credit strategies. The cost of these higher returns is managed by using low-cost beta and replication approaches for growth exposure, complemented by higher-cost specialty managers where investors or their advisors have high conviction.
These higher return strategies tend to perform well in macroeconomic regimes that generally reflect a stable growth environment. Conversely, investors may struggle to meet their return objectives should the macroeconomic environment exhibit greater fragility – perhaps due to falling growth, inflation surprises or higher volatility. For such environments, certain types of real assets, and diversified macro and risk premium strategies, potentially provide ballast to the portfolio.
About the author: Amit Sinha
Amit Sinha is head of Multi Asset Design for Voya Investment Management’s Multi-Asset Strategies and Solutions (MASS) team. With over 20 years of investment experience, Mr. Sinha is a portfolio manager for multi asset alternative strategies and is responsible for researching and developing investment solutions for Investment Management’s existing and prospective clients in response to their investment needs. More information can be found at www.voya.com.
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