29 Jul 2022
Alistair Sayer, Client Portfolio Manager
Alistair Sayer, Client Portfolio Manager, considers why investors’ need for real diversification in their portfolios could be a long-term driver of demand for liquid alternatives as they seek to manage inflation and rising rates.
For over a decade, equities have been in vogue. The relentless rise of stock markets since the global financial crisis has ensured that ‘buying the dip’ has been a successful investment strategy which, by a process of Darwinian selection, has fuelled the rise of many a senior investor. But what has underpinned this one-way bet?
As equity dividend yields dwarfed diminishing fixed income coupons, suppressed by lower and lower interest rates, the multiples applied to equities skyrocketed. It seemed irrelevant that many companies’ supercharged valuations were not underpinned by dividends at all; but were simply growth companies in a new paradigm – a shift in consumer demand for cleaner, more ethical and technologically pioneering investments.
However, with the advent of rampant and persistent inflation, TINA has ‘Turned’. Global equities were down more than 21% in the first half of 2022[1], and equities can arguably no longer be ‘simply the best’ investment choice for investors. Concurrently, and at odds with the predominant trend this century, fixed income assets have also cratered in 2022 on the fears of rising interest rates. Hitherto in this century, bonds and equities have delivered positive but uncorrelated returns. This low correlation has enabled a diversified portfolio, commonly referred to as 60:40 (60% equities, 40% fixed income) to deliver a stable growth profile to investors. But that paradigm seems to have come to an end. The Q2 2022 collapse in 60:40 returns surpassed even that experienced during the worst quarter of the Global Financial Crisis.
All this carnage to investors’ portfolios seems be happening like a slow-motion car crash. Volatility, as measured by the VIX ‘fear’ index is rising, but at a gradual pace relative to the sell-off in asset markets. One argument for this is that the market got overheated by post-COVID government stimulus. Furloughed employees looking for entertainment, unemployment cheques being spent on the advice of Reddit forums, disruptive technologies driving change, etc. Whatever your choice of market elixir, it might be argued a correction was to be expected and what we are seeing is just the froth that is being blown off the top of the market. After all, based on the last decade of returns, investors are still in the money.
Exhibit 1: A Change is Gonna Come
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Source: Bloomberg, Janus Henderson, 31 December 2019 to 28 October 2021. Past performance does not predict future returns.
The fall in markets has been implausibly smooth thus far, but if the VIX is to be believed, further volatility is expected (Exhibit 1). Given that statement, the asset allocation community faces some dilemmas. Has the correction thus far sufficiently priced in the expected risks? Now that equities have lost a fifth of their value since the start of the year, are they more or less attractive? Is credit pricing in a sufficient level of defaults, making this an attractive point to add to positions? Or should investors seek diversification from these asset classes in anticipation of further negative returns to come? In short, should you buy, should you sell, or should you hide?
The quest for real diversification has begun and has been a driving force behind investors’ growing interest in alternatives in recent times. Investors who previously relied heavily on traditional equity/bond models (like 60:40) have found themselves increasingly looking towards private markets and real assets, which are often quite illiquid, as they seek to manage inflation and rising rates’ consequent impact on traditional asset markets.
There are two problems we see with illiquid alternatives at present, such as private equity, real estate, venture capital, etc:
This is where liquid alternatives can prove to be attractive. Different types of liquid alternatives produce structurally different alphas, offering different kinds of diversification, with independent sources of risk, and if structured correctly, can exhibit little correlation to stocks and bonds, with liquidity as needed.
As we move further into the second half of 2022, we believe economic and market conditions are likely to get worse before they get better. With a strong inflationary backdrop for economies and markets, we see this as an attractive opportunity for trend-following strategies. Inflation is effectively autocorrelation in prices – something that trend-following strategies are specifically designed to capture.
Alternatives are a constantly evolving part of the investment industry, and new ideas or opportunities are implicit in the growth of the alternatives universe. It can be well worth the effort to consider the potential role that alternatives can play in a balanced portfolio in such uncertain times.
Typically, alternative allocations are regarded as satellite investments within a portfolio predominantly exposed to traditional equity and fixed income volatility. However, by leaving alternatives as a solely peripheral investment, the strong diversification that alternatives can offer can realistically only help to mitigate the risks presented by a core allocation to equities and bonds. It is likely a more significant allocation would be required to achieve stronger diversification benefits.
[1] FTSE World Index, 31 December 2021 to 30 June 2022, in US dollar terms.
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