This article was provided to us by Wylie Tollette, Chief Investment Officer, Franklin Templeton Investment Solutions and Gene Podkaminer, Head of Research, Franklin Templeton Investment Solutions
After a prolonged period of low inflation and solid growth, investors now face a more stormy economic scenario marked by rising rates and potential stagflation. The heartbreaking declines in equity and bond markets this year clearly illustrate the limitations of the traditional 60/40 stock/bond portfolio and the potential value of diversification with a dedicated allocation to alternatives.
But how big should this allowance be? And what to keep in it? The alternatives include a large number of potential investments, basically anything that isn’t a stock or bond. Alternatives tend to share some general risks (i.e. liquidity, complexity and some use of leverage) – but can potentially achieve many different goals in a portfolio, depending on the attributes specific (i.e. improve return, reduce risk, improve diversification, improve income).
This is why we believe that alternative allocations should match the needs of investors, the prospective macroeconomic environment and the specific strengths and weaknesses that each type of alternative (i.e. private equity, credit private, real assets and hedged/alternative strategies) can add to an existing portfolio. As with everything, you want the right tool for the job.
Alternative investments: different functions, different risks
In our experience, the different types of alternatives are best suited to do one “job” in one portfolio, and can sometimes do a second “job” reasonably well, but almost never tick all the boxes.
Consider real estate. Private real estate directly ties a portfolio to what is happening in the real economy and helps hedge against inflation, as rental contracts often include inflation clauses. This can be useful for diversifying stock and bond exposures as a primary ‘work’ and can provide some income as a secondary ‘work’. Therefore, they are often the first type of alternative individuals consider when looking beyond stocks and fixed income securities. However, over the long term, equities are likely to generate greater capital growth than basic real estate, so high growth is generally not the primary “job” of private real estate.
The hedged/alternative category, which encompasses a wide range of alpha-focused approaches, can be particularly useful in seeking diversification and risk management. While some of these strategies may be outdated, the vast majority seek to limit risk and achieve specific return objectives by hedging positions in equities, fixed income, currencies and/or commodities. Therefore, they are generally not where you go for the type of high return expected from private equity, which of course comes with the risk of high octane stocks.
Fund an alternative allocation
Funding an alternative allocation from existing positions in a stock/bond portfolio means making careful trade-offs. For private equity investments, which involve capital factors, it may make sense to draw assets from existing equity allocation. Similarly, existing credit assets are a natural place to fund private credit.
Real estate has both growth, interest rate and inflation characteristics, so its funding typically comes from both equities and fixed income securities, not one or more. the other.
Of course, there are nuances in each type. Private equity includes venture capital, growth and buyouts. Private credit includes senior direct loans and mezzanine capital. And real assets represent more than basic real estate, for example, forest land, agricultural land, infrastructure and raw materials.
The relative illiquidity of private credit and private equity can easily lead to the misperception that these assets require ongoing financial support from other parts of a diversified portfolio over time.
It is true that thanks to capital calls, private portfolios generally require additional liquidity during a “construction phase”, but in most market environments, mature portfolios tend to return more liquidity than they need. ask for it. Experienced managers of these strategies typically use pace models to estimate what can realistically be deployed and accessed each year, subject to a defined margin of error.
Alternatives have generated attractive risk-adjusted returns over the past 20 years, as shown in the chart below. However, index-level data has limitations that inhibit its value in guiding allocation decisions.
Exhibit: Historical Performance vs. Risk
It’s critical to recognize that many alternative indices are comprised of actual managers, not market-cap-weighted stocks. The dispersion of returns between these managers tends to be much wider than that of stocks or bonds. The reality is that manager selection is extremely important in alternatives, far more so than in traditional asset classes, and the performance of the index can be far removed from the performance of any specific manager.
Additionally, the data used to construct the private equity and private credit indices have issues that make them less representative and limit their usefulness. These indexes are usually made up of groups of peer managers with data quality issues; common biases that result from these indices include selection bias, survival bias, and evaluation bias.
It is generally best to compare alternative managers to a traditional combination of public assets that represents the opportunity cost of investing in private markets (for example, the return an investment might otherwise have had at a similar risk), such as equivalents on public markets (SMEs) and benchmark portfolios.
The reality of expanded choice
Many advisors and their clients continue to assume that private markets require large tickets with complex agreements and fees.
The reality, however, is that a continued “democratization” of private assets is now underway, thanks to non-traditional market vehicles that offer greater liquidity (via quarterly redemptions) and also open up the segment to generally accredited investors. – Individuals typically with a net worth between US$1 million and US$5 million who do not qualify as qualified buyers for private funds. Examples include publicly offered closed-end funds that are not traded on exchanges, REITs, and business development corporations (BDCs).
We expect this asset class to continue to grow as these options proliferate and more investors recognize the value that alternatives can bring to a portfolio.
Exhibition: The rise of “non-traded” vehicles
This article was written by Franklin Templeton Investment Solutions.
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