In an environment where past-cycle playbooks may prove ineffective, alternative investments may serve a valuable role in your portfolio. Here are five themes to consider.
Even the most seasoned investors face headwinds in the current environment. Stock and bond markets continue a volatile stretch, inflation remains high, and the Federal Reserve has turned hawkish on rates. In addition, geopolitical strains, ongoing COVID-19 outbreaks and persistent supply chain problems are dragging on the global recovery.
When such a “perfect storm” hits, and traditional investing playbooks may no longer be as effective, alternative investments may play an important strategic role in select portfolios.
Broadly speaking, “alternative investments” refers to asset classes that can deliver differentiated sources of return relative to traditional stock-and-bond investments. They can help diversify a portfolio and serve as an inflation hedge, as well as provide potential income.
Here are five strategies that can guide investor thinking on alternative investing in the near to intermediate term.
The “40” here refers to the percentage of fixed-income assets that often makes up a traditional balanced portfolio (the remaining 60% is typically stocks). This split may have worked well back when equities climbed steadily to new records and interest rates fell to near zero, but investors who take this approach face some key challenges today. For one, stocks and bonds may not sufficiently diversify each other, given that they’re both highly sensitive to interest rates and Fed positioning. Rising interest rates and elevated inflation challenge both returns and income.
This means investors may need to seek returns elsewhere—that is, balance portfolios away from bonds toward assets such as real estate. Actively managed public real estate investment trusts and private core strategies, for example, may fit the bill. Other diversifiers include illiquid investments in infrastructure and green energy, as well as lower-risk hedge fund strategies that may provide more attractive risk/return potential, as shown below.
Hedge funds can also work as an alternative to stocks, or in the mix in place of a traditional 60/40 stock/bond portfolio. Of course, strategy and manager selection are key in choosing a fund, given how significantly different fund performance can be. We also emphasize the use of certain options-based strategies, such as those that sell call options against a portfolio of stocks, in a more sideways-moving market. These liquid strategies can help boost yield and buffer market volatility in sideways or downward-moving markets.
Private credit strategies may also boost income and total return. In particular, direct lending, exposed to appropriate credit risk, can help hedge against rising rates given the floating-rate nature of most direct loans. There’s a record amount of funds in reserve within the private equity market to invest in opportunities as they arise, and that should provide fund sponsors ample runway for lending opportunities.
In addition, asset-based lending may provide above-market yields and serve as a complement to other alternative investments. Asset-based strategies lend money using financial or hard assets as collateral. They can provide exposure to a diversified pool of assets, such as real estate debt, consumer credit, intellectual property and equipment leases. Asset-based lending also tends to be resilient in rising-rate environments given the strategy’s amortizing nature and relatively short duration.
As a sector, health care is currently benefiting from a number of constructive secular dynamics, as biological and technological advances stimulate innovation and disrupt business models.
We believe these trends augur well for various alternative strategies. For one, within private equity, investors may consider later-stage managers who can generate compelling risk-adjusted returns. We also see tailwinds for private real estate strategies that focus on niche sub-sectors, such as medical office and life sciences properties.
Companies have maintained a relatively low default rate in recent years thanks in large part to easy access to financing. Looking ahead, a fast-tightening Fed and slowing economic growth may pressure businesses that are over-leveraged. This environment could see a credit market dislocation and/or individual corporate situations that have an element of distress.
We believe “distressed debt” and “special situations” investing strategies—which typically acquire stakes in a struggling company at a discount, with the intention of generating a profit as they turn the company around—may be in position to find value in these pockets of stress. The key for investors will be to find managers that target companies with unsustainable balance sheets but ultimately sound business models.
All in, these five themes guide our current thinking around alternative investing. We reiterate it’s important to recognize that alternative strategies are not all the same, nor are they right for all investors, who need to evaluate return, risk, income and liquidity profiles depending on the fund they are considering.
To learn more about how you may be able to incorporate alternative investments into your portfolio, contact your Morgan Stanley Financial Advisor or Private Wealth Advisor.
- How can alternative investments help me better manage risk and seek higher returns in today’s environment?
- Which alternative strategies are most appropriate for my investment strategy and financial goals?