In the current environment, strategies that worked before may not be effective. Alternative investments could play a valuable role in your portfolio.
Even the most seasoned investors face challenges in the current environment. The U.S. economy is coming off one of the most aggressive monetary-policy tightening campaigns, in which the Federal Reserve raised interest rates by about 5 percentage points in just about a year. Investors face uncertainty around the path of the economy and the likelihood and severity of a recession.
In such an environment, where traditional investing playbooks may be less effective than previously, alternative investments can play an important strategic role in certain 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 six strategies that can guide investors’ thinking on alternative investing in the near to intermediate term.
The coming years are likely to feature higher interest rates and inflation than in prior economic cycles. That could be a headwind to stocks and bonds, and correlation between the two asset classes may stay elevated. This means that bonds, which would typically hedge portfolios against stock-market volatility, may not be as effective in that role.
As an alternative to bonds, investors should consider hedge fund strategies that have historically offered low correlation to traditional asset classes, such as relative value and equity market neutral. Select hedge funds have broadly demonstrated an ability to mitigate portfolio losses when stocks sell off. This was apparent during market turbulence in 2022 and is expected to persist.
In addition, investors can also look to areas that are benefiting from the macroeconomic environment, such as infrastructure and green energy. Policy measures such as the $1 trillion infrastructure package mean there will likely be more opportunities to tap into related opportunities in private markets.
Hedge funds can be used not only as a replacement for bonds, but also for stocks or a mix of stocks and bonds. Certain strategies are considered potential “equity return enhancers.” Equity long/short, for instance, can involve both “long” positions, meaning holding a stock in the expectation it will rise in value, and “short” positions, or selling a borrowed security with the expectation of buying it later at a lower price.
In particular, for what we expect to be a higher-volatility environment ahead, the use of certain options-based strategies, such as those that sell call options against a portfolio of stocks, can help enhance yield and support investors at the portfolio level.1
Of course, when investing in hedge funds, strategy and manager selection are key, given how significantly different fund performance can be.
The private secondary market, which has grown significantly in recent years, allows investors to buy and sell an existing interest or asset from primary investors. For example, a primary private equity fund may purchase a stake in a private company, and then sell that interest to a secondary buyer.
Public-market volatility and a relatively sluggish pace of private-deal exit activity have created a favorable case for secondaries. This setup is providing opportunities to both the investors who commit capital, known as limited partners (LPs), and the private equity funds’ general partners, who pick and manage the investments. LPs may lean on the secondary market to rebalance their exposures to different investments, and GPs may use secondaries to help restructure their funds. On this score, investors should look for managers that have strong underwriting expertise and a range of deal experience.
Private credit, which can include various strategies investing in corporate debt, may also help boost income and total return. In particular, direct lending, a form of financing in which a lender other than a bank makes loans to companies, can help hedge against rising rates given the floating-rate nature of most direct loans.
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, which can lower the book value of the loan over time, and relatively short duration.
As a sector, health care is currently benefiting as biological and technological advances stimulate innovation and disrupt business models. These trends augur well for various alternative strategies. For one, within private equity, investors may consider managers who focus on late-stage companies that can generate compelling risk-adjusted returns. There is also potential opportunity in 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 the recent past, thanks in large part to easy access to financing. But given the Fed’s rapid interest-rate hikes so far, and the potential for rates and inflation to stay elevated, the pressure on the economy could weigh on businesses that are over-leveraged. This environment could see a credit market dislocation and 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 a 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.
These six themes offer an overview of potential opportunities in alternative investing. However, 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?