Concerns that last year’s wild swings in stocks and bonds will continue are boosting the appeal of investments uncorrelated with those two asset classes. Equities and bonds have already fallen in tandem at times this year, further derailing traditional diversification strategies such as the 60/40 model. That, in turn, has prompted a surge in demand for investments that aim to deliver returns that are not correlated with broader markets.
Volatility fears prompt drive into uncorrelated assets
Fearful investors search for havens
In 2022, the VIX index of volatility, fondly referred to by journalists as the ‘Fear Index’, surged to levels not seen since the global financial crisis (excluding the pandemic-related spike) – and there have been further jumps this year. That reflects unprecedented levels of uncertainty surrounding the outlook for economic growth, inflation and interest rates, as well as geopolitics. Meanwhile, traditional methods of protecting investors against uncertainty have failed as established correlations between assets have broken down.
Figure 1: Volatility in financial markets surged in 2022
The end of 60/40?
The popular 60/40 model, for example, in which portfolios contain 60% equities for growth and 40% bonds to protect investors against equity bear markets, is often touted as the ideal diversified portfolio. That’s because equity and bond prices generally move inversely throughout the economic and financial market cycle.
In an article published in early 2023, Wendy Lin, Senior Market Strategist at Goldman Sachs, cites the period following the global financial crisis. She writes that ‘a simple mix of 60% US large cap stocks and 40% investment grade bonds would have satisfied most investors as equities marched to new highs and interest rates descended to new lows’.
However, the tables turned in 2022, says Lin, ‘with a 60/40 portfolio experiencing one of its worst years on record as both sides of the portfolio came under pressure’. In other words, bond and equity prices fell in tandem.
Lin concludes that investors ‘have many reasons to be concerned that the 60/40 might be dead’. Consequently, Goldman Sachs believes that investors should ‘recalibrate their return expectations, increase the component of performance coming from income, and diversify into less familiar return-enhancing asset classes’1.
There is plenty of evidence that investors are doing just that. Nuveen’s EQuilibrium Global Institutional Investor Survey, published in March, found that ‘across the board, global investors are reassessing their views on risk and return, and preparing for a new market regime’. Indeed, 56% of respondents said the current environment was unlike anything they’d seen before.
Institutional investors are reacting to this new environment in various ways, including allocating to assets uncorrelated with equities and bonds. Interest in alternative assets – such as real estate, infrastructure and private markets – has surged, according to Nuveen. It says that in 2020 and 2021, between 25% and 35% of investors said they planned to increase allocations to the major categories of alternative asset classes. By 2022, that number had grown to the 43%-to-58% range.
Infrastructure was the most popular alternative asset, chosen by 58% of investors. Investors told Nuveen that they were using infrastructure for a host of solutions. Private infrastructure, for example, was the asset most often selected for inflation-risk mitigation. Meanwhile, infrastructure debt was selected for allocations to alternative credit2.
Alternative assets do have disadvantages, including a lack of liquidity. Yet as Elif Aktuğ, Managing Partner at Pictet, points out, ‘a simple shift in perceptions can cast this in a different light’. Aktuğ explains that by locking investors in for an entire cycle or longer, and removing the temptation to sell at the bottom of the market, illiquid assets can ‘protect investors against their own (sometimes unconscious) biases’3.
Meanwhile, investors also earn an illiquidity premium. Aktuğ adds that increasing allocation to alternatives can bring higher returns and lower volatility to a portfolio, but that a long-term view is vital.
Retail opportunity for hedge funds
After years of low interest rates and now the recent volatility of traditional stocks and bonds, many households are turning to alternatives, including hedge funds, as a source of diversified returns. McKinsey has predicted that the retail share of private markets alone could more than double to 5% by 2025 – adding between $500 billion and $1.3 trillion in new capital4. By contrast, many institutional investors already have around 30–50% of their portfolios in alternatives5.
The retail investor market has not traditionally been a focus for hedge funds and other alternative investment managers. However, many are now launching funds aimed directly at retail investors, including liquid alternative structures and hybrid funds, which combine exposure to illiquid investments with the liquidity terms and trading strategies of open-ended funds6.
Positive long-term growth outlook
Demand for uncorrelated assets is likely to continue to grow strongly in the years ahead. Many forecasters are predicting that inflation will remain at relatively high levels for some years – and that means monetary policy will remain tight. Pressure on corporate balance sheets, consumers and governments as a result of high borrowing costs could crimp the earnings outlook and economic growth, weighing on equities and some sectors of the bond market. The potential for further political instability –from Eastern Europe to Taiwan – also appears high. Given that institutional investors, at least, have successfully diversified into alternative assets, and demand for retail clients looks set to grow, the continued expansion of the industry appears assured.
1 https://www.gsam.com/content/gsam/us/en/institutions/market-insights/gsam-connect/2022/is-the-60-40-dead.html
2 https://www.nuveen.com/global/insights/news/2023/equilibrium-global-institutional-investor-survey
3 https://www.ft.com/content/07324c3d-d7a5-4ef4-a724-33ce4625f67f
4 https://www.mckinsey.com/industries/financial-services/our-insights/us-wealth-management-a-growth-agenda-for-the-coming-decade
5 https://www.ft.com/content/564acfa4-2fa2-4f75-be11-b875d5a843d2
6 https://www.funds-europe.com/industry-comment/hedge-funds-explore-the-next-big-distribution-opportunity
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