In the world of finance, the phrase “higher for longer” has been making waves. The U.S. Federal Reserve’s message to investors following the September Federal Open Market Committee meeting has left its mark on financial markets. While the merits of this hawkish policy stance have been hotly debated by financial experts, central bankers believe that interest rates may need to remain elevated to combat the looming threat of surging inflation. As a result, investor sentiment has soured, leading to price weakness across both bond and equity markets. What’s particularly surprising is the rapid surge in bond yields, with the U.S. 10-year treasury yield rising by 1% to 5% in just over two months, a level last seen over 15 years ago.
For decades, investors have grown accustomed to managing portfolios against a backdrop of falling interest rates and negligible inflation. However, as investors grapple with the possibility of interest rates staying higher for an extended period, there’s mounting evidence that the financial landscape has indeed shifted. An aging workforce has created a tight labor market, giving rise to inflationary pressures, while geopolitical tensions are reshaping supply chains, impacting the costs of goods and services.
The Case for Alternative Investments
Considering a future scenario with more volatile inflationary pressures reminds us of a recent research paper published by AQR Capital Management titled “A Changing Stock-Bond Correlation: Drives and Implications.” The paper’s authors conclude that there’s a higher correlation between stocks and bonds during periods of rising inflationary pressures. They suggest that investors can generate diversification benefits by increasing portfolio allocations to alternative investments. This represents a disruptive force for investors who have, for decades, reaped the benefits of attractive returns and diversification from traditional stock and bond portfolios.
Accessing Alternative Investments
While there has been a growing appetite among high-net-worth individuals for alternative strategies such as hedge funds, private real estate, infrastructure, and farmland, this space has traditionally been dominated by institutions and has been exclusively available to sophisticated investors. We believe that alternative strategies can be effective in delivering diversification benefits and attractive returns, but they are not suitable for all investors. When working with clients, we evaluate the merits of allocating to alternative strategies in the investment policy statement, taking into account factors such as an investor’s time horizon, risk tolerance, and liquidity needs.
Unique Characteristics of Alternative Investments
Investors considering alternative strategies should be aware of four common characteristics that set them apart from traditional assets like stocks and bonds.
1. Inferior Liquidity
The vast majority of alternative investments have inferior liquidity compared to stocks and bonds. Depending on the strategy, investors can expect limited access to their invested capital, ranging from months for liquid alternatives like hedge funds to potentially several years for private equity investments. Thus, individuals need to have a similar investment time horizon and the capacity to achieve their investment goals without compromising their liquidity needs.
2. Less Transparency
Alternative strategies often offer less transparency to investors than traditional assets. For instance, when investing in stocks, investors benefit from excellent price discovery with daily pricing. Companies also disclose quarterly results to investors with financial statements and detailed management commentary that is widely disseminated. In contrast, alternatives lack the same level of transparency due to less regulatory oversight on privately held assets.
3. Financial Leverage
Another common feature of alternative strategies is the use of financial leverage to boost returns. Hedge funds, for instance, may borrow from prime brokers, while sponsors may borrow to fund private equity or real estate investments. Properly utilized financial leverage and robust risk management practices can generate attractive returns for investors. However, excessive leverage and lax risk management can also work against strategies and disappoint investors.
4. Higher Costs
Lastly, alternative investments typically come with higher associated costs. This stems from higher management fees and additional tax compliance. Managers of alternative strategies often receive a management fee as a percentage of assets under management, along with a performance fee if returns surpass a certain threshold. Tax compliance costs can also arise, such as for a private real estate investment that holds assets in different jurisdictions, requiring tax filings in various countries or states/provinces.
As markets continue to adjust to an environment that may see interest rates settle well above the levels of the past decade, we see value in broadening portfolio allocations to include alternative strategies. This diversification can provide new sources of returns. However, it is imperative for investors to fully appreciate the unique investment risks associated with each strategy.
Want to Learn More?
If you are interested in exploring alternative investment strategies or if you have specific questions on how they could fit within your investment portfolio, please don’t hesitate to reach out to us. Our team of experts is here to provide you with guidance and insights tailored to your unique financial goals and circumstances.
