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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Cara Lafond, CFA, Multi-Asset Strategist
Adam Berger, CFA, Multi-Asset Strategist
Geopolitics, inflation, and Fed policy have agitated financial markets in 2022, leaving returns and diversification in short supply. Figure 1 shows just how challenging the results have been. Over the last several decades, global equities and bonds have provided some level of diversification. When equities have done poorly, bonds have often helped to compensate — and vice versa. But thus far, 2022 has been a rare exception, with both equities and bonds suffering drawdowns.
Looking back prior to the period in the chart, the only calendar year we found with simultaneous and similarly steep declines in equities and bonds was 1974 (a year marked, perhaps not coincidentally, by an energy shock). While we don’t know whether 2022 will end on a similar note, it seems clear that recent developments, from the end of central banks’ “easy money” policies to the beginning of a multiyear deglobalization trend, are likely to contribute to greater economic uncertainty and market volatility. In this new world, we believe alternative investments could play a vital role in improving portfolio resilience and returns. With that in mind, we want to focus on three topics we think alternatives allocators should consider: rising market dispersion, the equity-leadership transition from growth to value, and the need to break down “silos” in alternatives portfolios.
Higher market volatility often goes hand in hand with greater levels of market dispersion. To bring this to life, we examined performance dispersion for US stocks within the 25th to the 75th percentiles (excluding those outside of this band) from January 1996 to February 2022. The shaded area in Figure 2 shows the increase in dispersion beginning in 2021 (i.e., some stocks doing quite well and some quite poorly), which may provide a supportive environment for alpha generation for investors with the ability to go both long and short certain securities. In addition, equity market valuations have declined recently (blue line), potentially adding to the opportunity for active management to add value. While this analysis is focused on US equity markets, we would note that there has been a similar pickup in dispersion in other markets, including global equity, currency, and credit markets.
What types of strategies could potentially benefit from this environment? Long/short directional strategies may help enhance performance in a volatile market and their ability to modulate beta exposure may contribute to overall portfolio resilience. Figure 3 looks at the returns of long/short equity strategies across the phases of the economic cycle. While they trailed long-only equities during the expansion phase, they outpaced them during the later stages of the cycle, when volatility tends to return to the market. This may be particularly relevant in the current cycle, which has moved rapidly as a result of the enormous amount of stimulus pumped into the system and may now be transitioning toward the later stages of the cycle as the central bank spigots are turned off.
Macro strategies may also warrant a closer look in a period of greater dispersion, when the fundamentals of each asset may matter more. Macro strategies may offer diversifying characteristics and have the potential to benefit from higher levels of economic uncertainty and market volatility.
After a long stretch of outperformance by growth stocks, value stocks have shown signs of life over the past year — and deep value in particular. Despite the recent rally, the value factor has continued to trade at a steep discount to the market, especially outside the US. In addition to attractive relative valuations, higher interest rates and inflation may bode well for a continued rebound in value, which has tended to do well in periods of rising prices as shown in Figure 4. We would also note that there has historically been strong cyclicality in the performance of growth and value stocks.
Regardless of the specific timing and duration of a shift to value, we think the takeaway for allocators is that this may be a time to be thoughtful about factor exposures. Are there value-oriented strategies that might enhance an alternatives portfolio? Do certain managers in the portfolio have exposure to regions of the world that may be attractive from a value perspective (perhaps Europe or emerging markets, for example) or even just a value tilt in their philosophy and process that could be advantageous?
Finally, we think a number of trends may provide motivation for allocators to pull down artificial walls in their portfolios, including within their alternatives allocations. For example, across the global economy we are witnessing what we have described as an innovation super-cycle, which was accelerated by the pandemic. It has affected private companies as much as public companies, as evidenced by the shifting sector composition of the private equity market (Figure 5). We think this speaks to the need for allocators and managers to look across the entire equity “ecosystem” to understand sector dynamics and identify potential winners and losers, as public and private companies will increasingly compete with one another (a topic discussed in the recent paper, When public and private equity converge: An allocator’s guide). Taking this one step further, hybrid or crossover managers may be well positioned to identify arbitrage opportunities within the equity ecosystem.
Another area where allocators might do well to pull down walls is between traditional fixed income assets and complementary, diversifying alternative strategies that might help with the pursuit of objectives typically associated with traditional fixed income. Given fairly muted return expectations for some areas of the fixed income market, for example, asset owners seeking higher returns and willing to take on some additional risk might want to consider potential fixed income complements such as private credit and absolute return strategies (e.g., relative value).
Matt Witheiler, Private Equity Principal and Sector Specialist
The times they are a-changin’. The late-stage private equity market is digesting a public growth multiple collapse that took us from boom to bust in four months. But while valuations may be coming down in the private market as a result, the opportunity-creating trends of technology disrupting all parts of the economy and companies staying private longer remain in place.
The recent inflated valuation environment has finally corrected in a number of areas. For example, consider the software-as-a-service (SaaS) sector of the public market which is now back to the multiples of 2019 (Figure 1).
But how is this public market correction impacting the late-stage private world? We’ve seen prices in some of the most richly valued areas fall significantly, leaving valuations of some prominent private SaaS companies, for instance, looking quite different than they did just a few months ago.
The public market correction is also causing a slowdown in late-stage deal activity. Don’t get us wrong, activity levels remain near all-time highs, but things are tapering off. Looking at first-quarter industry data, venture capital activity as a whole dropped 19% quarter-over-quarter. The number of US$100M+ financings has also fallen each month since reaching a fever pitch in November of last year (Figure 2).
It’s worth noting there is a lag effect in data like this: Companies often wait a month or longer from signing a term sheet to ultimately taking capital in and announcing the raise. So, it is likely that much of the late-stage deal activity announced in the first quarter was actually struck at the end of last year. Our readthrough: The Q2 number could be even more depressed than the Q1 number. In our view, there will undoubtedly still be robust deal activity, just not at the frenzied level of 2021.
Amid today’s changing valuations and cooling deal activity, the new environment is also beginning to shift the behavior of investors. Many may be regretting getting caught up in the high-valuation craze of recent years and may now be pulling back from the market.
But overall, we may actually be heading into a more normalized environment where private prices come down, allowing disciplined investors to identify companies at more favorable valuations with potentially less competition.
Ehab Hosny, CFA, FRM, CAIA, Research Manager
Brendan Fludder, CFA, Research Manager
Noah Comen, CFA, Investment Strategy Analyst
Many allocators are asking questions about whether fixed income can continue to reliably perform certain roles in multi-asset portfolios, including those commonly played by interest-rate and credit-spread allocations. In some cases, they are turning to hedge funds as a partial substitute for traditional fixed income allocations.
A common solution has been to build a multi-manager hedge fund portfolio with bond-like volatility and minimal correlation to equities. But we see pitfalls in this approach. For example, volatility and correlation levels are often conditional on the market regime, and therefore unstable and unreliable when targeting a specific outcome. In addition, allocators constructing such a portfolio often focus on how to weight various categories of hedge fund strategies (e.g., Macro and Relative Value) in order to navigate certain market environments. But we have found that the behavioral profiles of hedge fund categories have been more similar than not in recent years, suggesting that a portfolio structured in this way may be less diversified than it appears.
We propose an alternative approach for analyzing hedge funds and constructing multi-manager hedge fund portfolios intended to stand in for fixed income. As factor-based manager researchers and allocators, we believe a style-factor lens can help allocators understand the biases of their managers and define the desired roles of their investments. In our research, we have used that lens to help capture the roles of a fixed income allocation and build portfolios of hedge funds that are more connected to those roles and the desired outcome. Among our key conclusions:
Read more about our research in our new paper, “Can hedge funds behave if fixed income doesn’t? A manager-selection view.”