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Among the ideas that are top of mind this quarter:
- Carving out new allocations to capture the growth in companies opting to stay private longer
- Breaking down silos between alternatives and traditional assets (e.g., private and public equity in a thematic allocation)
- Exploring new ways to integrate climate change into strategic asset allocation decisions
As asset owners contemplate allocation decisions for a post-COVID world, two topics are regularly showing up on the radar: alternatives and climate change. After more than a decade of strong equity performance — and with fixed income poised to deliver lower returns and perhaps a more modest diversification benefit — I think the time is ripe to revisit alternative exposures and consider several areas where the winds of change are blowing. Meanwhile, real-world weather patterns and climate events are raising issues that may impact not only security and manager selection but also broader investment policy, including capital market assumptions and strategic asset allocation. I’ll offer a preview of our Investment Strategy team’s work on these topics and suggest next steps for climate-aware portfolio decisions.
Alternative investments: Is their portfolio role evolving?
Looking across the alternatives space, there are a number of trends and best practices that haven’t changed, but also several important new ones that asset owners should be thinking about. Let me start with three things that haven’t changed:
- There is value in distinguishing between diversifying alternatives and return-seeking alternatives. The former are characterized by low beta, low total volatility, and the potential to diversify a broader portfolio. With diversifying alternatives (e.g., macro and market-neutral strategies), it’s important to remember that returns may be more modest in isolation and that “uncorrelated” doesn’t necessarily mean negatively correlated — these strategies could have a slight positive correlation and still offer a diversification benefit. By contrast, return-seeking strategies are more likely to use equity or credit exposure to pursue compelling alpha. The goal is to find strategies that are successful in timing the beta (adjusting equity or credit exposure) or in hedging. My colleague Cara Lafond wrote more about these ideas in her paper, “Mission critical: The vital role of alternative investments in pursuing investment success.”
- Demand for private assets remains high, including among those seeking to earn an illiquidity premium. Of course, earning a premium in illiquid assets requires investing in areas where the demand for capital exceeds supply. (If too many people are clamoring for a limited set of illiquid assets, one can imagine an illiquidity discount.) Currently, there seems to be ample capital prepared to invest in some areas of the private market, including the traditional venture capital and buyout segments. This may mean that investors need to look to niche-ier areas of the market.
- Manager selection is critical in alternatives. Figure 1 (in PDF available below) shows the dispersion of returns across managers in different asset classes. Compared with managers in traditional asset classes on the left, there are enormous differences between the top- and bottom-quartile alternatives managers on the right. As I discussed in last quarter’s Top of Mind, even top-quartile (and top-decile!) managers will underperform at times on their way to generating great results. For that reason, I think asset owners allocating to alternatives should focus more on…
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