This quarter’s topic returns to alternative investments which was previously a focus in our 4th Quarter 2021 and 1st Quarter 2022 newsletters. In those writings, we discussed the rise of alternative investments as a diversifier to a traditional stock and bond portfolio, the rationale for why private alternatives often have higher potential returns, the additional due diligence needed to evaluate alternative investment opportunities, and what forces in the industry have made them more accessible to high net worth investors today than in years past.
Recently, several large institutional investors have produced research recommending modifications to traditional portfolio construction that includes a growing allocation to alternatives. We believe these shifts are a result of both developments in terms of accessibility and the market environment we find ourselves in today. In the sections below we will share research that supports this shift in investing as well as explain how we are utilizing alternatives for our client’s portfolios today.
As we are now experiencing high levels of inflation, rising interest rates, and heightened geopolitical uncertainty, we have entered a new interest rate and investment regime. The traditional ‘60/40’ portfolio (60% stocks, 40% bonds) allocation has not provided the benefits it historically has - where bonds act as buffers that zig when stocks zag. This is because a selloff in stock has historically increased the demand for bonds, driving down interest rates which increases the price of bonds. In today’s environment, high inflation is driving interest rates higher and bond prices lower. This repricing of interest rates is driving discount rates higher, and stock valuations lower. The historical benefits of diversification have been diminished.
The chart below is how one large institutional group, Kohlberg, Kravis Roberts (“KKR”) recommends adjusting the traditional 60/40 portfolio:
What KKR, and other prominent institutions, are recommending are reducing allocations to traditional equities and bonds and adding new allocations to real estate, infrastructure, and private credit. In the case of equities in the KKR recommended portfolio, stock market risk is being replaced with alternative investments that have equity-like return potential (in their case real assets such as real estate and infrastructure). Part of the bond allocation is being shifted to private credit where (by our estimate) better risk-adjusted return potential exists. We find the chart below in which KKR analyzes the two hypothetical allocations' over high and low inflationary market environments.
The portfolio with alternatives slightly outperforms the traditional portfolio over All Periods with less volatility and hence better risk-adjusted returns as measured by Sharpe Ratio. What is particularly interesting though is that the portfolio with alternatives market performs in a Low Inflation environment (ie. where we have been for the past 30+ years) but outperforms in a High Inflation environment that we now find ourselves in. The portfolio with alternatives has lower volatility and better risk-adjusted returns in both High and Low Inflation environments. The key takeaway here is that alternatives can add meaningful diversification, increase return potential in a higher inflation environment, and lower overall portfolio volatility.
Below is an excerpt from our 1st Quarter newsletter about why we think now is a good time to shift 10-15% of a portfolio into private alternatives:
Our objective is not to chase returns but build wealth for the long term by getting good risk-adjusted returns through diversification. We believe we are in a challenging investment environment today. US Treasuries offer negative real interest rates, stocks by most historical metrics are expensive, and real estate valuations (via cap rates) are at historic lows. That said, this market environment has forced us to think outside the box as it is challenging to generate attractive long-term returns when bonds are delivering zero to negative returns. We believe we have found some solutions in the alternative lending arenas that offer attractive risk-adjusted returns that greatly exceed those of publicly traded bonds. We believe access to these types of investments and some other higher return options can be good diversifiers to an overall investment portfolio.”
We have focused our initial recommendations to clients on private credit and infrastructure investments. We believe the challenging interest rate and inflationary regime we find ourselves in today limits the upside potential of traditional fixed income. Similar to what KKR has recommended above, we are recommending to all of our accredited investor and qualified purchaser clients that they build up to a 10% allocation to private credit and a 5% allocation to infrastructure. The chart below from KKR depicts how private credit performs vs. bonds in both low and high-inflation environments.
Private credit has outperformed in both low and high inflation environments but has significantly outperformed traditional bonds in a high inflation environment.
Our team has been performing a great deal of due diligence to identify what we believe are attractive private credit and other alternative investment opportunities. We are actively sharing these ideas with clients as these investments require additional agreements to access. If you would like to discuss how we believe these investments may complement your portfolio, please contact your advisor for more information.