Hedge funds have shown their worth this year in reducing risk, adding diversification, and providing access to differentiated return streams. (ddp)

While the Fed is expected to raise rates by 50 basis points at its meeting on 14 December, after four 75bps hikes in a row, investors will be on alert for signs that officials feel more needs to be done to cool the economy after recent strength in jobs data and a robust service sector survey for November. The release of the Consumer Price Index for November also has the potential to spark volatility, especially if the reading tops expectations.

Against this uncertain backdrop, we advise investors to tilt exposure toward defensive parts of the equity and fixed income markets. We think the current market environment is also conducive to building up hedge fund and private market exposure.

Hedge funds have shown their worth this year in reducing risk, adding diversification, and providing access to differentiated return streams. Overall, hedge funds have outperformed, with the HFRI Fund Weighted Composite Index posting a return of –4.1% in the first 11 months of the year, compared to a 16% decline in the MSCI All Country World Index and a 15% loss for the Bloomberg Global Aggregate Total Return Index over the same period. And certain strategies have actually generated positive returns for investors. Macro, for example, has historically been less correlated to movements in the broader stock market, helping to diversify portfolios—these managers can take long or short positions across a range of asset class, regions, and financial instruments to try to generate returns through periods of significant dislocations. As of end of November, the HFRI Macro (Total) Index had returned 8.2% in 2022. We think a continuation of a tight monetary policy and high volatility regime should prove favorable for macro managers in 2023.

Other strategies that we expect to offer sources of relatively attractive, uncorrelated returns in 2023 are equity market neutral and multi-strategy funds. Focusing on managers with a lower net equity exposure relative to the market can help reduce the sensitivity of investor portfolios to broader market movements while continuing to earn returns. Multi-strategy funds, meanwhile, combine different hedge fund strategies and allow investors to build a diversified hedge fund portfolio without investing in multiple individual funds.

With public markets still facing headwinds, private market exposure can smooth returns and help investors focus on long-term value creation. Private market investments play a vital role in portfolio diversification and can provide attractive absolute risk-adjusted returns over the long term. Between 2001 and 2021, global private equity (CAPE Global Private Equity Index) returned 13.8% annually, compared to 7.1% for publicly traded global equities (MSCI ACWI index). While we expect additional valuation markdowns into the year-end as public markets fall further, it is unlikely that private investments will be marked down to the same extent as public markets. Looking at the past three recessions, US PE markdowns on average only reflected 55% of the S&P 500 drawdown, as measured by Cambridge Associates US Buyout.

In the current environment, we see opportunities in secondaries, distressed/restructuring debt, and value-oriented buyout strategies with a focus on healthcare and technology. The trend toward a green economy is also providing new investment strategies in a growing sector.

So, while investors will be focused on this week’s pivotal events, adding hedge fund and private market exposure can both reduce the magnitude of portfolio swings and provide alternative sources of return. For more on how to build an alternatives allocation, click here.

Main contributors - Mark Haefele, Daisy Tseng, Vincent Heaney, Jon Gordon, Christopher Swann

Content is a product of the Chief Investment Office (CIO).

Original report - The upside to alternatives in volatile markets, 12 December 2022.