Typically, alternative investments should be considered longer term and less liquid in nature than traditional investments. (UBS)

While today’s specific challenges will likely be resolved eventually, the events of 2022 show why investors need to think beyond traditional assets in order to help diversify, generate alpha, and grow portfolios over time.

In our view, the shift from quantitative easing to quantitative tightening has opened valuation gaps across almost all asset classes, improving the return outlook. But pricing risk is likely to matter more moving forward, strengthening the focus on fundamentals and rewarding selectivity. Opportunities to generate alpha for active strategies appear plentiful.

More structurally, 2022 revealed the need for fundamental changes in the world economy. Global supply chains are fragile. Energy dependence on fossil fuels is a threat. And achieving self-sufficiency in areas such as food, energy, manufacturing, technology and national security is at the forefront of every country’s strategic agenda. However, these measures require significant investment that governments can’t afford given their level of indebtedness and public companies can’t bear on their own. Yet for those with capital at hand, and time on their side, we see strong potential to generate good returns.

In today’s world, we think a balanced approach that derives returns from both beta and alpha strategies and makes use of the full set of available instruments will achieve superior outcomes. Portfolios including alternatives are well positioned in this regard.

How to build an alternatives allocation

1. How much should I allocate to alternatives?
Precisely how much to allocate to alternatives depends heavily on an individual investor’s investment horizon, cash flow needs and tolerance for illiquidity. Typically, alternative investments should be considered longer term and less liquid in nature than traditional investments, and some can require upfront and ongoing funding before providing returns to investors later (a “J-curve”).

But as a general rule, we think an allocation of up to 20% to less liquid asset classes should enable most investors to avoid liquidity issues, even during market turbulence. And an allocation of up to 40% could be acceptable from a liquidity perspective if portfolio cash flow needs are relatively low. This could be the case if, for example, personal spending needs are small, investors have other sources of income, borrowing facilities are available, or if alternative investments have been fully funded upfront.

2. Which assets can I buy?
To benefit from the broadest diversification and potential for higher returns, we consider hedge funds, private equity, private debt and real estate as good potential additions to a portfolio.

Hedge funds can help reduce risk, add diversification, and provide access to differentiated return streams, especially given the recent positive equity-bond correlation. Higher volatility and higher rates are also creating mispricings and a good environment for alpha generation. For example, we evaluated how different hedge fund strategies may be useful in a portfolio context, with strategies viewed as either “diversifiers” or “substitutes” for traditional asset classes.

In private equity a return pickup over equities is expected, but the risk of the investments and reliance on manager alpha is also greater. While investors withdrew billions of dollars from publicly-listed stocks and mutual funds in 2022, assets under management in private markets continued to grow. History has shown that putting fresh capital to work in private markets following declines in public markets may be a rewarding strategy.

Private debt, or direct lending, can potentially provide enhanced income opportunities—in excess of public market returns—for investors who can accept the additional risk and longer time horizon of the asset class.

Private real estate is an asset class with a risk-return profile between equities and bonds. Rental income streams are less stable than bond coupons but generally more stable than company dividends and do adjust over time due to changes in the growth and inflation environment. Also, compared to equities, real estate is typically less growth-sensitive, but provides a comparable hedge against inflation. Thus, absent a large recession, real estate’s ability to provide inflation-adjusted rental income looks attractive.

3. How best to combine them?
As well as looking at the intrinsic characteristics of each asset, when constructing a portfolio, we believe it is also important to look at the role each asset is expected to play. As such, when allocating to alternatives, we think it can be helpful to think about three “building blocks” that can complement public bonds and equities:

  • Active strategies aim to improve overall diversification, notably through generating uncorrelated returns and active management. Hedge funds are part of this group given their ability to dampen risk and to generate returns that are less sensitive to broad market movements.

  • Income-focused strategies seek to improve the overall income potential of a portfolio. Within private markets, core/core+ real estate, core brownfield infrastructure, and high quality direct lending can be key sources of yield.

  • Capital appreciation-focused strategies include asset classes that have a material return pick up relative to traditional markets. Private equity, for instance, would be such an asset class given over the long run, it has historically averaged 2–3 percentage points more returns a year than public equities.

We believe the highest expected risk-adjusted return and diversification is achieved by including all three building blocks, as a complement to listed bonds and equities. But investors can vary the weights they allocate to the different types of alternative strategies dependent on investors’ specific goals, objectives, and preferences.

For example, investors seeking more income and a “bond-like’ risk profile could opt for relatively more exposure to the income-focused strategies like private debt and real estate. Those seeking to reduce overall portfolio volatility could choose a high allocation to active strategies. Or, investors with an inter-generational time horizon might consider more capital appreciation-focused strategies like private equity.

Read the full report Why alternative investments matter in today’s environment November 2022 for more on why to invest in alternatives now.

Main contributors: Karim Cherif and Nicole Krieger

This content is a product of the UBS Chief Investment Office.