Where to find returnsin a world after quantitative easing
“To enhance portfolio performance in the current environment, all investors need alternate sources of return that are less dependent on market direction.”
Andrew Lee takes a closer look at asset classes that have performed well since the global financial crisis, and where returns are likely to come from in a time of economic global recovery.
Head, Alternative Investments
UBS Wealth Management
The five years following the global financial crisis have seen substantial returns for many financial assets, with investor confidence in major economies buoyed by the massive purchases of government bonds and other securities (quantitative easing) by central banks. Global equities have returned more than 20% on an annualized basis, US high yield credit has returned 17%, and even ‘safe haven’ government bonds have returned around 4%. Staying in cash has, on a relative basis, proved to be a losing trade.
Yet today, investors face a problem. The global economy is recovering, but equity valuations suggest that the scope for significant multiple expansion is now more limited. Credit spreads in areas such as US high yield credit are still attractive relative to fundamentals, but are pushing multi-year lows. Meanwhile, the volatility in commodities limits their attractiveness as an alternative play on an economic recovery. The choices for more cautious investors are even worse, since government bond and cash yields are close to, or at, record lows, and are likely to provide low single-digit returns at best.
To enhance portfolio performance in this environment, all investors need alternate sources of return that are less dependent on market direction. In this regard, alternative investments, including hedge fund and private market investments should prove relatively attractive. Both can help dampen potentially higher market volatility and deliver returns that are less tied to market movements.
Improve risk-adjusted returns with hedge funds
Hedge funds, though criticized over the past five years for lagging long-only equity indices, deserve consideration in well-diversified portfolios, as they generate attractive returns when adjusted for risk and underlying asset class exposure. For context, over the next five years we expect equities to return 7–8% on an annualized basis, with volatility of 15–17%. Over the same period, we expect hedge funds to offer marginally lower returns (4–6%) but with significantly lower volatility (5–7%). Their information ratio, a measure of return relative to risk, is therefore significantly higher.
In short, we expect hedge funds to deliver attractive risk-adjusted returns, diversify return drivers, and improve expected portfolio return characteristics. The tradeoff is moderately reduced liquidity, with most hedge funds providing quarterly liquidity at best. Although hedge funds are increasingly being offered via weekly or even daily structures, these vehicles do not have access to the full range of tools or strategies available to unrestricted offshore funds.
From a long-term perspective, we prefer hedge fund exposure that is generally balanced across the different strategy styles (equity hedge, event-driven, relative value, and macro/ trading), in order to reduce dependence on any specific driver and allow the allocation to perform across market cycles. Within this context, we maintain a preference for managers employing equity hedge strategies.
Although the return contribution from market beta is likely to be lower going forward, low correlations and relatively low valuation dispersion present a compelling environment for stock pickers. The relative value and event-driven styles should deliver solid performance overall, so we suggest core weightings in each though neither merits an overweight at this time.
Macro/trading remains our least preferred strategy style, with headwinds for systematic strategies offsetting a potentially attractive opportunity set for discretionary managers. Investors should keep in mind that bottom-up manager selection is a critical part of the hedge fund allocation process, as performance dispersion is wide compared to traditional asset classes and most alpha is generated at the individual manager level.
Capitalize on opportunities in private markets
Investors who are willing to take a longer-term perspective can enhance their portfolios by allocating to certain private market strategies. Private markets offer investors exposure to a range of opportunities that are unavailable via traditional liquid instruments, but obviously require more consideration due to their longer fund lockup periods.
In recent years, ‘private market’ opportunities have expanded beyond private equity to include private credit and real assets strategies. This evolution allows investors to select private market investments with underlying exposure ranging from equity-like to more fixed income-like, to complement their traditional exposures as desired.
As an example, private credit includes shorter tenor strategies generating return profiles similar to fixed income, in some cases even providing current yield. The longer term commitment required by private market investments can allow funds and their investors to capitalize on short-term negative market sentiment, and access return drivers that are less dependent on market movements.
While long-term commitment of capital can be daunting, an actively managed allocation to illiquid strategies can provide significant portfolio benefits: extracting an illiquidity premium from these investments provides another potentially attractive alternative source of return in a world of low yields.
Thoughtful investors assessing the appropriateness of their portfolios in the current environment will see the merits of these alternative investment strategies. Realized returns will ultimately depend on careful portfolio construction, identification of the right strategies and themes, and manager selection.
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