Alternative Investments Can Buoy a Traditional Portfolio

Luke Sauter |
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Alternative investments, particularly private equity and private credit, are increasingly proving their worth in the portfolios of high-net-worth and ultra-high-net-worth clients, according to speakers at the Investments & Wealth Institute’s “Focus on Alternatives” conference this week in New York.

Many of those clients now consider access to private markets “table stakes” in their advisory relationship, the speakers said, even if the vast majority of advisors are still stuck at 0% deployed in alts, despite their aspirations for more.

“The current asset allocation to alternatives is about 9%, with that mid-teens area that I think a lot of us aspire to being 13% to 15%,” said Danielle Singer, head of alternatives strategy at Invesco. “If you look at the broadest cross-section of advisors, though, that current allocation is actually closer to 0% to 5%.”

While that’s a significant range, she said, there remains a hunger for more, as the value creation of alternatives crosses many different asset classes and types of outcomes.

One way to make adoption easier, said Scott Welch, chief investment officer at Certuity, is to look at how the asset class might improve upon what’s been considered a gold standard of portfolio construction: the 60/40 allocation, where 60% of the portfolio is invested in equities and 40% in fixed income. (Certuity is a multifamily office based in North Palm Beach, Fla., with $3.9 billion in assets under management.)

Welch said he draws a distinction between alternatives investing and private investing, whether it’s equity or credit, because the universe of alternatives can include many other investments than just private equity or private credit.

“We tend to deal with high-net-worth and ultra-high-net-worth families, and one of the reasons we win business is because we provide our families with access to alternatives, specifically in the private markets, and people like that. It's a value prop for them,” he said.

In regards to the 60/40 portfolio, Welch said there are three primary reasons people own bonds, including a need to generate income, to hedge their equity risk and to improve their total return. But this reasoning can be rational only if stocks are riskier than bonds, if the correlation between stocks and bonds is negative or low, and if bond yields are higher than dividend yields.

“That portfolio really came under fire two or three years ago, and for reasons that make sense,” he said, referring to 2022, when one of the big draws of the 60/40—an inverse relationship to stock performance—failed to buoy portfolios against an 18% drop in the S&P 500.

“If you go out through time, you actually have less volatility in your performance in stocks than you do in bonds, with a higher return,” he said. “So are stocks really riskier than bonds? I’d say no, they’re not.”

Based on what happened in 2022, Welch said bonds can’t be relied on to hedge against poor equity performance. And dividend yields, when the underlying security is chosen correctly, can be higher than bond yields, he said.

“You can generate a higher level of income out of your stock portfolio if you focus in on dividend and tilted securities than you could on bonds,” he said.

In addition, dividend-focused securities tend to have lower volatility than non-dividend-paying securities because investors get more of their return faster in the form of dividends, he said.

“So a portfolio that has a higher allocation to dividend-oriented stocks can create a portfolio that pays you comparable-to-better yield with less risk than the traditional 60/40,” he said.

Running his approach through Monte Carlo simulation suggested that the optimal balance in a portfolio is 75% equities and 25% fixed income, even for investors who have a moderate risk profile, he said.

“It has a higher expected return, of course, because it has a higher allocation to stocks, but because of the factor tilts it only has slightly higher short-term volatility,” he said. “It has a better longevity profile, and if you focus on dividends within that portfolio, you can generate comparable to better yields. So even though you only have a 25% allocation to bonds, you make up for that with the dividend tilt in the equity portfolio.”

In terms of what should go into that 75%/25% mix, Welch said he believes the core portfolio should be focused on long-only equity and fixed income that is both cost- and tax-efficient, such as ETFs, index funds, tax enhanced funds, direct indexing, and factor-weighted ETFs, to name a few. “Use the most tax- and cost-efficient means possible, and then surround that with your alpha seekers.”

Those alpha-seekers are alternative investments, including private equity, private credit and other non-traditional investments.

“Even if I'm going to stick with the traditional 60/40, I want to put a 20% allocation into alternatives and into non-traditional stuff,” he said. “You can take a pro-rata out of your stocks and bonds, because some of these strategies are more income oriented, and some are more equity-like.”

From an allocation perspective, the 60/40 would look like 55% equities, 25% fixed income and 20% alternatives, he said. Meanwhile, the optimized 75/25 portfolio would look like 65% equities, 15% fixed income and 20% alternatives.

“Or if you wanted to take more out of fixed income, 70% dividend-focused, tilted equities, 10% fixed income, and 20% alternatives,” he said. “That’s how you build a better mousetrap.”

For advisors who feel that a 20% allocation to alternatives is too high, Welch pointed to family offices, where it’s common to have 20% to 30% of the portfolio allocation to alternatives.

“Clearly, there are people out there who believe in this, and they're putting their money where their mouth is,” he said.

Singer and her Invesco colleague Gregory Gore, a client portfolio manager and head of private markets specialists, added their own playbook on where a standard portfolio can make room for alternatives.

“As in traditional markets, private markets have a broad spectrum of risk and return,” she said, encouraging advisors to become more active as alternative investors. “So you can find a flavor that might align really well with different types of your clients' outcomes, from the most risk-averse all the way to the really whizzy assets.”

Gore added that the alternatives tent is big enough that there is an asset class for everyone, depending on the liquidity, outcome and risk tolerance needs of the client.

What’s critical is matching up the investment with its funding source, he said.

“For hedge funds, then, because they’re playing a similar role to what bonds might be today in a portfolio, it could be sensible to take that funding source from the bonds,” he said. “And then what you see in the credit, private real assets and listed real assets space is a little bit of a blend, depending on where their role falls between income diversification and growth.”

As a rule of thumb, Invesco looks at private credit potentially accounting for 20% to 30% of an alternative allocations, with 70% of the funding coming from bonds and 30% from equities; with private equity, which could account for 20% to 30% of the alternatives allocation, 100% of the funding would come from equities.

Real estate real assets could also account for 20% to 30% of the overall alts allocation, with funding coming from half from equities and half from bonds, they said. Hedge funds could account for 10% to 20% of the alts allocation, with funding coming 100% from bonds. And finally, listed real assets could account for 3% to 10% of the alternatives allocation with 70% coming from equities and 30% from bonds.

This is the first of two articles summarizing the presentations of the I&WI’s conference speakers. The second is "Alt Investors Point Out Four Opportunity Areas."

Sources:

https://www.fa-mag.com/news/all-flavors-of-alts-can-buoy-and-protect-a-portfolio--i-wi-experts-said-80090.html?section=43&utm_source=FA+Magazine&utm_campaign=d2ad261b8e-FAN_Alternative+Investments_Allspring_111224&utm_medium=email&utm_term=0_-02ce404ce3-245436795

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