An alternative solution to shallow returns

Key takeaways

• Traditional assets may be reaching the end of a long structural cycle of strong returns, pushing investors to explore alternative asset classes.
• Covering a wide spectrum, the contrasting characteristics that alternative assets offer can serve many different objectives.
• Private equity and venture capital are the archetypes of high risk / high reward assets, while real estate & infrastructure provide more steady returns and gold remains a hedge against the risk of currency debasement.
  

End of a cycle for traditional assets

Traditional assets, i.e. stocks and bonds, may be reaching the end of a long cycle stretching over decades that has seen them deliver very solid returns. Unprecedented inflation globally, driven by both cyclical and structural factors, is leading central banks to rethink years of ultra-accommodative policies. The tightening of monetary policy we expect will impact return expectations for bond investors who may have to stomach significant capital losses, at least in the short term. Equity valuations and margins are at risk of normalising just as visibility on future global growth decreases, hence impairing both sides of the risk/return equation for stocks.

Institutional investors have taken note of these trends and explored ways to maintain, or even improve, performance despite mounting headwinds to traditional stock/bond portfolios. Spearheaded by Yale and Harvard, the endowment funds of US universities started moving their asset allocation towards alternative assets in the 1980s, enabling them to consistently outperform a global 60/40 portfolio. In the past 10 years, the Yale endowment fund has returned 12.4% per annum on average (in USD), versus 8.0% for a global 60/40 portfolio.

Navigating the alternatives jungle

While the attractiveness of so-called ‘alternative’ assets has undoubtedly increased in recent decades, this category is a heterogeneous one, containing asset classes with very different characteristics. Investors therefore have to be clear about what they are seeking before venturing into the world of alternatives. Higher returns, steady income, diversification or outright tail-risk protection are all viable investment aims, but they cannot all be achieved simultaneously.

Risk-seeking investors aiming for very high returns will naturally turn to private equity (PE) and venture capital (VC). Global private equity has outperformed the MSCI AC World by an average of 3.9% per annum over the past decade, chiefly thanks to the significant leverage employed in deals. Over the long run, venture capital has generated only slightly higher returns than private equity, albeit with bursts of outperformance when innovation accelerates. We expect PE & VC to keep outperforming listed equities in the next decade (but to a smaller extent than before), each returning an average 9.2% annually in nominal terms.

Private investors have also been keeping their eye on debt markets as traditional lenders have partially retreated since the Great Financial Crisis (GFC) of 2008-2009. In exchange for sparse liquidity, lenders typically enjoy higher yields from private credit than offered by listed bonds, floating rates (a useful feature at times of monetary tightening), and the ability to tailor covenants to best fit their risk appetite. We believe private debt could return 5.3% in the next decade.

For illustration purposes only. Past performance should not be taken as a guide to or guarantee of future performance. Performances and returns may increase or decrease as a result of currency fluctuations. There can be no assurance that these projections, forecasts or expected returns will be achieved. The projection is not based on simulated past performance. Before investing, please always read the relevant fund/product documentation containing information about the Fund/Product and its specific risks. Private assets are only suited for large or professional investors with: (i) a long-term investment horizon (>10 yrs); (ii) no liquidity requirements; and (iii) an understanding of the risks linked to this asset class.

Not only are hedge funds a highly varied asset class due to the wide range of strategies they employ, managers’ efforts to maintain their competitive edge mean they are also among the most opaque. In aggregate, however, hedge funds are dominated by the equity factor, with a beta to listed markets of about 0.5 since the GFC (hence our average annual expected return of 3.1% in USD over the next 10 years). While hedge funds are able to navigate turbulent times effectively, such as was the case in 2020-2021, we see them as a diversifier offering alpha only to those able to perform thorough due diligence.

For investors seeking stable yields rather than stellar (but highly uncertain) returns, real estate and infrastructure may prove attractive hunting grounds. While levels of risk vary, along with return potential, both are traditionally seen as safe, ‘annuity-like’ investments providing steady cash flows and a partial inflation hedge. But relatively good income visibility comes with illiquidity, among other risks. Core infrastructure, for instance, bears significant regulatory risk that is hard to assess and must be managed through diversification.

We expect the yellow metal to play its role as a hedge against runaway inflation, currency debasement or sharp reversals in riskier assets. Yet the rise in sovereign yields, and in particular our expectation for the US 10-year real rate to turn positive, will likely erode the attractiveness of non-yielding gold relative to bonds. We expect gold to provide an average annual return of2.2% in USD terms over the next 10 years.

For illustration purposes only. There can be no assurance that these projections, forecasts or expected returns will be achieved. The projection is not based on simulated past performance. Before investing, please always read the relevant Fund/product documentation containing  information about the Fund/Product and its specific risks. Private assets are only suited for large or professional investors with: (i) a long-term investment horizon (>10 yrs); (ii) no liquidity requirements; and (iii) an understanding of the risks linked to this asset class.

A bright future… but all that glitters is not gold

More opaque, less regulated, less liquid and hard to access; alternative investments are indeed in a category of their own. Yet the diversity of alternative asset classes means investors have a wide range of attractive options to optimise portfolios according to their individual objectives and risk tolerance. We therefore continue to forecast a bright future for alternative assets in the next decade, especially as mainstream investors continue to gain access.

Private assets, in particular, may continue to deliver robust performances as the industry develops and private markets increasingly compete with public ones to finance large-scale projects and companies. But the wide dispersion of returns means astute manager selection is vital in private investing. Thorough due diligence is of the essence.