Global Asset Tracker: Banks urge investors to embrace alternatives

Hedge funds and private assets can help diversify portfolios and reduce volatility, but private clients remain sceptical

In 2022, when positive correlation between fixed income and equities hit traditional balanced portfolios hard, advisers’ mantra about the importance of diversifying into alternatives came into its own. Hedge funds were one of the few assets delivering positive returns last year, helping reduce investors’ losses.

Private clients, though, are still cautious about alternatives, with hedge funds and private markets being the area where the misalignment between client allocations and chief investment officers’ recommendations is most evident (see chart below). This is a key finding of PWM’s eighth annual Global Asset Tracker (GAT) study, conducted in January.

Fifty per cent of CIOs and market strategists at private banks state that clients have an exposure to hedge funds and private markets lower than they recommend, despite 80 per cent believing that alternatives in portfolios lead to greater risk adjusted returns (see chart below).

With an average strategic allocation of 13 per cent to alternatives, around 40 per cent of private banks entered this year with a tactical overweight, down from 60 per cent in 2022, with many shifting some of their alternative assets to fixed income (see chart below).

The rapid rise in interest rates has brought bonds back on the table as portfolio diversifiers, but it is questionable to what extent and for how long they can play this role.

“We saw correlations between equities and bonds jump higher last year but focus on monetary policy and inflation means those correlations could periodically be higher again in 2023,” warns UBS GWM’s Emea CIO Themis Themistocleous.

Over the past couple of years, under Iqbal Khan’s leadership, the global wealth manager has been vocal around the value of alternatives in asset allocation, with these assets representing today between 10 to 40 per cent of client portfolios across strategies. At the high end, clients are more like institutional investors that invest for the longer term and take advantage of illiquidity premiums.

Impact of inflation

“The very consistent negative correlation between bonds and equities enjoyed for the last 20 years, up until last year, is not necessarily going to remain as consistent in the future, particularly in an environment of higher secular inflation and/or more volatile inflation,” states John Wyn Evans, head of investment strategy for Investec Wealth & Investment.

Over the past two decades, not only was inflation low, but volatility on inflation indices was low too.

“If that cat’s out of the bag, we could well find ourselves flipping between positive and negative correlations between bonds and equities, on a regular basis, it could be happening every year or two. That’s going to really increase the challenge of running balanced portfolios, and certainly it makes a massive mess of risk parity, as well,” says Mr Evans, referring to the portfolio allocation strategy that uses risk to determine allocations across various components of an investment portfolio.

While the world is still dealing with the aftereffects of the Covid-19 pandemic, and the consequences of Russia’s invasion of Ukraine, several structural factors contribute to the risk of higher, stickier inflation than in the past.

These include deglobalisation or reshoring to home countries for manufacturing of critical goods and services, coupled with government spending to support it, which is inflationary, while also putting price pressures on wages.

The reversal of the ‘peace dividend’ associated with the end of the Cold War means increased spending on defence, which may squeeze out other parts of the private sector, driving up prices. Greater political will to use more fiscal tools to support economies, and greater social demand for such tools, are also inflationary, while ageing populations could put pressure on wages.

“Central banks aren’t used to dealing with higher inflation, so they’ll end up over tightening or under tightening,” believes Mr Evans. “This will create inflation volatility, especially in the headline indices, and if inflation comes off a higher base, it’s going to make their life harder than it has been for a long time.”

With higher inflation and greater inflation volatility, bonds tend to have a positive correlation with equities, so it is paramount to find different risk diversifying assets.

So why are clients hesitant to follow private bankers’ advice? Are the liquidity issues encountered by the hedge funds sector in the 2008-2009 financial crisis still fresh in their minds?

Education gap

It is “lack of understanding about portfolio construction” that leads clients to be underexposed to alternatives such as hedge funds, says Mr Evans.

Most likely, investors hold hedge funds in their portfolios as “structural risk diversifiers”, but then give up on them just “when they kick into action”. This is what happened recently, as hedge funds, effectively “long volatility products”, struggled to perform for a long time, as other risk elements of portfolios generated good returns.

“This is the whole point of having a balanced, risk diversified portfolio. Just like house insurance, hedge funds work just when they are needed,” says Mr Evans.

The end of repressed volatility will mark a new era for these instruments.

Hedge funds had a “very difficult time” over the past 10 years, because of ultra-loose monetary policy and ultra-low interest rates, which made it very difficult for them to outperform, making clients “less prone” to alternatives, says Edmond de Rothschild’s global CIO Lars Kalbreier.

But with central banks raising interest rates and stopping suppressing volatility, and with more geopolitical divergence, the outlook for hedge funds, and active managers in general, has “much improved”, he says, urging clients to reconsider their positions.

Liquidity needs, as well as little familiarity with the asset class, also explain the significant gap between institutional and private banking client portfolios, when it comes to exposure to alternatives.

“Even if bonds are back as portfolio diversifiers and source of income, alternatives provide investors with a higher return in the longer run, but at the cost of higher illiquidity, which some private clients cannot stomach,” adds Mr Kalbreier.

Free lunch

“In this highly volatile and uncertain environment, there is only one ‘free lunch’ and that is diversification,” says Alicia Levine, head of equities and capital markets at BNY Mellon Wealth Management.

“Last year, alternatives showed their power and mettle in stabilising returns in overall portfolios. We encourage clients to allocate to alternatives, because they are less correlated to bond and equity markets and lower the volatility of returns over time,” she says.

Looking forward, UBS’ Mr Themistocleous believes global macro and relative value managers will perform well, as they have historically done so in volatile markets, while slowing economic growth should be supportive of equity long short managers positioned to take advantage of dispersion between stocks.

Putting fresh capital to work in private markets in the years following declines in public markets have historically proven positive for strategies like secondaries, distressed debt and value-oriented buy-out, he adds.

Wealthy clients not only hold too few alternatives, but sit on too much cash, according to 60 per cent of CIOs. This is an issue, especially with high inflation.

“Cash is perceived to be safe, but in fact is a depreciating asset, while many financial assets are appreciating assets and can compensate for inflation,” explains Edmond de Rothshild’s Mr Kalbreier.

Guiding clients into the most appropriate asset allocation may be a constant battle with clients, he says, but “that’s what makes our job so interesting”.