With interest rates at rock bottom for most of the last 15 years, and with the fixed income markets providing little yield at the same time, investors turned to the higher yields asset classes such as infrastructure, real estate, transport leasing and private credit.
Newton Investment Management's head of mixed assets Paul Flood said that while the 60/40 portfolio saw the worst performance in over a decade in 2022, the inflation linkage or variable interest rates in many alternative assets meant the sector held up better.
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However, he noted that more recently the overall performance of alternatives has weakened as bonds were now competing more effectively for investor capital, given the higher yields available.
While bonds are now back in fashion, JP Morgan Asset Management's global market strategist Mike Bell said investors should not disregard alternatives.
"Higher interest rates are likely to cause a recession, potentially bringing fixed income yields lower again. The income available from assets like core infrastructure is likely to be more persistent throughout economic cycles," he said.
Structurally higher inflation
Over the longer term, structural pressures suggest inflation is likely to be higher than over the previous decade, Bell noted, which will mean alternative real assets that can provide some inflation protection, such as core renewable infrastructure assets, are likely to be in high demand.
Against this backdrop, investors may also see more frequent periods where central bank tightening leads to stocks and bonds falling together, meaning the diversification benefits of many alternative assets continue to be sought after, he added.
On the other hand, Flood said that changes to cost disclosures for open ended funds may have led to some managers reducing their exposure to alternatives.
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"For more astute investors this may offer an opportunity to add some inflation protection back into portfolios and benefit from irrational selling from those not wanting to show an artificially higher all-in cost," he said.
A recession could challenge the outlook for more cyclical parts of the alternatives universe, such as parts of real estate, private credit and private equity, argued Bell.
"Valuations in some of the cyclical parts of private markets have so far fallen less than similar publicly listed assets and so could be vulnerable to lagged declines," he said.
"Investors should be selective, focusing on reasonably valued, high quality assets without structural challenges or weak balance sheets, while also remembering that recessions tend to provide good opportunities for managers to deploy new capital."
Strategies for current conditions
In periods of high levels of inflation, when bonds and long duration equities come under pressure, liquid real assets can achieve a more "predictable" risk and return profile, Flood argued, noting "they are not without risk".
"Historically, in periods of high inflation, an allocation to real assets has provided a more stable risk and return profile for the traditional 60/40 portfolio," he said.
"As such, we shall continue to include exposures to these assets in our portfolios when the valuation and diversification benefits prevail to compete for our client's capital."
Anja Needham, investment analyst at Secor Asset Management, said that an environment of higher rates, high inflation and tight employment rates may stretch opportunities in the public and private credit markets.
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As such, she suggested stressed and distressed special situations, particularly those strategies which are focused on rescue financing, recapitalisations, bridge lending and complex structured solutions.
She also pointed to flexible capital solutions in the large cap space, asset-backed lending, unlevered direct lending strategies and real estate debt.
"[Real estate debt] is now pricing in low double digit territory to due bank financing retrenchment and nearing returns we typically looked for in real estate equity strategies over the last 10 years but with more downside protection," she said.
Spotlight on secondaries
The recent declines in public markets have forced many institutional investors to sell private assets to rebalance portfolios. As a result, supply in private asset secondary markets now outstrips demand, offering prices much lower than they have been for several years.
Secondary investments, which are purchases of a stake in an existing private equity asset, are currently a small part of the overall private markets space, but their importance is growing rapidly.
Nina Kraus, principal at the $832bn private markets asset manager Hamilton Lane, said that secondaries are not just attractive in the short term, as they are also one of the market segments where the firm is finding the most innovation and creativity around exits and liquidity options.
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"[Secondary transactions] can provide the secondary investor the opportunity to invest in a diversified, well-performing portfolio of assets later into a fund's investment cycle while letting the seller redeploy assets elsewhere to enhance overall return," she said.
As a firm, Hamilton Lane is seeing a challenging road ahead for private markets fundraising, as inflation, rising interest rates and an overall volatile market environment leave their mark on the sector.
At par with slower investment activity, Kraus is also seeing reduced realisation activity through traditional channels, which she said will continue to support new investment opportunities within the secondaries market as investors seek liquidity.