Alternatives, Diversification, and a Forward-Looking Approach During a Downturn

By Sloan Smith, MBA, CAIA, CPWA®

In both the equity and fixed income markets, 2022 was a historically difficult year. Global equities were down close to 18%, while high quality fixed income dropped nearly 13%, worst in approximately 100 years. But if we look at alternative asset classes, it tells a different story. Real estate, real assets, hedge funds, private equity, and private debt all outperformed both equities and fixed income in 2022 and played key roles in mitigating portfolio volatility. Including allocations to these asset classes further diversified portfolios and reduced drawdowns found in typical equity and fixed income portfolios. Utilizing a forward-looking approach helps minimize inflation and interest rate risk. Inflation-sensitive asset classes like infrastructure, farmland, timberland, and midstream energy benefitted portfolios, along with opportunistic fixed income managers who were able to reduce duration risk. Portfolios weren’t immune to the struggles found in 2022, but diversifying through alternatives and following a prudent, forward-looking approach made the year significantly less painful.

Benefits of Alternatives

Numerous alternatives asset classes were helped by the dramatic increase in inflation and interest rate risk over the course of 2022. They included:

Real Estate – private real estate was helped by increased rents tied to higher inflation and strong fundamentals. Multi-family and industrials saw the largest investment volume. For 2022, private commercial real estate was up around 7.5% as measured by the NCREIF Open End Diversified Core Equity Real Estate Index (ODCE).
Real Assets – private infrastructure, timberland, farmland, and midstream energy saw strong performance in 2022. Strong demand in infrastructure led to meaningful premiums for container movement while port volumes remained close to all-time highs. For farmland, grain shortages in much of the world drove prices of some commodities to record levels. Timber pricing was robust considering housing remained at elevated levels. Lastly, midstream energy experienced strong outperformance due to the supply constraints driven by the Russia/Ukraine war.
Hedge Funds – there was wide return dispersion among different strategy types for hedge funds in 2022. However, as a whole, hedge funds were only down approximately 5.5% during 2022, which was robust relative to equity and fixed income. These strategies were able to capitalize on the rapid change in market dynamics and proved their worth as a key risk mitigators in portfolios.
Private Debt – interest in the private debt asset class is mainly due to its potential resilience, in part because of its seniority in the capital structure. Most private debt deals are floating rate in nature, which significantly minimizes interest rate risk. Private debt has become more practical in an environment where public debt is offering comparatively less return to investors. Lastly, recent bankruptcies of Silicon Valley Bank and Signature Bank have made the asset class even more attractive, going forward, as more businesses will search for financing through the private markets.

Other alternatives performed relatively well and offer some unique opportunities going forward but face potential headwinds. They mainly include:
Private Equity – private equity faces increased borrowing costs caused by higher inflation. Issues in the public market in 2022 had an impact on exits, given that the market for initial public offerings (IPOs) dried up substantially. Nonetheless, opportunities in some areas remain strong. For example, private equity secondaries have become attractive. Large institutions (e.g., sovereign wealth and pension funds) have been forced to rebalance due to their private equity positions outperforming equities and fixed income. Therefore, these institutions need to sell some of their private equity portfolio to get back to their target allocations. In some cases, there have been discounts of 20% in the private equity secondary market, an attractive entry point for potential buyers.[1]

Advantages of Diversification and a Forward-Looking Approach

Going into 2022, the US equity market experienced a strong year, while high quality fixed income was down modestly. However, substantial amounts of monetary and fiscal stimulus flooded the US economy following the COVID pandemic, which caused concerns about potential inflation. We made some changes to client portfolios which included adding inflationary assets (i.e., infrastructure, farmland, timberland, and midstream energy), incorporating opportunistic fixed income managers with limited duration to reduce interest rate risk, minimizing fixed income exposure, using the proceeds to invest in hedge funds to act as a fixed income proxy, and rebalancing portfolios to their target allocations. These changes further diversified portfolios utilizing a forward-looking approach.

We did not know how the market was going to perform in 2022, but we wanted to be prepared for any type of environment. Our clients were rewarded, from a relative standpoint. As inflation increased and interest rates rose at their fastest pace in 40 years, drawdowns in client portfolios were significantly less compared to an equity and fixed income-only portfolio. Real estate, real assets, private debt, and some private equity strategies recorded positive performance, which further assisted portfolios. Ultimately, the decision to enhance alternative exposure through diversification while applying a forward-looking methodology helped portfolios in 2022, and we believe that will remain the case going forward.

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