An Alternative(s) Take on the New Year

Written by: Ash Lawrence | AGF

There are always lessons to be learned from a bear market such as the one investors experienced this past year. But of all the wisdom that can be gained, perhaps one of the most important takeaways is the increasingly important role that alternative investments can play in support of a more traditional 60/40 portfolio.

Such a portfolio on its own no longer provides the kind of fail-safe diversification it once promised — or regularly achieved — since it was first theorized in the early 1950s and put into practice shortly thereafter.

After all, without some allocation to alts in 2022, many investors utilizing a strict mix of stocks and bonds just endured one of the worst calendar years of performance in almost a century. Both asset classes were down more than 20 per cent at various times, Morningstar data shows, and combining them in a portfolio led to a 18.6 per cent year-to-date loss through November based on a 60-per-cent allocation to the S&P 500 Index and 40 per cent to the Bloomberg 10-Year+ U.S. Treasury Index.

Moreover, this disturbing trend may not have run its course just yet. A further moderation in rate hikes by central banks and their eventual pause could bolster stock and bond returns in the new year, but it’s still unclear when exactly the United States Federal Reserve and other central banks will stop their current tightening cycle and declare victory in their fight against inflation.

In turn, both asset classes should remain volatile over the next few months and may be susceptible to further losses if monetary policy doesn’t shift direction as expected and correlations between the two asset classes remain at historical highs.

That, however, doesn’t mean 60/40 portfolios should be abandoned altogether. In time, the historical dynamic between bonds and stocks is likely to return, especially in the case of a recession, which could give bonds an undoubted boost while leaving equities more vulnerable.

But in this type of uncertain environment, we believe the benefit of alternative asset classes or strategies that supply less-correlated returns to stocks and bonds has never been more obvious. And while institutional investors are well known for having very large exposure to alts, even the smallest of allocations can make a difference to the overall performance and volatility of a portfolio.

Of course, investors now have several options available to them on this front, including private-capital alternatives that were once the sole reserve of institutions not too long ago. These strategies include private equity, private credit, real estate and infrastructure. Though less liquid in nature, they have largely escaped the volatility that the public markets have experienced over in 2022.

Specifically, we believe an asset class such as private credit offers some attractive characteristics heading into the new year, namely, returns that are correlated with rising rates, attractive distributions moving forward and a market growth opportunity in Canada that has historically been dominated by traditional bank lenders.

Regulations that place increasing capital buffer requirements on Canada’s banks have cooled their lending appetite and increased the bar for borrowers to qualify. This has opened the door for private lenders to access a pool of potential credit-worthy borrowers that had typically satisfied Canada’s largest banks.

Couple this market opportunity with the attractiveness of issuing floating-rate loans in today’s rising rate environment and interest payments that provide distributions to investors, and we think investors should give private credit a look.

Institutional investors are certainly paying more heed to the attractive features of private credit, with institutional assets in the sector projected to grow by almost US$800 billion globally over the next five years, according to Preqin, an alternatives investment data firm.

Granted, investors will need to assess the potential risks and rewards of the various alternatives at their disposal in 2023 with the same scrutiny they pay to the stocks and bonds they own. As an example, the term “private credit” covers a wide spectrum of risk, from direct senior secured lending to riskier unsecured or mezzanine loans. All are not created equal.

And be wary of cryptocurrencies or other highly speculative corners of the alts complex that are either unregulated or lack proper governance and legitimate track records to be confidently assessed. In our opinion, they may not be worth the risk, especially today.

But with the right approach, and the right asset classes and strategies, the knowledge that alternatives can enhance portfolio outcomes during these uncertain times is one lesson from the past year that should not be forgotten anytime soon.

Related: December CPI Report Makes Next Fed Moves More Uncertain