What a year 2023 is closing out to be. Markets have been up, down and all around. For investors with a traditional 60/40 portfolio, the current value of their portfolio is probably less than the start of the year. Add in the current headlines of two international conflicts, persistent inflation, higher for longer rates and recession predictions and it’s ok to admit as an investor you are a little exhausted. Here is the good news. If you look back in history there has always been some international crisis and markets push through. Regarding interest rates, the real story was the near zero rates that persisted too long, today rates are simply normalized. In fact, the current rates take bond yields back to what was normal 20 years ago. And finally, capital markets continue to evolve and offer individual investors access to more options. In 2024, that frontier is likely to be a deeper consideration of alternatives.
What are alts?
Alts are investments outside of traditional cash, bonds and stocks. They can include anything from vintage cars and artwork, to fine wine collections. This article will focus on alts that have been used by institutional investors for some time, namely private equity and debt, infrastructure, real estate and hedge funds. The goal of these alts has been to provide less mark-to-market volatility, better inflation-adjusted returns and portfolio diversification. Sounds good, right? What is new heading into 2024 is that more retail products in
the form of ETFs and mutual funds are being offered that provide access to these alts.
Why are you hearing so much about alts?
Many of the components that traditional 60/40 portfolios are invested in, such as the S&P 500, TSX 60 and bond markets are highly efficient. That means that most information is known and priced in, making it difficult for active managers to add value (known as alpha). Over the past three decades, ETFs introduced by firms such as Vanguard have done an excellent job of providing low-cost access to these highly efficient markets, causing them to attract more capital. You have probably heard the term “a rising tide lifts all boats”. A passive 60/40 approach did well enough. However, while the ability to invest in these markets has become more cost-effective interest rates have been declining making it harder to turn a profit with a 60/40 portfolio. Heading into 2024, capital is not scarce, but it is no longer free. Today, when capital is provided, investors have higher return objectives and are more selective. More selective investments mean a growing gap between the winners and losers and more differentiated asset performances.
This makes the case for more active management in markets where these differences can be most exploited such as private equity and debt, infrastructure, real estate and hedge funds. The global investible market today is about $153 trillion, and alts make up about $18 trillion or 12%. However, it is expected that alts will produce nearly half the asset management industry profits due to the advantages of active management. It is the combined opportunity for the industry and investors alike that is making this area so talked about.
Are alts still attractive during elevated rates and inflation?
Retail investors today have about 5% of their portfolios in alts while wealthy investors have closer to 50%. That is because alts have proven to be remarkably inflation protected. Real estate has been long known to be inflation protected and is a natural first step for new investors to alts, but rising rates will amplify these secular trends already in place:
1) Movement away from bricks and mortar retail to industrial and e-commerce logistics
2) Reimagination and redesign of office space to accommodate hybrid work
3) Strong focus on multi-family residential builds to address housing shortages
4) Renewed focus on sustainability of properties as projects weigh environmental costs
As higher inflation demands higher interest rates, the most interest-rate sensitive areas of real estate investing will be hit but much of that has already been priced in.
Where Do I Start?
We enter 2024 at a period of transition from a world of disinflation and easy money policy to a world of some inflation and more historically normal interest rates. Investors will need to pay more attention to the corrosive nature of inflation on real returns. The 60/40 portfolio will remain at the core but requires extensions into alts to build a smarter strategy.
Alts is an umbrella term, so going into 2024 it is important for investors to understand what asset classes under alts are important complements to an existing 60/40, have investible products and work in an inflationary period. Real assets such as real estate, infrastructure and transportation all fit the bill and are an excellent place to start to move your 5% exposure to something more aligned with wealthy and institutional investors.
References:
https://caia.org/blog/2022/04/06/state-alternative-investments-2022
https://pimcoprimerealestate.com/_Resources/Persistent/b7f29921e384c6b281653a7a2ffb3ec53d2dd5a3/Real%20Estate%20Reckoning.pdf
https://www.trezcapital.com/industryeventinsight/the-state-of-real-estate-investing-navigating-opportunities-in-the-current-real-estate-landscape
