Will we have a recession? Will it be deep or shallow? What’s next for inflation and interest rates? There is no shortage of questions and uncertainty about the direction of the economic cycle and the markets. While asset allocators can’t control the outcomes, there are some alternative investment ideas that we think could help lessen the importance of the cycle to their portfolios — or even take advantage of the uncertainty.

1. Doubling down on diversification — Could we see a repeat of last year’s positive correlation between equities and bonds? It’s certainly possible at a time when central banks are still battling stubborn inflation and interest rates are a key weapon in their arsenal. We see the double whammy of a declining stock and bond market in 2022 as a valuable reminder of the necessity of diversification and a warning not to take it for granted that traditional strategies will always be effective. In other words, this may be a time to seek additional sources of diversification.

Potential solutions: Low-beta or market-neutral hedge funds may serve as a complement to bond allocations at times when the latter can’t offer the downside protection from equity declines that they’ve historically provided. Our Fundamental Factor Team dug into this topic in a recent paper. We also think commodities are worth a close look for diversification purposes in the current inflation environment, although we recognize that some asset allocators don’t classify them as an alternative investment.

2. Seeking equity substitutes — The role of equities in portfolios is to generate returns, but given all the uncertainty and potential risks facing the market, are there ways of generating returns from sources other than equity beta? This is where alternatives may play the role of “equity substitute.” 

Potential solutions: The unconstrained nature of hedge funds means they can use a variety of strategies to limit risk while still seeking returns. In particular, long/short equity hedge funds could function as equity substitutes. Although long/short strategies lagged the market rebound in the first half of 2023, we continue to believe they will be able to capitalize on market dislocations and performance dispersion in the coming years.

3. Taking advantage of volatility — Whether we ultimately experience a recession, rate hikes/cuts, or any number of other economic developments, one outcome we’re quite confident about is greater macro volatility (our colleague John Butler makes a compelling case here). This includes a less synchronized global economy, with sharper differences between countries as they tackle their own unique inflation and growth challenges and adopt different monetary and fiscal policy solutions. 

Potential solutions: This environment could be problematic for some long-only strategies, but it may be ideal for global macro strategies, which can seek to capitalize on bouts of macro and market volatility driven by shifting cycles and country-specific risks (e.g., elections, policy changes). Allocators may also want to consider opportunistic investment strategies that seek to identify winners and losers in idiosyncratic situations like the US banking crisis.

4. Tapping opportunities in credit — As credit markets continue to feel the impact of higher inflation and interest rates, there will likely be more focus on company earnings, free cash flows, and other fundamentals. This should drive greater dispersion and more instances of market mispricing. 

Potential solutions: Long/short credit hedge funds may be best placed to take advantage of market volatility and dislocations, while also avoiding adding credit beta heading into a possible recession. At the same time, current challenges in the banking industry may create opportunities in private credit, as reduced bank financing leaves room for others to step in. We encourage private credit investors to stay conservative on lending standards and leverage, given that the relatively young private credit market has never been tested by a credit cycle.

5. Getting more from core equity with active extension strategies — In a volatile environment like the current one, with the potential for a broad opportunity set of both winners and losers, the flexibility to incorporate shorting strategies may be especially attractive. 

Potential solutions: Extension strategies (often referred to as 130/30 or 140/40 strategies) seek to outperform a benchmark while maintaining a moderate level of tracking risk, consistent with a core equity profile. The primary difference is that an extension strategy has the flexibility to short stocks. These strategies may be attractive to allocators looking to enhance returns in more efficient markets (e.g., large-cap stocks). Compared to other active equity strategies, they may be less exposed to underperformance when “mega-cap” stocks drive market rallies. Extension strategies can also appeal to those who want the “secret sauce” of alternatives but may be constrained on capacity or fees.