Allocators thinking about the long term should also consider thematic investing, which has been an active area of research for our Investment Strategy team (read our research on incorporating thematic investments into a multi-asset portfolio). Thematic strategies are typically focused on enduring structural trends (e.g., the energy transition and artificial intelligence) and, as a result, may be less tied to the economic cycle and less reliant on strong economic growth to drive returns.
7. Spend some time in the alternatives world
Alternatives represent a significant area of exposure for many allocators and warrant a dedicated review to begin 2024. In the illiquid space, the focus should be on developing a commitment plan for the year ahead. This requires a detailed review of the opportunity set, prospective returns, current positioning relative to targets, and broader liquidity needs (discussed in more detail below). In the hedge fund space, review your major allocations, including at the hedge fund category level (e.g., macro, equity long/short, and relative-value strategies). How have they performed? What are the potential headwinds or tailwinds? Are there any crowding concerns?
In terms of the current environment for alternatives, here’s my take:
Hedge funds — I know some investors are concerned about higher interest rates, but I think hedge fund returns will ultimately benefit (on a nominal basis) from higher cash yields. In particular, funds that are more market neutral and balanced long and short typically pass through the alpha from their relative positions on top of cash. So, for a hedge fund targeting, say, cash plus 3% – 5%, the total nominal return in the decade ahead may be very different from the past decade, when cash yields were historically low.
I also think global macro strategies could benefit from the less synchronized world that I described earlier, with more volatile and varied business cycles in different countries and the potential for more volatility in currency markets, for example. Finally, in this higher interest-rate environment, hedge fund allocations may also be a valuable portfolio building block if fixed income is less effective in the role of downside mitigation.
Private equity — Here, the impact of higher rates may be less positive. As I noted in my list of potential market surprises, there may be a cost for returns on legacy LBOs that were financed in the previous lower-rate regime, are not ready to be exited, and now need to refinance at higher rates. More broadly, the higher cost of capital may limit the range of investments that make sense for private equity buyers.
I think allocators should consider a global opportunity set, which may allow for tapping into pockets of attractive valuations and perhaps some “governance alpha” in markets outside the US where there is appetite for improving governance and performance. There may also be opportunities in niche areas of the private equity market that are not as reliant on debt financing.
Private credit — This is where we could see the flipside of the higher interest-rate challenge facing LBOs, as refinancings drive some transfer of value from private equity holders to private debt holders. However, as I’ve noted before, allocators should be attentive to the risk of crowding in areas of private credit that have grown at high rates for an extended period. This is also a relatively new asset class that has really not been through a period of significant market stress, which argues for remaining very focused on managers’ underwriting standards, use of leverage, and ability to be opportunistic if the asset class does face challenges down the road.
8. Rouse your inner risk manager
I’ve talked a lot about returns, so let me offer some thoughts on risk in 2024. Last year, the major risks turned out to be the market dominance of the Magnificent Seven and the impact that had on portfolios that were underexposed to US mega-cap stocks; the degree of interest-rate volatility, with rates swinging meaningfully in both directions; and the interest-rate sensitivity of some equity sectors, including banking, real estate, and utilities.
So, what risks should allocators be contemplating for 2024? I think credit spreads bear watching, as does the potential for a recession in Europe. There are also ongoing risks that some have overlooked, including the possibility the US dollar eventually breaks the trend and moves in a different direction and that there are more episodes of positive stock/bond correlation like we saw in 2022.
How do you bring all of this into your risk-management process? I’d suggest two approaches. The first is scenario analysis — sketching out different scenarios for how some of these things could go awry and trying to understand what that means for a portfolio. The second is stress-testing portfolios with some extreme outcomes. If you’re comfortable with the results, you’ll be better positioned to manage through such a scenario. If not, it may be an opportunity to do some hedging or adjust your asset allocation.