- Head of Multi-Asset Strategy
United States, Institutional
Change
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In many respects, 2023 ends where it started: with investors wondering what’s in store for inflation (cooling enough for comfort?), interest rates (higher for longer?), and economic growth (slowdown or recession?). In a case of déjà vu all over again, we expect macro and market uncertainty to be a commanding theme once again in 2024. With that in mind, it may be an opportune time for allocators to take a fresh look at alternative investments and the roles they could play in their portfolios.
Pursuing more attractive returns — Companies face a number of challenges in the current environment, from a higher cost of capital to a fluctuating macro cycle. But these conditions can also create more differentiation between companies, with more explicit winners and losers. That, in turn, can expand opportunities to add value through security discrimination — using long/short strategies, for example.
Europe is one potential hunting ground for these strategies, as our colleague noted in a recent paper. Shifting conditions in the region, including structurally higher inflation and interest rates, seem likely to drive greater dispersion of returns than in recent years, potentially creating a more attractive opportunity set for fundamentally focused long/short investors.
Or consider the financials sector. In the post-global financial crisis era of unprecedented liquidity, differentiating good business models from bad was generally not rewarded. But as members of our Financials team explain, that appears to be changing and, as they put it, the new higher-rate/lower-liquidity environment means that “good companies can once again distinguish themselves.”
Adding diversification and downside mitigation — Economic uncertainty was on full display in 2023, with the recession predicted by so many failing to materialize. For those who agree that 2024 could bring more of the same, we think there’s a case for strategies that can provide diversification and downside mitigation. Also contributing to the case for diversification is the divergence in policy paths of different regions (e.g., the US is late in its tightening cycle, while Japan is sticking with deeply negative real rates). This fundamental divergence is reflected in more sustained differentials in valuation and relative performance. Finally, it’s also worth recalling that in 2022, both stocks and bonds struggled, reversing a key risk-mitigating relationship in portfolios. As we’ve written, this positive stock/bond correlation may rear its head more in the future, requiring additional diversification and downside mitigation.
So, where are the opportunities for diversification in alternatives portfolios? We think the current environment has created space for macro strategies to add value — by taking advantage of regional divergences, for example. Macro strategies may also provide downside mitigation in volatile environments.
Allocators may also want to consider multi-strategy funds, given their potential to provide diversified returns. With a single manager at the helm, a multi-strategy fund may be able to assemble a diversified collection of alpha sources and limit unexpected/undesired correlations between underlying strategies/managers.
Expanding the tool kit in efficient markets — Market structure has become a key area of concern, particularly for US or global equity investors as they confront the implications of narrow markets and indices dominated by a handful of mega-cap stocks. Narrow markets pose a headwind to active managers, but even passive investors are left with indices that are less well diversified by name and sector compared to history. Here we think active extension strategies can play a role.
Often referred to as 130/30 or 140/40 strategies, these 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 extension strategies have the flexibility to short stocks, which means portfolio managers can overweight the stocks they favor without having to underweight (on average) the largest names in the index to source capital. Compared to other active equity strategies, they may be less exposed to underperformance when mega-cap stocks drive market rallies. The use of shorting may also be attractive to allocators seeking to enhance returns in efficient markets (e.g., large-cap stocks), where managers may have an easier time identifying “short alpha” opportunities than trying to find differentiated long ideas.
One final note on alternative investing in 2024
Of course, none of this is to say that some alternatives strategies won’t face their own challenges in the current uncertain environment. But we believe alternatives could fill a number of portfolio roles in the coming year. To help with your own alternatives decision making, watch for our latest research on the role of hedge funds. In 2024, our iStrat colleagues will be sharing insights on hedge fund categories, including event-driven, equity hedge, relative value, and macro strategies, and how they map to different portfolio roles.
Please refer to the investment risks page for information about each of the following risks:
- Alternatives risk
- Capital risk
- Risks of derivative instruments
- Manager risk
- Short selling
