Seeking an Alternative
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Seeking an Alternative Understanding and Allocating to Alternative Investments Alts Lab Seeking an Alternative: Understanding and Allocating to Alternative Investments 3 Seeking an Alternative Understanding and Allocating to Alternative Investments Summary In this paper we look at some of the forces that may be inclining individual investors to incorporate “alternative” investments in their portfolio, and then offer some general allocation suggestions on how they may do so. We think there are several compelling reasons why investors are considering “alts.” While the century is young we’ve already had two severe market declines, and two long, painful recoveries. The result is a world with lower growth, a good deal of uncertainty, and the feeling that traditional investment options alone may not suffice. We believe some investors are seeking alternative investments to find yield, some for higher returns, or protection from rising rates, or a haven against market volatility—or any combination of the above. Unfortunately there’s no standard approach or “style box” to guide investors on how to reach their goals with alternative investments. We offer up a framework to address this gap. Seeking an Alternative: Understanding and Allocating to Alternative Investments 5 Investor PTSD: Laboring to Forget the Turbulent “Aughts” Let’s look at some of the realities of investing today The display shows that, for U.S. equities, the which are driving investors to consider “alts.” number of days when markets moved 3% or more reached a peak of 95 in the last decade First, volatility has changed—and has changed (the tall grey bar), versus 81 episodes in us. During the previous decade, we had far more the previous 50 years all together. More frequent occurrences of extreme (or “fat-tail”) important, we’re still living with the emotional moves in the equity markets, which deeply repercussions from that experience. scarred most investors. In the last several years, with the flood of central Technically speaking, a fat-tail event is three bank accommodation across developed markets standard deviations (“three sigma”) away from acting as a kind of shock absorber, volatility has the mean and has only a 0.1% probability of tapered off. But the real damage has been done: happening—that is, statistically it should occur Investor PTSD will manifest itself for some only once in every 1,000 periods under analysis. time in the form of higher sensitivity to market But in reality these “low probability” events volatility. occur far more frequently, as they did during the 2008 credit crisis (Display 1). DISPLAY 1 Extreme Volatility Leaves Deep Scars Number of 3% Daily S&P 500 Moves by Decade 100 95 75 Total over previous 50 years = 81 50 25 27 24 25 16 5 9 0 1950-1959 1960-1969 1970-1979 1980-1989 1990-1999 2000-2009 2010-2018 Source: Standard & Poor’s, Morningstar Direct through 12/31/18. Blackstone 6 True Diversification Is Harder to Come By Another post-crisis reality is the rise in But since the crisis, correlations across these correlations across many asset classes and the assets have risen (the blue bars). The data resulting difficulty investors may face in truly suggest that today only investment grade diversifying their portfolios. fixed income remains a compelling diversifier to equities. In the decade prior to the financial crisis, investors were able to diversify their equity But that’s cold comfort for most investors today: portfolio by allocating, for example, to non- the role of bonds as the traditional anchor to U.S. Stocks, High Yield Bonds, REITs or windward for equities is shifting, as we now Commodities—most with correlations below 0.5 face the likely end of a 30-year bull market in relative to the S&P 500 (as shown in the green bonds and the prospect of rates rising well into bars in Display 2). the future. DISPLAY 2 Higher Correlations Leave Nowhere to Hide Correlation of Key Asset Classes with the S&P 500 Index1 1998-2007 2008-2018 1.2 0.9 0.8 0.8 0.7 0.7 0.5 0.5 0.4 0.3 0.0 0.0 (0.0) (0.2) (0.4) International U.S. Investment U.S. High Yield REITs Commodities Stocks Grade Bonds Bonds Source: Morningstar Direct. For International Stocks we use MSCI ACWI ex-U.S.; for Investment Grade U.S. Bonds: Barclays U.S. Agg Bond TR; for U.S. High Yield Bonds: Credit Suisse HY; for REITS: FTSE NAREIT TR; for Commodities: S&P GSCI TR. Index Definitions provided at the end of this presentation. (1) As of 12/31/18. Seeking an Alternative: Understanding and Allocating to Alternative Investments Bond Bull Market: AThingofthePast? Bond BullMarket: (2) Returns(2) after inflation as of 12/31/18. (1) Historic Yields as of 1/1/19. Source: U.S. Treasury and Federal Reserve, and Morningstar Direct. Equities For we use: S&P 500 TR; for Fixed Income: Barclays U.S. Agg Bond TR. Investors have long understood fixed income’s income’s fixed longunderstood have Investors Over the last several yearsthey’ve several thelast hadto Over they have also grown toexpectfromtheir alsogrown they have and investors starved for yield. Moreover, with foryield.Moreover, starved and investors combination (Display 3). combination (Display rates on the rise, many of these investors may may oftheseinvestors rates ontherise,many period of losses in their bond holdings. period oflossesintheirbondholdings. But toequities. primary roleasadiversifier unlearn thissecondbenefit,withratesnearzero for the portfolio as well—historically arare for theportfolioaswell—historically begin to suffer through the first-ever extended begin tosufferthroughthefirst-ever sourceofreturn bond allocationarobust Historical Yield on 10-Year TreasuryBond,1953-2019 Yieldon10-Year Historical Where Bonds CouldLoseMoney A World DISPLAY 3 DISPLAY 1 1 0 6 2 8 % % % % 1953 1955 1957 1959 Returns after inflation: 1961 Fixed =0.2% Income 1963 1965 Equities =5.8% 1967 1953-1981 1969 1971 1973 2 1975 1977 1979 1981 1 1983 1985 As the longer history of the 10-Year TreasuryAs history the longer the of 10-Year A common way togenerate A commonway thistypeofforecast U.S. may be constrained by slower growth inthe growth slower by beconstrained may U.S. Most analysts agree that equity returns inthe agreethatequityreturns analysts Most yield shows, bonds may not alwaysyield shows, may bonds not be a three underlyingcomponents:areasonable overall portfolio. if thing there is one investors tomorrow’s will need, may be it aboost in returns their for discount rate (Treasuries), overall economic discount rate(Treasuries),overall is tolookattheequityriskpremiumbasedon going forward. economy 1987 support to total return. And based forecasts, on 1989 1982-2019 1991 Fixed =4.5% Income Equities =8.6% Returns after inflation: 1993 1995 1997 2 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 7 Blackstone 8 Performance Headwinds Ahead growth (GDP), and the valuation dynamics This is far below the target annual return (price-to-earnings ratio) of equities (Display 4). that most institutions aim for to cover their liabilities (generally between 7% and 8% per All three of those measures—low current yield, year), and could easily leave most individual tepid economic growth, and relatively high investors wanting more as well. equity valuations—suggest anemic returns for equity markets ahead. It’s no surprise then that Simply put, investment returns may be up some analysts see lower returns over the next against some strong headwinds over the near to several years—with U.S. equities projected to medium term, and this could be another factor earn a nominal return of 3% and a combined driving investors to look at “alternative” options. 60/40 stock/bond portfolio returning just over 2.5% over the next 5 years.1 DISPLAY 4 Economic Backdrop Suggests Anemic Future Returns 1985-2007 2008-2018 Valuations Rising 26.2 21.4 Interest Rates Growth Falling Declining 6.5 3.2 1.6 2.7 U.S. GDP 10-Year S&P 500 Growth U.S. Treasuries Price / Earnings Ratio Source: Standard & Poor’s, Morningstar Direct, as of 12/31/2018. Index Definitions can be found at the end of this presentation. (1) The quoted returns represent asset class forecasts as estimated by Goldman Sachs (Investment Strategy Group: Outlook, January 2018). Goldman Sach forecasted a 5-year nominal return for U.S. Equities, as measured by the S&P 500 at 3.0%. Their 5-year forecast for Municipal Bonds was a nominal return of 2.0%. In line with these forecasts, a 60/40 Portfolio of U.S. Equities and Municipal Bonds has a 5-year forecasted nominal return of 2.6%. There can be no assurance that any alternative asset classes will achieve their objectives or avoid significant losses. There can be no assurance the forecasts will be achieved. These comparisons are provided for informational purposes only and should not be relied upon as a benchmark or target for any index or Blackstone fund. There is no assurance that an allocation to alternatives would provide higher real returns. Please consult your own third-party advisors before making any investment decisions based on this information. Seeking an Alternative: Understanding and Allocating to Alternative Investments 9 Alternatives as Complements to Traditional Strategies But first a problem of definition: A common Alternatives offer different attributes. Instead mistake investors make is to treat alternative of simply replicating the market, managers investments as a homogeneous category. The are less constrained, are often activist in their reality is alternatives are not a single asset approach, and their performance tends to vary class. Alternatives include an array of assets, substantially. As a result, returns tend to be strategies, and structures and should not be less correlated to the beta of traditional market construed as some monolithic investment investments and are more dependent on the or a single slice in the allocation pie.