Private equity and hedge funds for the sake of your portfolio’s stability
2022 proved to be an extraordinary year on the capital markets – but the current year is definitely keeping up in terms of surprises. Turbulence in the banking sector in March, for example, caused a slump in equity markets. This was followed by a rapid recovery over subsequent months, but the upside potential for equities remains limited. Apart from bonds, which asset classes can currently offer added value for investment portfolios? Read on for a closer look at private equity and hedge funds.
2023 remains challenging for investment portfolios
The year 2022 was an exceptional one, with stocks and bonds both recording negative performance. Rising inflation and aggressive central bank rate hikes prompted losses for fixed income assets, while weakening growth weighed on equity markets. This strong positive correlation between stocks and bonds within a calendar year is rather unusual.
It is likely that 2023 will be as exceptional as last year, but from a different perspective. After the strong start to 2023 in terms of financial markets, the collapse of US banks and the integration of Credit Suisse into UBS have occupied investors’ minds from mid- March going forward. Although markets have recovered since the March low, yield curves are likely to stay inverted for some time with moderate growth and high inflation readings. Such an environment breeds uncertainty, which is also reflected in the Interest Rate Volatility MOVE Index. This is showing an unusually high level of volatility outside a recession.
Investors must look beyond traditional investments
In this environment, it is advisable to act in a considerate manner without losing sight of long-term goals. Lower-risk investment options outside the scope of traditional investments – such as hedge funds and private equity – can be a good choice for stabilizing your portfolio. After all, despite a challenging financial market environment, investors looking beyond traditional investments have found rewarding opportunities. For example, global macro strategies, which achieved 14.8%1 in 2022 as the best-performing hedge fund strategies, brought a smile to investors’ faces. While specific strategies shine brightly in certain market environments, diversified hedge fund and private equity investments can have a positive effect on a portfolio in the long run.
Footnote: 1) HFRI 500 Macro Index with outperformance in 2022. Link (( https://www.hfr.com/news/hfri-500-macro-gains-in-december-leads-industry-to-record-outperformance-in-2022 ))
Hedge funds and private equity as valuable sources of return
There are several reasons why alternative investments can have a positive effect on portfolios. Hedge funds and private equity enable investors to tap into new sources of return and thereby facilitate the wider diversification and reduction of overall portfolio risk. This latter attribute is possible because alternative investments are often influenced by different market parameters to those of traditional investments such as equities and bonds. As a result, alternative investments typically exhibit low correlations with traditional investments, which is beneficial from a portfolio diversification perspective. Such diversification advantages are particularly relevant in today’s market environment where bonds and equities are increasingly converging.
Based on these observations, it is not surprising that institutional investors have been interested in alternative types of investment for many years. Swiss pension funds, for example, have overhauled their traditional investment mixes and are increasingly investing in private equity and hedge funds. This has had a positive impact on their performance, especially in challenging years like 2022 when everyone was searching for returns.
Trend toward higher share of alternative investments in investment portfolios
Despite some differences regarding investment behavior between pension funds and private investors, there are many similarities. These include the trend toward more alternative investments in portfolios. The alternative investment market, which was previously accessible mainly to institutional investors, has been opened up to private investors thanks to new product structures that are accessible with lower minimum investments.
Credit Suisse experts recommend investing up to 17% in alternative investments, with the allocation depending on factors such as the size of the portfolio, the client’s risk appetite, and liquidity restrictions. Even though the outlook on bonds going forward is more positive, fixed income together with more volatile equities will have a hard time achieving individual performance expectations. Given this situation, opportunities may exist to reach the overall return expectations of portfolios when investing in private markets and hedge funds.
Importance of stock selection for alternative investments
Private equity and hedge funds are much less easily traded than traditional investments, which means investors are tied in for longer. Such investments are either open-ended or closed-ended. In other words, they can either be sold within a few months or the investor is bound to them for several years. It is essential to weigh up this factor prior to any investment decision. But the illiquidity of certain alternative investments is also what gives investors potential added value: Assuming that investors should logically prefer liquid to illiquid investments, an investor should only be willing to accept the liquidity risk if it is offset by an additional return, i.e. a so-called illiquidity premium. Furthermore, a number of alternative strategies often have a higher risk profile than traditional investments due to their lower liquidity, the possible use of leverage and derivatives, and other factors.
Every investor should be aware that there is a wide spectrum of different risk levels in the area of alternative investments. Just as in the world of traditional investments, there are strategies that are more stable and those that are riskier, strategies that move together with equities or bonds, and those that move more independently. Distinctions therefore have to be made as, for example, one hedge fund may be very unlike another, and even private equity funds exhibit a wide range of different strategies and risk levels. Alternative investments for a portfolio should be selected with extreme care.
Neither historical nor future performance indications and financial market scenarios are reliable indicators of current or future performance. Historical performance indications and financial market scenarios are not reliable indicators of future performance.