6 minute read
Exploring alternative investments to improve yields and hedge inflation
Zainab Faisal Kufaishi Head of the Middle East and Africa and Senior Executive at Invesco looks at how Alternatives can be beneficial for investors during times of uncertainty
It took just one short year for the world to emerge from the grip of a pandemic into the clutches of historic inflation and a sudden surge in interest rates. As post-COVID supply chains reconnected between March 2021 and May 2022, OECD consumer prices soared by 9.6%—the biggest and fastest annual jump in more than 30 years1. Now, with the economies of most developed nations entering double-digit inflation, investors are quickly reconsidering their macro assumptions, applying them to new investment strategies as they look for more lucrative returns and higher yield from their portfolios.
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Consequently, the traditional 60/40 asset allocation model of equities/ fixed income, which many investors had relied on for its stable growth and steady income over the long-term, is being challenged. At a high level, 60/40 portfolios have declined by roughly 17% over the first six months of 20222 , and so, with long-term return expectations on the decline in equity and bond markets amid surging inflation and rising interest rates, asset owners are exploring how the alternative asset class can support their long-term investment goals and enhance growth, diversify holdings, and generate income. Alternative and private market investments may involve more risk, however that is defined, but can help meet long-term objectives.
Alternatives are a broad asset class with a growing spectrum of outcome possibilities. The alternative space covers many different types of assets —including private equity, private debt, infrastructure, hedge funds and real estate—each with its own distinct drivers of risk and return. The unique characteristics of alternative assets allow the investments to behave differently than traditional equity, fixed income and cash investments due to their non-correlative nature to broad market trends. In addition, these assets may offer an illiquidity premium, generating additional return potential that compensates for the longer holding periods. The multifarious nature of the alternative asset class gives investors flexibility during times of high volatility and unfavorable environments, allowing them to manage investment outcomes in a more robust fashion.
For Middle Eastern investors, surging global inflation over the last year prompted investors to reassess asset allocations with private markets coming out as the beneficiary. Notwithstanding concerns about deal flow and crowded markets, regional investors turn to alternatives as the class has been a good shelter from volatility over the long-term.
At the heart of many investors’ alternative strategies is real estate, which despite soaring construction costs and raw materials supply chain problems, is providing many investors with a hedge against inflation due to its return components of income and appreciation. In fact, rising construction costs might limit new supply from entering the market, potentially benefiting owners of existing real estate.
Zainab Faisal Kufaishi, Head of the Middle East and Africa and Senior Executive, Invesco
Real estate’s appeal comes not only from its low correlation to other asset classes but also because as inflation increases, the correlation of private real estate to inflation tends to strengthen. Real estate’s inflation hedge derives from revenue streams that can quickly adjust in an inflationary environment due to lease terms and structures. Different property sectors – retail, offices, industrial parks, residential and self-storage - have different characteristics, so rent increases used to offset inflation could vary in magnitude and timing as the result of the distinct lease structures.
Sovereign wealth funds are among the largest investors in alternatives, with allocations to private equity, infrastructure, as well as real estate rapidly increasing over the past ten years, standing at $719 billion at the end of 2020, up from $205 billion in 20113. The growth of alternatives – a market expected to reach $14 trillion by 20234 – shows that the broader investor community is transitioning from a traditional 60/40 allocation and looking to alternatives to hedge some of the macroeconomic risks facing their portfolios.
This transition has also seen investors turn to private debt, as alternative credit may provide outperformance during periods of rising interest rates due to structural advantages over traditional, long-duration fixed income. For example, senior loans, which typically have a short duration, pay interest based on floating rate coupons and in this way benefit from rising interest rates. Senior loans are secured via a lien against the borrower’s assets which means that holders are the first ones to be paid in a bankruptcy situation – a consideration for investors balancing their portfolio risk.
The lower duration of senior loans combined with higher yields may make them an attractive option. A historical analysis of periods of rising rates since 1993 showed that senior loans performed well5. Should interest rates continue to rise, loans could be well positioned to outperform longer-duration credit and treasuries. Much like real assets, loans mitigate risk and may deliver greater long-term stability – factors that are also driving change in how another large
investor segment - insurers - approach their alternatives exposure.
Surging inflation and geopolitical uncertainties present insurers with new investment risks. While many are already investing in alternative investments, insurers are looking to increase their allocations, as alternative asset classes often have inflation riders built-in which can help protect them against these new risks. Lease contracts, for example, may have a rider that increases the income stream from a building as inflation rises, which helps insurers better manage the impact of inflation.
For all investors, it is vital to understand the characteristics of specific alternative asset classes and not consider alternatives as a standalone portion of their portfolio. Looking more closely at the specific drivers of risk and return helps investors to align holdings with desired outcomes. Real estate is especially attractive to most because of its positive link to inflation, whereas private debt is attractive because of its inherent credit risk mitigation mechanisms. Private market assets can often generate additional returns through the value added by
skilled management, as owners have greater control over their companies in navigating volatile markets.
Higher-than-average inflation and a series of interest rate hikes warrant building a portfolio that can sustain nominal returns in a challenging and uncertain market environment. Invesco’s Investment Solutions team conducted an analysis6 that added a small portion of alternative assets to a traditional portfolio to show that diversification towards alternatives can improve outcomes. The analysis looked at the potential impact of a 55/25/20 allocation and showed that optimizing a portfolio by redistributing just 20% of traditional fixed incomes and equities towards private credit, real estate, commodities and loans can improve yields with an optimized portfolio delivering 2.45% rather than 2.09%. The transition to an optimized portfolio could also increase the probability of outperformance during rising inflation and interest rates and reduce downside exposure in the event of a market sell-off.
1 OECD, July 2022. https://www.oecd.org/newsroom/consumer-prices-oecd-updated-5-july-2022.htm 2 Bloomberg, July 2022. 3 https://www.preqin.com/insights/research/blogs/swfs-in-alternatives-in-pursuit-of-higher-returns 4 “Alternatives in 2020,” Preqin, February 2020. 5 Credit Suisse, Bloomberg and FTSE analysis, data as of December 31, 2021. 6 Invesco Vision, hypothetical scenarios produced by MSCI Barra, as of Dec. 31, 2021
