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The Holy Grail of Diversification

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Stockholm (HedgeNordic) – With inflation becoming omnipresent and geopolitical uncertainty rising due to the war in Ukraine, market participants witnessed a conundrum of consequences in the first quarter of 2022. The first quarter’s market environment characterised by rising interest rates – hence falling bond prices – and falling equity markets has – yet again – shown the fragility of the traditional balanced portfolio of 60/40 stocks and bonds. The objective of the bond component to act as a stabilizer to the equity allocation has not been fulfilled, again.

“The historical relationship between bonds and equities that so many portfolios rely on, namely a negative correlation between those two during times of crisis, failed,” says Christoph Junge, Head of Alternatives at Danish pension provider Velliv. “This, by the way, is not something new and has happened before,” he continues. “When looking at historical data, one could even argue that the negative correlation between bonds and equities during the last 20 years was the exception, not the rule.”

“The historical relationship between bonds and equities that so many portfolios rely on, namely a negative correlation between those two during times of crisis, failed.”

With the role of bonds as portfolio ballast frequently coming under pressure, alternative investments are increasingly becoming more mainstream as institutional investors seek ways to diversify their portfolios. “So which options does this leave investors to build robust portfolios?,” asks Junge. “More and more are turning towards alternative investments in the hope of the holy grail of portfolio diversification.”

“More and more are turning towards alternative investments in the hope of the holy grail of portfolio diversification.”

Velliv, one of the largest pension funds in Denmark, allocated DKK 22 billion to alternative investments at the end of 2021, up from DKK 18 billion at the end of 2020. The alternative basket, which accounts for about a tenth of Velliv’s assets under management, comprises investments in private equity, illiquid credit, real assets such as infrastructure and timber, as well as liquid alternatives. “Private equity and illiquid credit are the largest allocations in our alternative investments portfolio, followed by real assets (infrastructure and timber) and liquid alts,” Junge tells HedgeNordic.

The Multi-Faceted Roles

Although the use of alternative investments as a “risk diversifier” alternative to bonds has been increasing, alternatives play multi-faceted roles in a multi-asset portfolio. “The alternative investment universe is very heterogenous, so the various strategies or sub asset classes fulfil all their own purpose,” highlights Junge. “For us, private equity is all about higher returns than on public equity. The same for illiquid credit strategies.”

The illiquidity premium is seen as a key component in the long-term return investors can receive from private equity, private credit or other unlisted investments. However, Junge goes on to emphasize that investments in the unlisted corners of financial markets benefit more from earning a complexity risk premium rather than the illiquidity premium. “Not that I am a firm believer in an illiquidity premium, but there is more a complexity premium in these investments,” says Junge. “Where skills meet opaque and inefficient markets, magic happens.”

“Where skills meet opaque and inefficient markets, magic happens.”

Describing the role of the other alternatives in Velliv’s portfolio, Junge says that “infrastructure has – for us – the role of delivering stable returns and some kind of inflation hedge.” Hedge funds and other liquid alternative investments, meanwhile, act as portfolio diversifiers. “Some alternative investments provided much needed relief and diversification in the first quarter of 2022, and especially CTAs had a huge comeback with crisis alpha when it was the most needed,” according to Velliv’s Head of Alternatives.

“The defensive and inflation protection characteristics offered by some alternative asset classes are most attractive to investors.”

In the current market environment dominated by unabating inflationary pressures, gepolitical tensions, and financial market uncertainty, “the defensive and inflation protection characteristics offered by some alternative asset classes are most attractive to investors,” according to Junge. However, the most wanted characteristics alternatives can offer are “very much dependent on the market regime, the asset class, and last but not least, the individual investors’ goals.”

On-Ramps for Alternatives

In the past, institutional investors had to build their own infrastructure and teams to be able to access alternative asset classes. Co-investment opportunities have served as more unique, lower-cost ways to access the alternative investments space. “In alternative investments, we are only going the indirect way and have also teamed up with partners to make co-investments in private equity,” he emphasizes. “It would be too resource-intensive to run it in-house at the moment.”

“The advantages of fund investments are better diversification, access to high quality teams and, of course, access to co-investment deal flow,” considers Junge. The disadvantages of fund investments, however, are the associated costs and the J-curve. “Co-investments are much cheaper, even when externally managed, but increase the concentration risk when the company is both in the primary fund and the co-invest vehicle,” continues Junge. “In addition, co-investments typically allow for quicker ramp up and less J-curve.”

Rising Bond Yields – Inflection Point for Alts?

As bond yields have started climbing with expectations of them rising even higher in the coming months, some institutional investors started seeing investment grade bonds attractive again – thereby skimming off some investor interest in alternatives. “My expectation is that investors who have embraced alternatives won’t stop just because rates are higher now,” considers Junge. “They have built up the resources and knowledge and as alternatives hopefully still offer a premium over risk free rates (or risky but liquid rates for that matter) and have other interesting portfolio characteristics, there are still reasons to invest in alternatives,” he elaborates. “But maybe there will be fewer new entrants to the market?!”

“My expectation is that investors who have embraced alternatives won’t stop just because rates are higher now.”

On the question of which alternative asset classes are best positioned for the current market environment, Junge says “it really depends on how the future unfolds.” According to Velliv’s Head of Alternatives, “if we just see a rise in nominal yields, but flat or falling real yields, those asset classes that profit from inflation could benefit, like certain parts of the infrastructure space or parts of the credit space that are of floating rate nature.” He goes on to emphasize that “credit could suffer if rates rise too much, leading to an increase in defaults.”

“A substantial increase in real yields would most likely lead to losses on many of the alternative and traditional asset classes. In this scenario, I would only expect certain types of hedge funds to be able to perform.”

“If we, on the other hand, see a substantial rise in real yields, there is not much shelter from any asset class that is long-only,” considers Junge. “Like in the listed markets, certain areas of the alternative asset classes have reached frothy valuation levels,” he adds. “A substantial increase in real yields would most likely lead to losses on many of the alternative and traditional asset classes. In this scenario, I would only expect certain types of hedge funds to be able to perform.”

 

This article features in HedgeNordic’s “Private Markets” publication.

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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