Equity-bond correlations rising
Increasing geopolitical tension and inflation have pushed the correlation between equities and bonds close to an all-time high. Correlations between stocks and bonds edged into positive territory in 2021 and jumped up to 0.58 for the full year in both 2022 and 2023, according to Morningstar*. To compound matters, higher inflation usually leads to closer links between stocks and bonds, reducing the benefit of constructing portfolios composed exclusively around these two asset classes.
Could diversification towards alternative investments be the key to creating portfolios that can generate better long-term risk adjusted returns?
The only free lunch
‘The only free lunch available in the world of investment right now is diversification. We believe that it is the best way to build high-performing portfolios while reducing portfolio risk,’ said Kunal Shah, managing director and head of private asset research and model portfolios.
‘Rising inflation, the war in Ukraine, and forthcoming elections mean that equity-bond correlations are closer than ever. That’s why investors need to look away from purely traditional asset classes towards diversification. That’s why we get so excited about alternative investments. Diversification is very important, and alternatives can be a helpful tool for achieving that.’
As long as the outlook for inflation and interest rates remains uncertain, the correlation between stocks and bonds will probably remain higher than in the past. So, what alternative instruments specifically could advisors look to with an eye to generating returns for clients? Private equity, private credit, and real estate are three potential contenders. Alternatives tend to be more illiquid than traditional asset classes, which means that the investor mindset here needs to be different – specifically, holding these as part of a long-term strategic asset allocation plan is the best way to harness the total value that this asset class can create.
Zooming in on private assets
‘Compared to your traditional asset classes, private equity or private credit have really outperformed. Let’s take private equity as an example here. Analysis done in 2020 by Professor Steven Kaplan of the University of Chicago Booth School of Business showed that buyout fund performance – one of the sub-categories of private equity – has been remarkably good. Kaplan’s analysis showed that every vintage year since 1992 had outperformed the S&P 500 and that outperformance had been roughly 5% per year over a long period of timei,’ Shah said.
Part of this outperformance is likely due to the long-term horizon of a private equity holding, which allows managers to focus on unlocking value, Shah added.
‘As an investor you have the ability to own a company and be an influencing or a controlling shareholder of that company. When you are in that position, you’re likely to make investment decisions of long-term nature.’
‘In contrast, if you are a shareholder of a publicly listed company, you don’t really have a voice since most shareholders are passive investors. This long-term nature of private equity changes the way an investor reacts to change. In private equity, investors really focus on the fundamental value of the company. We believe that public markets are far more sentiment-driven while private markets are far more fundamental in terms of how companies are valued and how they are priced.’
Bringing alts onto the RIA desktop
But while alts can make sense as part of a diversified portfolio, RIAs cite several challenges when it comes to selecting, implementing, monitoring and reporting on alts portfolios.
As a leading financial technology company, iCapital was created specifically to power the alternative investment marketplace with its end-to-end lifecycle operating system.
‘iCapital was designed around the financial advisor. We sought to meet the advisor where they were, looking to make it easy to transact across structured investments, alternative investments, and annuities – minimal interruption to the tools and systems they use to manage the rest of their business,’ said Binoy Talati, managing director for enterprise RIAs at iCapital.
‘We think of iCapital as the global operating system for advisors doing business in products that are not exchange-traded. Over the past 10 years, the firm has continued to add incremental tools and services to help advisors do their jobs even better. For instance, Architect is a recent innovation that enables advisors to seamlessly analyze and integrate alternatives and structured investments, offering the potential for enhanced return and income opportunities to achieve better client outcomes more efficiently.
At the service of RIAs
But not all alternative strategies are created equal – and crucially, they don’t deliver equal performance. This is where in-depth research and data intelligence become important. With an arguable ‘over choice’ of products, advisors report that they can find it difficult to differentiate between the managers that are available in the marketplace. So, what is the best way for investors to evaluate and compare managers?
‘Advisors often ask to sit with our research team at iCapital to get their viewpoint. They intuitively know that not all managers are created equal, but you need to spend the time understanding those differences and know where to look. Our advisors expect us to be more objective given the broad platform we represent’ said James Costabile, managing director for alternatives distribution at iCapital.
‘We seek to deliver more flexible technology with a lot of qualitative-oriented services. I’d say the crowning glory is our research team, whereas other firms may outsource. If you’re giving your homework to someone else to complete, how valuable can you be when it comes to providing insight on the client situation? We think that being able to speak intelligently about the products that we have and integrate that into discussions with our advisors is a big differentiator.’
* Morningstar’s The 2024 diversification landscape report
