The Year of High Hurdle Rates and Lower Potential Returns
(and What To Do About It)
After a blockbuster and eventful 2021, we expect 2022 to be a little slower, both in terms of growth and market returns, but potentially equally as eventful. COVID-19 will likely still be with us. We should, however, increasingly move to a new normal, given the expanded medical toolkit now available to manage new variants and regional flare-ups, even while those may lead to occasional travel restrictions. We anticipate economic growth will slow and inflation will remain high in 2022. In this environment, investors will have a higher hurdle rate to achieve inflation-beating returns. For those looking to still achieve growth and realize returns that are above the inflation rate in 2022, we think there are six key investment opportunities to consider.
STRATEGIES FOR POTENTIAL HYPERGROWTH
Investments experiencing hypergrowth may deliver returns above today’s high hurdle rates
Given high inflation and expected rate increases, diversified investors will need exceptional returns from their growth allocations. Investments experiencing hypergrowth have the potential to deliver returns well in excess of today’s high hurdle rate. Following are two ideas on where investors may find that hypergrowth.
Venture capital could continue to outperform private and public markets
Venture capital (VC) had a blockbuster year in 2021, and we expect the interest in VC will continue throughout 2022. At more than $2 trillion, venture capital assets constitute half of the private equity assets under management.1 VC fundraising growth outpaced private equity in 2021. It is clear that investors’ interest continues to be on finding the next Google, Moderna, or Tesla earlier in their lifecycle. Still, there is a wide dispersion of returns among VC fund managers. For investors in VC, getting manager selection right is crucial.
In the crypto ecosystem, all eyes are on DApps
Cryptocurrencies, tokenization, and decentralized finance (DeFi) applications — collectively known as the crypto ecosystem – can provide additional sources of hypergrowth. Through the first half of 2021, the number of crypto users globally doubled to more than 200 million.2 If user growth continues at this rate, the adoption of crypto will outpace the explosive adoption rate of the internet back in the 1990s.3 At the same time, the global value add from blockchain technology is expected to reach $1.76 trillion by 2030, as businesses increasingly shift toward more digital ways of working, communicating, and transacting with customers.4
“In this environment, a traditional 60/40 portfolio could return 5.2%,5 barely enough to overcome the expected inflation rate of close to 4%.”
INFLATION AND RATE SHOCK ABSORBERS
A challenging year for traditional income investments
The anticipated interest rate hikes in 2022 would not bode well for fixed income. The two-year rate is expected to rise by 39 basis points (bps) to 1.12%, and the 10-year rate is likely to rise by 53 bps to 2.04% by year-end 2022.7 This likelihood means that the Barclays Capital Aggregate Bond Index, which was down 1.54% in 2021 in terms of total return, could be poised to have another downbeat year.
Still, we think there are a number of ways to position portfolios for an upside in short-term and long-term yields in an environment of continued above-trend inflation.
Private credit is well positioned for the anticipated market environment
Private credit continues to cement itself as a fast-growing asset class, well positioned for both the current and anticipated market environment. Private credit assets under management have expanded to $1 trillion and continue to edge closer in size to the $1.6-trillion U.S. high yield market.8 Amid a 2022 backdrop of rising short-term rates as the Fed prepares to hike rates, we see private credit, specifically middle market direct-lending strategies, offering a significant buffer over publicly traded high yield or leveraged loans.
Real assets historically do well in periods of rising rates
In 2022, we see real assets offering an attractive return profile given their favorable valuations, strong income streams, and hedging abilities amid an inflationary and rising-rate backdrop. Real estate, infrastructure, farmland, and natural resources have historically performed favorably in inflationary environments and have excelled when prices of goods and services have risen rapidly. We particularly see opportunities in the commercial real estate segment.
16% to 17%
U.S. real estate’s average historical annualized returns during periods of high inflation (>2.5%) 9
Hedge fund arbitrage strategies thrive amid volatility
Every asset class offers two fundamentally basic approaches to generate returns: directionally or relatively. While the vast majority of funds in public and private markets invest directionally, others use relative value or arbitrage strategies to drive performance. In the same way that directional strategies need rising asset prices to drive returns, arbitrage strategies similarly need certain market conditions to thrive. The two primary factors are volume (i.e., new issuance) and velocity (i.e., market volatility). With increasing volume and velocity across asset classes globally, arbitrage strategies will likely provide strong risk-adjusted performance for clients in 2022.
Earn extra yield by using options to monetize elevated volatility
While rates are likely to rise in 2022, for investors looking to earn a reasonable level of current income, rates are still not going to be high enough. Beyond real assets and private credit, investors may also look to the options market for additional income opportunities. Investors may sell a put option or a call option and collect a premium. Implied volatility is one of the biggest determinants of how cheap or expensive the options premium will be. What makes selling options attractive today is that, despite a reset to lower volatility throughout 2021, volatility levels are still elevated, relative to their pre-pandemic levels.
(1) Source: PitchBook, Q3 2021.
(2) Source: Coinbase, World Bank, Crypto.com, as of September 30, 2021.
(3) Source: Coinbase, World Bank, Crypto.com, as of September 30, 2021.
(4) Source: PwC, Time for trust: The trillion-dollar reason to rethink blockchain, October 2020.
(5) Source: Bloomberg, as of December 31, 2021. Note: 60/40 portfolio is comprised of 60% S&P 500 and 40% Bloomberg Aggregate Bond Index with 2022 expected returns of 10% for the S&P 500 and -2% for the Bloomberg Agg.
(6) Factset, as of December 30, 2021.
(7) Source: Bloomberg, as of December 31, 2021.
(8) Source: PitchBook, Bloomberg as of December 1, 2021. Note: $1.6 trillion represents the size/market value of the Bloomberg Barclays US Corporate High Yield Bond Index.
(9) Source: BlackRock, Inflation & Real Assets, 2021.
IMPORTANT INFORMATION
The material herein has been provided to you for informational purposes only by Institutional Capital Network, Inc. (“iCapital Network”) or one of its affiliates (iCapital Network together with its affiliates, “iCapital”). This material is the property of iCapital and may not be shared without the written permission of iCapital. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of iCapital.
This material is provided for informational purposes only and is not intended as, and may not be relied on in any manner as, legal, tax or investment advice, a recommendation, or as an offer or solicitation to buy or sell any security, financial product or instrument, or otherwise to participate in any particular trading strategy. This material does not intend to address the financial objectives, situation, or specific needs of any individual investor. You should consult your personal accounting, tax and legal advisors to understand the implications of any investment specific to your personal financial situation.
ALTERNATIVE INVESTMENTS ARE CONSIDERED COMPLEX PRODUCTS AND MAY NOT BE SUITABLE FOR ALL INVESTORS. Prospective investors should be aware that an investment in an alternative investment is speculative and involves a high degree of risk. Alternative Investments often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; can be highly illiquid; may not be required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; and often charge high fees. There is no guarantee that an alternative investment will implement its investment strategy and/or achieve its objectives, generate profits, or avoid loss. An investment should only be considered by sophisticated investors who can afford to lose all or a substantial amount of their investment.
iCapital Markets LLC operates a platform that makes available financial products to financial professionals. In operating this platform, iCapital Markets LLC generally earns revenue based on the volume of transactions that take place in these products and would benefit by an increase in sales for these products.
The information contained herein is an opinion only, as of the date indicated, and should not be relied upon as the only important information available. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. The information contained herein is subject to change, incomplete, and may include information and/or data obtained from third party sources that iCapital believes, but does not guarantee, to be accurate. iCapital considers this third-party data reliable, but does not represent that it is accurate, complete and/or up to date, and it should not be relied on as such. iCapital makes no representation as to the accuracy or completeness of this material and accepts no liability for losses arising from the use of the material presented. No representation or warranty is made by iCapital as to the reasonableness or completeness of such forward-looking statements or to any other financial information contained herein.
Securities products and services are offered by iCapital Markets, an SEC-registered broker-dealer, member FINRA and SIPC, and an affiliate of iCapital, Inc. and Institutional Capital Network, Inc. These registrations and memberships in no way imply that the SEC, FINRA, or SIPC have endorsed any of the entities, products, or services discussed herein. Annuities and insurance services are provided by iCapital Annuities and Insurance Services LLC, an affiliate of iCapital, Inc. “iCapital” and “iCapital Network” are registered trademarks of Institutional Capital Network, Inc. Additional information is available upon request.
©2024 Institutional Capital Network, Inc. All Rights Reserved. | 2024.01
