Alternatives can serve as a cornerstone of resilient portfolios but their success depends on thoughtful integration
December 2024
This article appeared in the Business Post on December 29th.
For decades, the 60-40 (stock-bond) portfolio reigned supreme. Stocks provided growth in good times, while bonds acted as a cushion during downturns. But in 2022, it suffered its worst performance in decades, forcing investors to rethink everything about asset allocation.
Today we are witnessing a paradigm shift in asset allocation – the rise of alternative investments. Many investors and wealth managers are moving towards allocations like 50-30-20 or 40-30-30, where alternatives play a significant role alongside traditional assets.
But while the growing acceptance of alternatives is welcome, debating whether alternatives should make up 20 per cent or 30 per cent of a portfolio misses the larger point: the type of alternatives matters more than the exact allocation.
A broad church
The term alternative investments encompasses a diverse range of assets, from private equity, private credit and venture capital to hedge funds, cryptocurrencies and even collectables. Interest in the space has soared in recent years and BlackRock predicts assets in private markets alone (which excludes hedge funds) will rise to $20 trillion (€19.21 trn) by 2030.
A diverse set of circumstances has driven this shift. After early adopters of alternatives, such as David Swenson at Yale University endowment, had success, other institutional investors began to replicate the Yale (alternatives heavy) model.
Following the Global Financial Crisis, stricter regulations reduced bank lending, allowing firms like Blackstone and KKR to expand private credit. The combination of ultra-low interest rates and steadily rising asset prices in the 2010s also provided a perfect environment for the leveraged asset purchases of private equity. The strong returns achieved fuelled even more interest.
Although the 60-40 portfolio also performed well in the 2010s, Covid-19 exposed the cracks in the model. The pandemic triggered supply chain disruptions, inflation surged and central banks tightened monetary policy. Both stocks and bonds fell in 2022, producing the worst year for the 60-40 in decades.
Fast forward to today and with alternatives more accessible than ever it is not surprising that they might constitute 20 per cent to 30 per cent of the portfolio.
Very often the case for alternatives rests on a desire for diversification – not having all your eggs in one basket. However, alternatives are not all created equally. Some aim to enhance returns, others to provide diversification and protection in tough times. Ideally, you want exposure to different baskets rather than different eggs in the one basket.
While private equity may be able to generate higher returns by being patient and locking up capital for years – capturing what is called the ‘illiquidity premium’ – its underlying risk is still tied to the broader economy, just like public equities. The same applies to venture capital and even private credit to an extent. Such assets are best seen as growth enhancers.
Bitcoin, often called ‘digital gold’, dropped 75 per cent in 2021-22, failing to provide any diversification value when traditional markets struggled.
As we saw in the global financial crisis, in a severe downturn, asset liquidation, sometimes driven by deleveraging, can weigh on all types of markets.
In contrast, certain hedge fund strategies – because of their flexibility in trading rather than owning assets – can generate returns when traditional markets decline. Global macro and systematic trend-following funds, which take long or short positions across commodities and currencies as well as bonds and equities, performed well in 2022.
The challenge with hedge funds is that sometimes investors can lose patience when they lag equities in a year like 2024 when the S&P 500 is up close to 30 per cent.
Looking ahead
In 2025, markets face divergent trends. Economic growth is solid in the US but weak in China and Europe. Although there is optimism about the new US administration, there are risks to growth from potential tariffs and concerns about persistently high fiscal deficits.
Equity valuations are stretched, the high level of concentration in the Magnificent 7 is a concern and sentiment (often a contrary indicator) seems very optimistic. Should public equities take a hit at some point private markets would be unlikely to be immune from some adjustment.
Taking it all together it seems reasonable to plan for growth but prepare for volatility.
As investors navigate an uncertain future, alternatives can serve as a cornerstone of resilient portfolios. But their success depends on thoughtful integration — balancing growth ambitions with a need for true diversification.
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