At This Critical Point, Choose Your Own Portfolio Construction Adventure

If you grew up in the 1980s or 1990s, you probably remember the Choose Your Own Adventure series, where, as the reader, you would step into the shoes of the main character.

Choose one path and you’d find yourself surrounded by carnivorous dinosaurs. Choose the other and you might be trapped aboard an alien spaceship.

In January, the annual inflation rate for the United States was the highest it has been since 1982. Because many of us in the industry were kids devouring Choose Your Own Adventure books during the last such environment, it’s a significant milestone: For the first time, we’ll have to manage assets in an environment that includes record inflation, high valuations and an inverting yield curve.

What does all this mean? That we’re at a critical decision point in our “portfolio construction” adventure. For advisors looking to utilize alternatives, there are two paths:

Choice #1: Incorporate alternatives that are considered return enhancers.

Those who choose this path want to outpace inflation by incorporating an option like private equity or real assets into their portfolios.

Real estate investment trusts (REITs) as an asset class has been a strong performer in 2021 and 2022 through April and rents can escalate quickly with multifamily investments. Thanks to its macro tail winds, infrastructure could improve revenue numbers faster than cap rate expansion, resulting in total returns that exceed inflation.

Private equity is also a good choice as it tends to outperform when public markets falter. According to iCapital, six months around an initial rate hike, stock returns are on average flat to slightly negative, and 12 months after the first hike only see modest gains of 3%-6%.

Meanwhile, when public markets returned between -5% and 5%, all private equity funds outperformed the public index by 6.5% to 8.2%!

Many investors may choose to outpace inflation as well as returns of traditional asset classes by incorporating return-enhancing alternatives into their portfolios. If current valuations are a concern, perhaps choice #2 is more attractive…

Choice #2: Hunker down and manage volatility.

Since the beginning of the last bull market a decade ago, hedge strategies have struggled to achieve market returns. But with a 60/40 equity/fixed income asset allocation strategy and duration-sensitive bonds losing nearly 10% in the first quarter of 2022, advisors may be seeking alternatives.

Within this choice, there are number of options that haven’t been as attractive in recent years as they are today. Advisors may choose to look at the hedged strategy space for the first time in years. Strategies like market neutral or long-short equity are also options, aiming to isolate factors that are not correlated to inflation or rising interest rates.

Turning to private markets once again, private credit is a space that many investors find comfortable. While investments can range in credit quality, it’s possible to find senior secured investments. Often, these have underlying notes that are variable in nature and carry inherit protection against interest rate increases.

Advisors must understand the nuances of these investments, such as underlying leverage and where an investment stands in the capital stack. Being over-leveraged or allocated too heavily to subordinate debt could lead to exposure with undesired idiosyncratic risk characteristics.

Unlike in the Choose Your Own Adventure books, advisors and clients also can choose to blend several strategies to take an objective/risk replacement approach, especially if they’re underweighted to alternatives. As we head into this new adventure of weaker bonds and equities, more diversification could be your best path to choose.

Josh Vail, CAIA, is managing director of Hamilton Lane.