Strategy note

Embrace alternatives or potentially be left behind

A new strategy note from Chief Market Strategist Troy Gayeski

Troy A. Gayeski
April 25, 2024 | 7 minute read

As the powerful “everything-rally” from November last year through March of this year (well, everything other than bonds of course) turns back into a sloppy, choppy mess, let’s examine what’s now driving this period of market volatility.

The economy continues to grow

The U.S. economy is in even greater shape than we imagined when we first came up with the Dare to Dream thesis (the Fed hikes as much as possible and keeps rates high for as long as possible without cratering the U.S. economy).

Despite the recent slightly below expectations Q1 GDP report, the American consumer is still strong, courtesy of a still warm-to-red-hot labor market, with only subtle cracks showing in the lower income cohorts. And every other gross domestic product (GDP) contributor is in good shape: Business fixed investment, construction, residential housing, state and local government spending—and now even manufacturing—have come back. So, for all the duration1/bond permabulls out there, give up praying for a recession. It’s not happening anytime soon.

In fact, at this stage of the cycle, other than an endogenous or exogenous market shock, it is hard to see what negative force would be powerful enough to crack the labor market to the point where the U.S. economy rolls over into a recession. Remember, the economy is like an aircraft carrier or a ginormous cruise ship—it takes a tremendous amount of force to turn it meaningfully away from steady state growth, up or down.

Markets respond to stubborn inflation

This, of course, leads us to the problem that inflation has surged again, particularly service inflation excluding energy services and rent (the Fed’s favorite “supercore” measure), and owner equivalent rent (cost of a home, basically inclusive of expenses like insurance for instance).  

This has led to another bout of higher interest rates and little hope for the Fed to cut rates anytime soon (isn’t it funny that bond markets were pricing in six rate cuts this year as recently as eight weeks ago)!

Which is why markets are going through a mini repeat of the August to October 60/40 correction. Equity markets could ignore the first leg higher in rates, but eventually, at a recent peak multiple of 21X and with the 10-year Treasury yield north of 4.5%, the equity markets cracked.

And of course, in bonds/duration, it’s once again all about pain (sort of like the last three to five years…what else is new) with the Bloomberg Aggregate Bond Index (BAGG) down another 2% year to date (YTD). The great 40-year bond bull market is now a distant memory now.

Stronger for longer, higher for longer

The stronger for longer (growth), higher for longer (interest rates) economic regime is supportive of floating rate2 private lending—whether the strategy is focused on real estate, middle market corporations or other asset-based loans. Stronger for longer, higher for longer is also constructive for middle market private equity, where the biggest risk to positive outcomes is a nasty, deep recession where EBITDA and earnings growth falls under expected targets.

How do you navigate the current environment?

This brings us to the core question of this strategy note and the current decisions facing investors and financial advisors looking to navigate this environment.

  • Manage risk: How do you balance greed and fear to make thoughtful portfolio changes?
  • Deploy cash: How do you put massive cash hoards to work to meaningfully increase return, without taking uncomfortable levels of risk? Even after recent, substantial tax payments (tax bracket creep driven by inflation is painful indeed), there is still $4 trillion more in commercial banks deposits and $2.5 trillion more in money markets funds than pre-pandemic.
  • Grow your business: How do you grow your business as an advisor and best serve your clients in a highly competitive marketplace for financial services?

Nothing sells like differentiated performance

How do you tackle these questions? Let’s start with my simple philosophy for investment strategy success: Performance sells, but nothing sells like differentiated performance. I’ll say it again, performance sells, but nothing sells like differentiated performance. This is obviously easy to say, but much more challenging to execute. However, that is the fundamental basis for the entire alternative investment asset class.

Generate attractive returns with low risk of loss, low volatility and low beta/duration/correlation.

Whether the strategy is middle market private equity (PE), private credit, or liquid multi-strategy funds, performance has been attractive for the last five years, but it is really the differentiation relative to equities, bonds and now cash that has driven improved investment outcomes and the growth in institutional and now individual investor assets under management.

Offering access to democratized structures

One can extrapolate the “performance sells, but nothing sells like differentiated performance” to wealth management practices.

If a financial advisor is only providing access and advice on easy-to-replicate liquid markets, where is the differentiation? If an advisor is not educating clients on thoughtful ways to put cash to work, where is the differentiation? However, if a financial advisor is also providing access to private market strategies in democratized structures like private equity regulated investment companies (RICs), perpetual business development companies (BDCs) or non-traded senior secured lending focused real estate investment trusts (REITs), there can be clear differentiation between the client outcome with their advice and without their advice.

And remember, you don’t have to be a hero—just a few thoughtful portfolio changes per year can potentially make all the difference.

Individual investors are embracing alternatives

I am sure most of you are aware that the differentiated performance of alternatives has driven the vast majority of large institutions to embrace alts in a big way for decades.

However, we are still in early innings for the adoption by individual investors. As Matt Wirz pointed out in his recent article for the Wall Street Journal, current estimates are that only 2% of wealthy individuals’ assets are invested in “true” alternatives—not counting listed REITs, master limited partnerships (MLPs), etc., which are typically highly volatile and have a very high correlation to equities—and by 2027, approximately 6% will be invested in alternatives.

Why are the growth prospects for further adoption so strong? I’ll say it again: Performance sells, but nothing sells like differentiated performance. 

Given these estimates, it is clear if you are in the wealth management business and are not focused on embracing alternatives within your portfolio allocation process, you risk getting left behind. And let’s face it, nobody wants to be the Polaroid of their industry.

If you are not armed with the most timely, thoughtful, democratized alternative strategies to compete, it is highly probable those client assets will flow away and your revenue stream along with them. If you are an investor and have not been given the opportunity to at least be educated on alternatives, maybe it’s time to reevaluate your current advisor or wealth management firm.

Why alts now? The opportunity cost of cash

Assuming you are already armed or soon to be armed with the potentially “right” alternatives, you still have to fight inertia to embrace them and fortunately there is more than ample reason to do so now; primarily, the opportunity cost of cash relative to a select group of alternative strategies, elevated equity valuations and continued turbulence in bond markets.

Major wealth management firms estimate approximately 20% of their account balances are now sitting in cash and cash equivalents, and while nobody is bashing cash, allocating to cash is hardly a value-added service—and certainly not differentiated at all in the current market environment. And in terms of performance? Nothing to write home about.

So, for what rational reason other than near-term liquidity needs would an investor or advisor not crush inertia and embrace alternative strategies that could meaningfully increase return potential without taking uncomfortable levels of risk?

It’s potentially a win/win/win.

Picking an asset management firm

The great news in the current market is that—in terms of balancing greed and fear, improving investment outcomes relative to cash and accessing areas of differentiated performance—there is a lot of opportunity. The most thoughtful alternative firms have democratized strategies like private equity, private credit, real estate lending and multi-strategy for (at the very minimum) wealthy individuals to access just like sovereign wealth funds.

The last point to discuss is that the trend in wealth management adoption and alternative growth has brought many Johnny-come-lately asset management firms to enter the space.

We wish them well.

However, we believe that investors and advisors are likely to be better served by firms that were founded on the mission to democratize alternatives, that have alternatives in their DNA and that are staffed with investment professionals whose entire careers have been focused on alternatives.

Conclusion: Don’t leave cash on the sidelines

So, embrace alternatives. Don’t get left behind. And even though the portfolio replacement or compliment use case always evolves, “The Time for the Right Alts is Still Now!”

Investing in alternatives is different than investing in traditional investments such as stocks and bonds. Alternatives tend to be illiquid and highly specialized. In the context of alternative investments, higher returns may be accompanied by increased risk and, like any investment, the possibility of an investment loss. Investments made in alternatives may be less liquid and harder to value than investments made in large, publicly traded corporations. When building a portfolio that includes alternative investments, financial professionals and their investors should first consider an individual’s financial objectives. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be determined.

  • Duration: A measure of a bond price’s sensitivity to changes in interest rates. Given the inverse relationship between bond yields and prices, a bond with a longer duration should theoretically experience a larger price decline when rates rise or increase than a bond with shorter duration.

  • Floating Rate: A floating interest rate is one that changes periodically; their interest rates adjust or “float” as market interest rates rise or fall. Therefore, their value tends to be less impacted by changing interest rates than traditional fixed rate investments such as investment grade and high yield corporate bonds.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Troy A. Gayeski, CFA

Chief Market Strategist

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