The writer is founder and head of the investment department at AQR Capital Management
My colleagues and I have been saying for years that traditional portfolios are expensive and therefore face potentially low returns in the long run. Indeed, the expected returns of such portfolios with 60 per cent of the money in stocks and 40 per cent in bonds seem to be hovering around the lowest ever.
However, our predictions didn’t pan out – until recently (honestly, we would have preferred it never to happen, we’d like the markets to go up too). But this is not surprising, because the long-term forecast is not only about the timing of the market in the short term.
Stocks, bonds and a host of other asset classes have struggled this year amid persistent inflation, hawkish central bank responses, geopolitical turmoil and recession fears. And much of this has come from a reversal of low and seemingly always-low real interest rates that have kept markets elevated. The bright side, as some might hope, is that after all we’ve seen this year, the markets may be too finally Be cheap.
Unfortunately, they are not. Yes, the markets aren’t as expensive as they were at the beginning of the year, but a few months of cheapness after a decade or more getting rich is a small drop in a terribly big bucket. We still live head-on in a world of low expected long-term returns for most conventional investments.
What’s the solution? Something investors likely already knew, but probably gave up during an exceptionally long bull market: diversification. But when it comes to diversification, we must be careful. Just because something looks different doesn’t mean it’s diverse, and just because something is called “alternative” doesn’t mean it’s not essentially the same thing (private property is still equity, for example).
The alternatives industry, while a diverse group, can roughly be categorized as 1) strategies where most of the return depends on exposure to market factors such as private equity and private credit and 2) strategies in which returns are often unrelated to the overall performance of capital markets such as some hedge funds Macro and neutral stock market strategies and managed futures.
The first, private, has seen explosive growth over the past decade – not surprising given that these strategies, by and large, have generated very strong returns. but why? No doubt many of these managers are skilled, but the historically strong environment for stocks and bonds also helped. Any strategy with returns that are economically related to the markets should He does well when the markets are doing well, especially if the stakes are raised.
The private sector has also benefited from reported volatility that often greatly reduces the risk of actual assets – something I (bronly) have called ‘volatility laundering’.
This risk reduction has been so successful in attracting investors that it may have turned the typical illiquidity premium (increased return from wanting to own illiquid assets) into a headwind. In fact, the lack of liquidity has become a feature that you will pay for, not a bug that you may need to make up for. However, a long-term low return environment for stocks cannot be hidden from forever.
In comparison, the second type of substitution did not have the same tailwind. If anything, a strong trailing hold of stocks and bonds has led many to it scale down Its exposure to really diverse investment types due to disappointing relative returns (unfair comparison, but that doesn’t mean it doesn’t happen). It seems that we collectively learn these lessons and get rid of them in a painful cyclical fashion.
Now, back to the day. The markets still offer much less than usual, and the first type of alternative is in the same boat. Frankly, many of the strategies that have posted above-average returns over the past decade are likely to underperform over the next decade.
However, this is not the case for the second type of alternative. Since they are primarily trying to generate returns regardless of market direction, these strategies may prove to be the most valuable in the next decade. Given that these are our strategies, we argue here with clear self-interest. But I would like to point out that market-neutral strategies that buy cheap and short expensive stocks are actually at record levels of licenses. Another shout out for self-serve should go to managed futures, which often lag when beta — or follow the market — is king but then shine when they aren’t (as in 2022).
The current environment provides plenty of short and long-term reasons for diversification. When investors are looking for alternatives, just make sure it’s actually an alternative.