TOL - 22nd Jun, 2022
Why Morgan Stanley doubled its allocation to Alternatives
To launch Livewire's Alternatives Series, we reached out to Alexandre Ventelon, Head of Research and Investment Strategy for Morgan Stanley Wealth Management to get his thoughts on why Alternatives are front of mind at the moment, and how Morgan Stanley is incorporating these into their strategic asset allocation. Enjoy
When we last updated our Strategic Asset Allocation (SAA) in April 2021, we noted that our portfolio return expectations for the cycle ahead were the lowest since we began publishing SAA projections in 2012.
This subdued outlook was due to a combination of depressed starting yields - together with an upward trajectory in the next cycle for the fixed income and cash asset classes - as well as stretched P/E ratios on the equity side.
One of the key implications was that we increased our allocation to Alternatives within our SAA profiles to around 20% versus around 10% in our prior published SAA, and this was at the expense of our traditional allocations to both equities and bonds.
Since the beginning of this year, global bonds have recorded their worst performance on record, with the Bloomberg Global Aggregate Total Return (USD) Index down around 10% year to date. This performance has also coincided with a sell-off in global equities, with the MSCI World Net Local Total Return Index down around 21% over the same period.
The last time that we saw a multi-month sell-off in both global equity and bond markets was in 1994 – a time when the Federal Reserve also had to sharply reverse policy.
Figure 1: Since 1990 global bonds and global equities have posted negative 6-month cumulative returns together only twice
Source: Bloomberg, Morgan Stanley Wealth Management Research. Data as at 31 May 2022. Indices used: Bloomberg Global Aggregate Total Return (USD) Index and MSCI World Net Local Total Return Index.
Therefore, essentially bonds have struggled to provide their traditional diversification benefits so far this year as rising interest rates and elevated inflation have both challenged returns and income. In this environment, appropriate hedge fund strategies have offered a preferred alternative to holding government bonds, as shown by recent studies undertaken by Morgan Stanley Wealth Management’s Global Investment Manager Analysis team (see Figure 2 below).
Figure 2: Certain hedge fund strategies provide a more attractive risk-return trade off potential than bonds
Source: FactSet, Bloomberg, Morgan Stanley Wealth Management Global Investment Manager Analysis. Data as at 31 March 2022.
In addition, recent studies undertaken by Morgan Stanley Wealth Management’s Global Investment Committee have also shown that hedged strategies have historically outperformed traditional fixed income in periods of rising rates (see Figure 3).
Figure 3: Hedge strategies have historically outperformed in a rising rates period by 13.6% on average
Source: FactSet, Bloomberg, Morgan Stanley Wealth Management Global Investment Committee. Hedge Fund performance proxied through HFRI FOF Composite Index. Data as at 31 December 2021.
Hedge funds can also offer an attractive alternative to stocks, or in the mix in place of a traditional 60/40 stock/bond portfolio, given they can potentially provide superior risk-adjusted returns (see Figure 4)
Figure 4: Certain hedge fund strategies may provide a more attractive risk-return trade off versus equities
Source: FactSet, Bloomberg, Morgan Stanley Wealth Management Global Investment Manager Analysis. Data as at 31 March 2022.
In terms of mitigating the drawdowns within a portfolio, hedge funds can also potentially assist. Although most strategies do not have a negative correlation to equities, hedged strategies have historically outperformed traditional equities during equity bear markets, as shown in Figure 5.
Figure 5: Hedge strategies have historically outperformed in bear market periods by 24% on average
Source: FactSet, Bloomberg, Morgan Stanley Wealth Management Global Investment Committee. Hedge Fund performance proxied through HFRI FOF Composite Index. Data as at 31 December 2021.
Finally, recent studies undertaken by Morgan Stanley Wealth Management’s Global Investment Committee show hedge strategies/funds appear among the most effective portfolio diversifiers (see Figure 6), which in turn further supports our relatively significant positions in Long Short, Market Neutral and Relative Value strategies this year. Of note, real assets have also demonstrated effective hedging benefits with rising real yields and breakeven inflation levels.
Figure 6: Hedged strategies appear among the most effective diversifiers
Source: Bloomberg, FactSet, Morgan Stanley Wealth Management Global Investment Committee. Data as at 31 December 2021.
Private Real Estate Overview
Despite exceptional performance across the real estate sector over the past year, increasing inflation and continued interest rate hikes remain top concerns for investors in 2022.
Supply chain disruptions, labour shortages, rent increases and a general surge in energy prices have all contributed to the high inflation rate. In efforts to subdue inflation, the Federal Reserve has started to raise interest rates and is expected to continue to do so over the next 12 months.
In this environment, Morgan Stanley believes that investors should have a well-balanced real estate investment strategy. Real estate serves a number of key functions, including as a source of diversification, as an effective inflation hedge, an attractive and consistent source of alternative income and potentially as a total return enhancer (for select “value-add” and opportunistic real estate investments).
While strategies and allocations will vary according to investor risk appetite and investment objectives, attractive opportunities exist in the current market.
Given the current geopolitical and inflationary backdrop as well as complicated crosscurrents, it is also important to note that the selection of good active managers is crucial. For further details see Morgan Stanley Wealth Management GIMA: Opportunities in Private Real Estate dated 22 April 2022.
Private Equity Overview
The private equity industry has grown to be a large, global and developed industry with close to US$7 trillion in assets under management, drawing significant interest from both companies and investors alike.
From small start-up firms to large private or public firms, companies seek private equity as a source of capital to aid in the development of their respective lifecycles. For investors, private equity has the potential to deliver strong returns relative to public equity and may help meet investment objectives, particularly given the expectations for lower returns from traditional assets going forward.
Private equity is a model that requires investors to take a long-term view and to understand the mechanics of the private equity fund structure.
While the locked-up nature of the structure can be a drawback, Morgan Stanley believes it is a benefit that allows fund managers to be patient and augment performance over various market cycles.
Moreover, historical results indicate that higher returns from private equity over the long term often compensate an investor for the illiquidity and risk that comes with the investment. Investing in private equity requires patience and a consistent allocation with strong manager selection, and having access to astute fund managers is critical in building a successful private equity portfolio.
As shown below, historical performance between top-quartile and bottom-quartile managers has been dramatically different, once again reflecting the importance of good manager due diligence and selection. For further details see Morgan Stanley Wealth Management GIMA: Opportunities in Private Equity dated 19 May 2022.
Figure 7: Wide range of returns shows the importance of manager selection
Note: For vintage years 2005-2018. Private equity returns are net of fees to limited partners. Private Equity index data sourced from Thomson Eikon’s Cambridge Associates benchmarking database. Source: Morgan Stanley Wealth Management Global Investment Manager Analysis, Thomson Eikon. Data as at 30 September 2021.
Private Credit Overview
Over the last decade, private credit strategies have become a more integral part of alternative investment allocations.
Private credit strategies generally come in two categories: those that focus primarily on income generation and those that focus on capital appreciation. Strategies that emphasize income generation mainly invest in privately originated direct corporate loans, asset-based loans or specialty lending opportunities - all of which have typically been higher yielding in nature and have generated attractive current income.
Strategies that invest in distressed and special situations credit tend to seek higher total returns through capital appreciation and are less concerned with current income.
Morgan Stanley believes that investing in private credit may potentially enhance overall portfolio returns through either the illiquidity premium associated with non-traded originated investments or by taking advantage of credit market dislocations.
Morgan Stanley believes that at this point in the credit cycle, strategies with flexible solutions-oriented mandates focusing on attractive risk-adjusted returns, whether via first-lien, second-lien, or uni-tranche loans, will have more freedom to negotiate higher spreads, more covenants and better call protection than is available in the broadly syndicated loan market.
Asset-based lending tends to be resilient in rising-rate environments, given deal structures that are amortizing in nature, which may reduce extension risk. Morgan Stanley believes asset-based lending may be an option to supplement fixed-income portfolios for investors who can support the extra illiquidity.
Finally, the winding down of stimulus programs and the tightening of monetary policy by key central banks could potentially increase market volatility, creating attractive new entry points for distressed investing.
Morgan Stanley believes that investors should be prepared to allocate assets to distressed debt managers who are patient with capital deployment and will be ready to invest if the credit markets experience further dislocations.
Given the potential wide dispersion in private credit manager returns, Morgan Stanley once again emphasises the importance of manager selection.
As shown below, with the average difference between top and bottom quartile returns at 7.9% from 2000 to 2019, comprehensive manager due diligence can provide a meaningful difference in investor returns. For further details see Morgan Stanley Wealth Management GIMA: Opportunities in Private Credit dated 8 March 2022.
Figure 8: Private credit returns have exhibited significant dispersion
Note: Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. Internal rate of return is used to evaluate the attractiveness of a project or investment. Source: Hamilton Lane Data via Cobalt, Bloomberg. Morgan Stanley Wealth Management Global Investment Manager Analysis. Data as at 30 June 2021.
Specialist advice from Morgan Stanley
Morgan Stanley Australia focuses on providing individuals and institutions with specialist strategic advice and then helping implement these strategies through superior investment execution. To learn more, please visit their website.
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