The first quarter of 2022 was indeed a very interesting one – not least from an investors’ point of view.

We have witnessed rising interest rates, falling equity markets, rising energy prices and in general a rising price level (inflation) as measured by the consumer prices indices (CPI) around the world.

Falling bond prices with equities plunging at the same time also means, that a traditional portfolio consisting of bonds and equities did not offer any protection. A 60/40 portfolio, a widely used benchmark for a balanced portfolio consisting of 60% equities and 40% bonds, lost 5,25%. in the first three months of 2022.

The historical relationship between bonds and equities that so many portfolios rely on, namely a negative correlation between those two during times of crisis, failed.

This, by the way, is not something new and has happened before. When looking at historical data, one could even argue that the negative correlation between bonds and equities during the last 20 years was the exception, not the rule.

So which options does this leave investors to build robust portfolios? More and more are turning towards alternative investments in the hope of the holy grail of portfolio diversification.

The goal of this column is to discuss the performance of various alternative asset classes during these interesting times and builds upon an article written by Frank Hvid Petersen and myself and published in the journal Finans/Invest in December 2020, called “Alternative during crises”, where we examined the performance of the same set of asset classes as discussed in this column.

Before we dig into the numbers, it is worth mentioning a few technical facts of importance.

1. Most alternative investments, aside from liquid alternatives, are long-term investments. To evaluate the performance over a single quarter has limited explanatory power.
   
   
2. There is always a time lag between reported returns and public market returns due to the illiquid nature of the underlying investments.
   
   
3. The benchmarks chosen for private equity and venture capital are liquid replication benchmarks. Over longer timeframes, I found them to give a somewhat reliable picture of the asset classes but over a shorter horizon they typically overstate the movements in the market (both up and down).
   
   
4. Alternative investments are very heterogenous in their nature with huge dispersion also on the manager level. The realized returns of an investor will most likely deviate from the benchmark level returns.

(The column continues below the table)

Performance of various alternative and traditional asset classes

Source: Bloomberg.

CTA, a sub-asset class from the hedge fund universe, are often believed to offer “crisis alpha”, a term that Kathryn Kaminski from AlphaSimplex came up with following the financial crisis of 2008–2009 describing the positive returns of this strategy during this crisis.

But CTA have also been accused of that their performance can be explained mostly by being long bonds instead of being short equities during the last equity bear markets and it was hence doubted whether they can offer protection when rates eventually start to rise.

During Q1 2022, this myth was debunked as CTA profited mostly from being short bonds and long commodities. The BarclayHedge CTA Index, which we also used in our analysis two years ago, was up 5,3% during Q1 while the SG CTA Index was up with 12,8%. in the same period, showing that the index composition is of importance.

The index level returns cover over even larger dispersion on manager level where some of the well-known funds were up more than 20%.

Real Estate, as represented by the NCREIF Property Index, an unlevered index of directly held properties in the US, posted positive gains of 5,3%. All sub sectors contributed with gains.

The largest positive contributor was the industrial sector with 11% followed by the apartment sector with 5,25%. The weakest performance came from offices and hotels.

Even though it often is argued that rising rates will lead to negative returns from real estate, this has not been the case in Q1. As Frank Hvid Petersen and I also argued in our aforementioned article, we are not that certain that this relationship is so clear and always holds.

I am very excited to follow the development of both rates and real estate returns to see whether our theory holds true or whether it will break.

Timberland and farmland both posted positive returns. The largest part of the timberland total return came from appreciations and only app. 25% came from running income from operations. The data for farmland is not as conclusive but it seems that most of the total return came from operations.

Infrastructure, as represented by the EDHEC Infra300 Index, had a negative quarter with losses amounting to -6,1%.

While all sectors contributed with losses, the biggest detractors were transportation and renewable power. Also from a business model perspective, all three sectors contributed with negative returns, with contracted assets being the biggest detractors, followed by regulated assets and merchant assets.

EDHEC has not yet released a performance comment, but my clear expectation is that the increase in interest rates was the main culprit as contracted assets typically have some of the longest duration and are hence the most sensitive to changes in the discount rate.

However, it is worth mentioning that there are opposite effects in play as many (but certainly not all) infrastructure assets profit from an increase in inflation, either through explicit or implicit linkage to CPI.

Furthermore, some of the listed infrastructure indices were up or at least flat during the first quarter, so again, the performance has been very much dependent on the benchmark composition and even more on the portfolio composition of the investors as some infrastructure assets directly profit from increase in inflation and from the supply chain disruptions we are witnessing at the moment.

This should also hold a hand under the valuation as there is increased demand for these types of assets. So absolutely possible to see positive infrastructure returns in Q1, besides the negative index level returns.

Private Equity incl. Venture Capital, not surprisingly, did not offer shelter as there shouldn’t be any difference depending on whether a company is listed or unlisted as it is exposed to the same macro factors.

There are plenty of reasons to invest in private equity, like a much larger investment universe, potentially earning an illiquidity/complexity premium, better possibilities to improve governance than on public equities and last but not least, alpha from skilled managers.

Diversification is just not the main reason to invest in private equity. As mentioned in the beginning of this column, the chosen benchmarks often overstate the movements in the market compared to “real” private equity over shorter time frames.

Carried interest (also known as performance fee) has a dampening effect on private equity returns as it reduces the upside in positive markets (the GP sets aside carried interest in the capital accounts) while it gets reversed in times of write downs.

Manager dispersion is enormous in private equity and might lead to significantly different results. In addition, dispersion on sector level to be expected (Tech vs. Energy for example).

We have seen uplifts in fund valuation for the first quarter due to increased EBITDA, but nevertheless, gravity will at some point catch up with private equity, should the public markets stay sour for longer.

Insurance-Linked Securities (ILS), often also referred to as “CAT Bonds” (catastrophe bonds), once again proved resilient from market turmoil.

Due to the floating rate nature of the asset class, rising rates did not do any harm and as the payoff is contingent upon the non-occurrence of the insured event, there is no link to the business cycle either, as hurricanes and earthquakes do not happen more frequently during recessions than during upswings.

ILS might in fact be the only truly uncorrelated asset class.

Conclusion: After so many years of complacent markets where cheap, passive exposure to equities often was enough, the first quarter of 2022 highlighted the value of asset allocation, diversification, and active management.

There was not only dispersion across asset classes, but also within asset classes and across managers.

Some alternative investments provided much needed relief and diversification and especially CTA had a huge comeback with crisis alpha when it was the most needed.

Should the remainder of the year continue being volatile, I am certain that active management and allocations to alternatives can help investors to navigate through the turbulent market conditions. But as so often, the devil is in the detail and not all strategies are created equal.

I will follow up with another column once the data for Q2 has been published.

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