The second quarter of 2022 continued to follow the same playbook that we witnessed in the first: Rising interest rates, falling equities and a lot of volatility across the commodities space, with copper dropping 22% and European Natural Gas being up 19%, just to name a few.

According to Deutsche Bank, the total return on US 10-year Treasury bonds during the first half of 2022 was the worst it has been since 1788!

Equity markets were not shy of breaking records either, with the S&P 500 posting the worst first half year since 1962.

A 60/40 portfolio, a widely used benchmark for a balanced portfolio consisting of 60% equities and 40% bonds, lost 17.9% in the first six months of 2022.

With more and more investors turning towards alternative investments in the hope of finding the holy grail of portfolio diversification, it is interesting to follow up on the performance of Alternatives during these volatile times.

Before we dig into the numbers, I want to remind you of a few technical facts of importance.

1. Most alternative investments, aside from liquid alternatives, are long-term investments. Evaluating 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, they 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), according to my own analysis.
   
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.

Performance of various alternative and traditional asset classes

CTA, a sub-asset class from the hedge fund universe, that are often believed to offer “crisis alpha”, a term that Kathryn Kaminski from AlphaSimplex coined following the financial crisis of 2008–2009, continued their run during Q2 2022, where the continuation of the “inflation trade” (being short bonds) sustained to produce good returns. But also across the currency space, lasting downtrends in both the EUR and Japanese Yen, were widespread trades with positive returns.

According to estimates by Andrew Beer from Dynamic Beta investments, a hedge fund replication specialist, the short Yen trade has been the single biggest money maker for CTA this year. There were, however, some turning points in some of these trades by the end of the quarter that will be interesting to follow up going forward to see whether this is sustained or just a minor reversal in the longer trend.

The EurekaHedge CTA / Managed Futures Index was up 1.53%. during Q2 while the SG CTA Index was up with 7.39% in the same period, bringing the performance for the first half year up to 7.29% and 21.14%, respectively, highlighting the huge dispersion in the universe.

The index level returns cover over even larger dispersion on manager level where some funds were up more than 15% in Q2.

Real Estate, as represented by the NCREIF Property Index, an unlevered index of directly held properties in the US, posted positive gains of 3.24%. and is up 8.73% year to date.

All sub sectors contributed with gains. The largest positive contributor was again the industrial sector with 5.86%, followed by the apartment sector with 3.86%. The weakest performance came from offices. Even though it often is argued that rising rates will lead to negative returns from real estate, so far this has not been the case.

One could argue that stale pricing due to the appraisal-based nature of the index is the explanation and that gravity sooner or later will drag real estate down, but also some listed real estate companies have posted positive returns, with Danish Jeudan being one local example that is up 15.9%. in Q2. This highlights once again the very heterogenous nature of many alternatives, including real estate, where idiosyncratic factors can have significant influence on the outcome, more than overall market trends.

Both timberland and farmland posted positive returns in Q2 and are up 5.14% and 4.12% respectively year to date, which combined with real estate gives the impression that real assets live up to their reputation of being a, at least partial, inflation hedge.

Infrastructure, as represented by the EDHEC Infra300 Index, had a negative quarter with losses amounting to -1.27% and is now down 5.21% year to date.

Please note that EDHEC revised the Q1 return of the Infra300 index upwards, from -6.09% to -3.99% after updating the cash flow forecasts when new financial data from the company accounts was received. Some (but certainly not all) infrastructure assets profit from an increase in inflation, either through explicit or implicit linkage to CPI, which leads to higher cash flows.

From a business model perspective, the regulated and contracted assets were detractors while merchant assets contributed with solid gains. Especially airports and seaports had a good quarter, but also independent power producers posted gains. The rise in interest rates is still the most significant factor impacting the discount rates and the valuations, but the increase in expected cash flows over the last year has offset more than half of this negative impact, according to EDHEC.

Also listed infrastructure benchmarks, even though often not directly comparable with institutional infrastructure investments, are keeping better up this year than broad equity indices and are approximately flat as of end of the second quarter, depending on the composition of the index.

Private Equity and Venture Capital had another rough quarter with losses of 28.5%. and 36.9%, respectively.

As stated 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. In addition, the reported private equity returns as of 30/6 by institutional investors are, at least for funds, in fact Q4 and Q1 returns (often with adjustment based on movements in public markets) as the quarterly NAV for the end of the second quarter are not yet received for most of the funds due to the time lag mentioned in the beginning.

So, the liquid replication benchmarks could be an indication for what might be coming, but with that said, manager dispersion is enormous in private markets in general and in particular in private equity. We have only received a few quarterly reports for Q2 yet but have seen some nice write ups of portfolio companies during Q2, where the underlying business fundamentals develop in a positive way, justifying the write ups.

Critics of private equity often argue that managers are not marking to market, but we have also seen exits during Q2 at prices that were above book value, some even substantially above book value, and at valuations that could raise an eyebrow. A good reminder that the true price of an unlisted asset is only known at the time of a transaction and that a skilled manager and the right buyer is all it takes to create great returns, even when public markets turn sour.

The beautiful thing about private equity is indeed that it is much more complex than just taking public market performance adjusted for beta. Returns are created by improving the company and finding the right exit. Worth also keeping in mind that some listed stocks are up as well, so not everything is bad. But especially growth/venture-oriented funds could come with write downs after a period of frothy valuations. If the Swedish buy now, pay later lender Klarna is the canary in the coal mine, things could become nasty for growth deals.

Last summer, Klarna was valued at USD 45.6bn and, according to Pitchbook, the firm is currently raising a new round of financing at a valuation of USD 6.5bn. That’s a drop of more than 85%. We will know more when all quarterly reports are received but expect huge dispersion dependent on manager skill, sector & vintage allocation.

Insurance-Linked Securities (ILS), often also referred to as “CAT Bonds” (catastrophe bonds), were only slightly up in the second quarter with +0.02%.

The second quarter is typically a bit weaker as the ILS market is highly seasonal as a good portion of the market covers US hurricane risk, where the risk is largest between July and October. In the months that are off risk, the price of these CAT bonds typically falls. But according to Twelve Capital, the weakness in the second quarter was intensified by a lack of capital in the primary market that led to rising spreads in the secondary market. With the latest rise in spreads and the risk-free rates, the CAT bonds market now yields app. 10%, according to Twelve Capital.

Conclusion

The first half of 2022 was certainly not easy to navigate for investors.

It also highlighted that a long-only investor has not many places to hide when the going gets tough. The ability to take long/short positions helped CTA tremendously, especially being short bonds in an environment of rising interest rates.

The 1-million-dollar question is whether the next years will resemble a replay of the 1970’s with sustained higher inflation and massive interest rate increases or whether this will be rather short lived.

2022 has so far shown the value of adding alternatives to a portfolio and debunked the myth that rising rates per se are negative for all types of investments as higher cash flows can offset the impact from higher discount rates. But with geopolitical and economic uncertainty being high, it will be interesting to monitor whether real assets like timberland & farmland, real estate and infrastructure can continue to defy gravity.

Column: Alternative investment returns showed wide dispersion in Q1

Velliv: ”We are specialists in choosing specialists”