What happened to my free lunch? They told me that diversification was there for the taking, yet there has been no zig to my zag. They promised me downside protection, but all I see is red. They said liquidity was a benefit, but never mentioned the bid/ask spread. Welcome to dystopia in the era of dislocation.

William Kelly

William Kelly

The basic value proposition for diversification went something like this: put 60% of your portfolio into public equities and the balance into a laddered bond portfolio and you will be good to go. That worked until it didn’t work anymore and perhaps in hindsight, a basic question should have been asked. What happens when the very accommodative central bankers decide to turn off the liquidity hose and, at the same time, take their boot off the neck of rates that had been pinned to ground zero? 

That hypothesis is now reality; the MSCI All Country World index (ACWI) has drawn down 20% in the year to date and the proxy for bonds has drawn down almost as much, posting (so far) its worst year on record. Yet the reformed central banker is not the only actor in this era of dislocation where inflation, supply chains, wars, COVID hangovers, energy shocks, and now missiles in the sky over the Korean peninsula threaten the stability of capital markets and the base-level expectations of humankind. 

We have again proven that the only things that goes up in down markets are correlations, and have reaffirmed that nationalism, taken to the extreme, makes our world an extremely dangerous place.

Finding a solution for that latter point is beyond the reach of this article but what about diversification, where the siren song is calling the investor to the wonderful world of alternative investments to solve their woes? 

Hedge funds, private equity and direct lending are among the offered entrees, and for those bold enough to skip to the desserts, distressed options are aplenty but maybe not for the faint of heart.

Hedge funds have been the asset class that most have loved to hate, but the ‘asset class’ moniker is perhaps part of the problem in the first place. While the actual number of active funds is hard to capture, given the private structures, informed views put these offerings at over 25,000 globally. 

Offerings that have become ubiquitous but far from unique can no longer be defined as an asset class, where even strategies within more focused labels such as long/short equity can show large performance chasms between the median returns and those in the rarified top quartile. 

Expectations need to be better managed too, in a space where even absolute return should never mean zero draw-down capture, or an upside potential correlated to the risk-on trade in the equity markets, which mostly persisted until the end of 2021. 

According to JP Morgan, the average hedge fund drew down about 4% this year to end-August, while the MSCI ACWI was down 20%. The worst performers in this industry (it’s not an asset class) were any strategies exposed to equity risk premia but there, too, they were down only about half as much. 

The club house leaders were the global macro crowd (about the only ones who love a good crisis) and the commodity trading advisers who finally found the volatility they sought, reaping outsized profits from their directional bets. Clearly an oasis of diversification for the discriminating investor.

Private equity and direct lending have also captured their share of headlines, but undifferentiated median results and high dispersion of intra-quartile returns also define the outcome for the investor who dares to treat these offerings as (mostly) fungible asset classes. Capturing an illiquidity premium is now mostly a fool’s errand as the true value proposition here is to capture a complexity premium in the most inefficient corners of a market that is clearly the new home for capital formation and value creation. 

The investor here must have a sector strategy that can be comfortably deployed beyond the higher multiples seen in the North America buyout space where greater efficiencies (code for median returns) reign, as they consider growth and venture investing in areas such as India and sub-Saharan Africa.

Meanwhile, back in dystopia we find the distressed-fund crowd getting ready to pounce on the many private debt and equity investments that are soon to see large double-digit write-downs, especially for any business model that loaded up on cheap financing, thinking that fresh capital flowed freely. 

Not for the faint-hearted

The current macroeconomic environment is likely to bring some form of nuclear winter to almost every business model and only the wise stewards with a healthy balance sheet will successfully weather this storm. Those seeking liquidity will find it, but at a price point that will make their eyes water, while the barbarians at the transaction gate will drool.

This market will also cause some rebalancing for most institutional investors as they look to reset their portfolios back to target weights. No doubt this will mean higher resets (allocations) to international equities offset by what has been a very active year for sellers in the private secondary markets. 

What was once a distressed play, this market has now become considerably deeper and more active, where spreads have tightened, and vintage-year diversification is an opportunity for the buyer. Money can get in the ground quickly as the J-curve is no longer a consideration and portfolio transparency is high.

There is no easy exit from dystopia when the hypothetical becomes real. Dislocation will be the new normal, but the (very) patient and educated investors will always be able to distinguish themselves from the more panicked market participants. 

Diversification may no longer be a free lunch but remains findable for the patient investor who realised long ago that this game is all about time in the market, rather than the village idiot in dystopia determined to time the market.

Seek education and diversification and know your risk tolerance. Investing, even in a place called dystopia, is for the long term. 

William Kelly is CEO of Chartered Alternative Investment Analyst Association