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Alternatives can plug return expectations gap in times of high inflation: UBS AM

Goola Warden
Goola Warden • 9 min read
Alternatives can plug return expectations gap in times of high inflation: UBS AM
The panel, moderated by Goola Warden of The Edge Singapore (from left), and featuring Massimiliano Castelli and Barry Gill of UBS Asset Management / Photo: UBS
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UBS Asset Management held its Alt+Shift conference on March 9–10. Alternative investments (also known as alts or alternatives) are those outside of the 60:40 equities-bonds split that is common in many portfolios. Institutional investors tend to turn to alternatives for their uncorrelated returns visa-vis equity and bonds, and their lower volatility. On the other hand, alternatives require patient capital.

Alternatives include private equity, private debt, real estate, venture capital, commodities and hedge funds. Among these different asset classes, private equity and venture capital are often preferred for their capital appreciation and alpha generation. With venture capital, investors would be able to hedge the macro risk that comes along with it. Elsewhere, hedge funds can play an important role in diversification or correlation risk. Real estate has often been seen as an inflation hedge, and also a provider of stable income.

Non-cash-flow-related assets such as art, wine and cryptocurrencies are extreme versions of alternatives. Institutions and investors who use alternatives usually include pension funds, sovereign wealth funds (SWF), global family offices and university endowment plans.

Massimiliano Castelli, head of strategy, sovereign institutions at UBS AM, says the shift into alternatives was a “powerful trend” in the previous monetary environment of low interest rates. “Investors entered many illiquid asset classes to boost returns because they had certain return targets,” Castelli says during a fireside chat titled Where next for the wall of money in alternatives investing? on March 9 at the two-day Alt+Shift event.

Castelli had attended a conference of SWFs during the same week of March 9–10 to gauge whether they would still be interested in alternatives given the volatility and higher interest rates which continue to cause the repricing of most asset classes.

The answer is that SWFs are still very much interested in alternatives but they have become more selective and careful about the role alternatives play in their asset allocation.

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Similarly, Barry Gill, managing director and head of investments at UBS AM, says there is increasing consensus that alternatives can plug the gap of higher return expectations in the face of structurally higher inflation in the global economy.

“As the inflation rate rises, if you’ve got as a sovereign wealth fund, and if it has a CPI plus 4% target, it becomes harder and harder to hit that. A traditional portfolio might get that return figure to one and a half points [short of 4%], but [wouldn’t be able to] close that gap without alternatives,” Gill indicates. If beta is no longer the engine of a portfolio, the gap between performance and return may be boosted by alternatives.

One of the reasons alternatives may provide better returns is inefficiencies in new asset classes. For instance, green transition play is an investable theme where alternatives can provide choice and a better return.

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Unlike the public markets which have many players, the private market has fewer players but with larger amounts to invest. Investments in green transition are “being made to extract inefficiencies in the market and they’re being made at a scale that others are left in the dust” suggests Gill.

An example of green transition is the very new carbon capture sector. “The challenge is that establishing the integrity of the project is quite difficult. Most of the people who are coming into this space are effectively ex-commodity trading firms or existing commodity trading firms. The concept of a carbon capture credit is interesting but there are scaling issues,” Gill says.

He believes that if a carbon capture project can be bolted on to a green project which has a 4% yield, yields can go up to double digits.

Private equity, real estate

Private equity is an increasingly popular alternative class due to the lack of volatility and better returns for patient capital. Private equity often has “absolute return strategies” where investors exert more control than in listed companies.

“You have this lever of control [in private equity]. If I don’t like what the underlying CEO of a company I’ve invested in is doing, I can switch him out. We can’t do that in the public space,” Gill points out.

Real estate is the largest alternative sector but it is in itself not homogenous because of various sub-sectors including retail, office, data centres, warehouses, multi-family and rental housing, and retirement homes.

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“You need to be much more specific when you’re allocating to real estate. For instance, retail space has been in a bear market for a long time and since Covid, [so has] office,” Castelli notes.

In particular, US office space has hit a road bump. The combination of tenant incentives and capital expenditure to finance improvements may no longer be accretive to net operating income (NOI) given the rising cost of debt in the US.

“Real estate used to be the perfect replacement for fixed income in the sense that if you are an investor already with a balanced portfolio and you think about higher returns, what should you do? Add more equity or fixed income? That could raise the volatility of the overall portfolio. The alternative would be to boost returns by replacing fixed income with real estate because it gives you an income, with volatility at half that of equity. Yet it provides a correlation with equity,” Castelli explains.

Now though, with higher interest rates, real estate is taking a lot longer to reprice. One of the reasons could be its popularity. According to Castelli, Middle Eastern SWFs prefer real estate. “For SWFs from the Middle East, real estate is a very, very important asset class for historical reasons, probably because they know real estate as an investment class well.”

Interestingly, SWFs from China and Singapore appear to be more partial to private equity, venture capital and infrastructure. “I believe that is a reflection of the dynamics of this economy. There is more entrepreneurship going on in Asia. The Middle East is more sort of bricks and mortar type of investment,” Castelli says.

In 2021, tech was bubbling over and a popular asset class. Yet, in 2023, tech companies are shedding jobs. “Valuations have come down since then. The higher yield environment immediately led to a repricing of the risk assets. Interest rates have moved from near zero to 4% and higher. This of course has an impact on all asset classes but the impact on the listed equity is almost immediate. For the alternatives asset class, the price discovery process is longer,” Castelli says.

Castelli does not see a situation like the global financial crisis developing. That correction was driven by dramatic drops in asset values themselves, he says. “This time around, asset values have not moved very much. Instead, they have moved very little in terms of magnitude, compared to 2008. I think we’re going to see more price discovery and valuation.” To get a price in some asset classes in private equity, the bid and ask spreads need to compress, he adds. Much depends on the interest rate cycle, and a possible recession.

Gill, who is based in New York, believes interest rates are going to continue to rise. “I have a view that the Fed will risk the economy to reestablish its inflation-fighting credentials this cycle. I think over the very long run they will fail in that endeavour but in the near term, they will be successful.

“The cost of capital across the system is going up. It will continue to go up for the rest of this year. It’s very difficult to predict [a recession] but I’m in the camp of a 2024 recession,” Gill says.

While it is very difficult to make a call on a recession, many investors are looking at alternative scenarios. “With our team in UBS Asset Management, we prepare our capital market expectation [also] based on alternative scenarios because of the big differences between the softish lending scenario and a recession,” Gill says.

The problem with art

What about art? “Art in aggregate is a terrible investment. For every castle, there are 10,000 pictures gathering dust somewhere in somebody’s attic. The probability of finding a Picasso is so infinitesimally small but that doesn’t stop people from trying to invest. The problem with art is it doesn’t have cash flow and you can’t fractionalise it at the moment so you can’t democratise access to art as an investment,” Gill explains.

“The concept of tokenisation is applicable to non-cash-flowing assets. It makes them accessible. It makes them tradable. Right now, you can do these through other structures but tokenisation would broaden access. You can’t hang it on your wall but it wouldn’t be nice to know that you had a one-millionth share of Picasso?” Gill remarks.

Cars are not usually an investment class, but collectable cars form a very small sliver of an investable asset class, Gill continues. “The market has gone hot for these non-cash flowing assets, and these extreme alternative assets. They have been in an incredible bull market primarily due to their scarcity value. This search for uniqueness is taking on an exponential value,” he says.

Interestingly, both Castelli and Gill own some alternatives in their personal portfolios. Castelli owns real estate directly and indirectly through UBS’s pension plans. Gill says he has never owned a bond and is heavily into single stocks and cash, and an allocation into private debt, “We have a very good private debt offering at UBS which is tied into our wealth business and that I invest in,” he says.

Gill has invested in a series of angel investments. Two of them are directly related to the alternatives space. One of the challenges of accessing private equity is the documentation associated with it. “One of the firms that I’ve invested in has figured out a way to automate that [documentation] and deliver it at scale,” Gill says

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