Alternative Assets & the 60/40 Portfolio Crisis

Not All Alts Are Created Equally – The Case for a Simple Solution

This paper will demonstrate the following:

1. 60/40 Asset Allocation models have come under crushing stress over the last several months
2. Combined, popular alternatives like private equity, private credit & venture capital strategies are often merely leveraged, high-cost variants of “60/40” with lagged reporting, in our view
3. Simple evidence below shows that equity market neutral strategies, where long exposure is hedged using short positions, have a history of compounding wealth in a manner that is truly beta-agnostic

The Headwinds to 60/40 are Well Documented:

The stresses and strains afflicting traditional asset allocation approaches have become so well documented we feel no need to add further evidence to the obvious. However, one of the issues we would like to draw attention to is the failure of many alternative asset classes to offer the promised diversification results. As the bull market roared beyond dot.com levels, the performance of disciplined market-neutral managers waned. Understandably frustrated, many allocators abandoned the strategy.

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Private Equity and Venture Capital: Crowded & Precarious Alternatives?

In this lengthy cycle, the preferred solution for adding alternatives to 60/40 strategies has been allocating to private equity and venture capital. Our firm has written extensively about what we believe is one of the most crowded trades ever seen in our lengthy careers. In our piece on Private Equity Returns and The Next US Financial Crisis, we explain the risks of permanent capital impairment in some private equity and venture capital strategies.

For the purposes of this piece, we will keep it both simple and obvious. The appeal of strategies where the managers can price their own assets predictably leads to low reported volatility. Low reported volatility helps an asset allocation strategy even if returns are muted. But returns have been anything but “muted.” Rather, private equity and venture capital produced the Holy Grail of low volatility and astronomical returns.

Our research has documented that many of these products have simply supercharged the last decade’s trends. Relentlessly cheaper debt and 12 years of multiple expansion in equities are the perfect backdrop for most private equity and venture capital structures. Those days are over. Investors need to adjust accordingly.

The macro-environment in 2022 has been characterized by persistent inflation and rising bond yields. This has, predictably, caused some mean reversion to the most expensive equity valuations seen in the post-World War II period. KCR believes that many private equity and venture capital funds, sitting on privately marked portfolios of expensive and highly leveraged companies, may be sitting on devastating losses with lagged reporting.

Our firm makes no claims to market timing. Yet we find the odds that inflation abates, rates decline, and geopolitical stresses vanish while avoiding a recession to be an unlikely scenario. We believe the trailing price stability and high returns of venture capital and private equity are over. We are not alone in this view.[1]^,[2],[3]

Traditional equity market-neutral strategies offer one of the few remaining sources of non-correlated absolute returns. In this environment, the importance of downside protection has never been greater.

Equity Market Neutral: The Least Crowded & Most Attractive Alternative?

In January 2020, our research noted that Warren Buffett’s favorite aggregate valuation metric was above levels seen at the peak of the dot.com bubble. Feeling the writing was on the wall, we penned Why Market Neutral Now. In that work, we documented the extraordinary value spreads in markets and spoke to the benefits of owning non-correlated assets, particularly with market valuations at reckless extremes.

Only weeks later, the emergence of Covid would send US equities into their sharpest and most violent decline since the Great Depression. As shown in Fig. 1 below, that decline would wipe out all the returns to equity owners from 2017 in just 23 trading days. A healthy reminder of how quickly equity returns can evaporate, particularly when starting from elevated valuation levels. Note: even after recent pullbacks, market valuations are well above where they were at the onset of Covid.

As we all know, the Covid induced crash was met with stimulus dwarfing anything seen in modern history. By early June of 2020, investors who held on had recovered 100% of that drawdown.