Private assets and alternatives as an asset class continue to attract more attention, in light of higher interest rates which have resulted in increased volatility in equity and bond markets, as well as finally providing a compelling investment to those seeking income, and worthy of inclusion in a retiree’s portfolio as they allow for improved risk-adjusted returns. The ubiquity of exchange-traded funds (ETFs) in retirement portfolios has attenuated the benefits of diversification. In the current climate, the spread between short- and long-dated government bonds is not compensating investors for the additional risk and income requirements of longer-dated securities. The benefits of alternative asset classes are that they offer higher yields, additional diversification, and a lack of correlation with public markets, making them advantageous for providing downside protection in a retirement portfolio. Overall, private asset classes and alternatives offer retirees greater opportunities for yield and the ability to generate outperformance on a risk-adjusted basis.
Where Does the Benefit of Diversification Cease?
In public markets, traditional financial theory states that the benefit of diversification diminishes the more securities which are added, typically 15-20 securities is sufficient to diversify idiosyncratic or company specific risk. The introduction of passive investors and the use of index funds has allowed investors to access public markets worldwide at a low cost. As a result, the heart of retirement portfolios benefits from a cost-effective, diversified solution. The dilemma with ETFs, however, is that the underlying securities are generally weighted on a market capitalization basis, which disproportionately allocates to larger-weighted stocks. As cap-weighted indices give higher weights to stocks with large market capitalizations, these stocks may become overvalued and have higher price-to-earnings ratios compared to their fundamentals. Notwithstanding, actively managed funds often fail to outperform over the long term due to higher fees, especially when managers allocate similarly to large-weighted stocks. The value of active management is realized when managers compete on a fundamental basis in markets where there is less competition, a key feature of private markets where information between investors is not equal.
What Does This Dilemma Mean for Retirees?
If the core equity sleeve of a portfolio tracks indices like the S&P 500 or ASX 200, there is a tradeoff: exploiting market inefficiencies becomes increasingly difficult unless retirees are willing to accept the higher volatility associated with growth-oriented securities. This may conflict with a retiree’s preference for high-yielding stocks and income-focused equity investing (e.g., Rivkin’s Events Portfolio). Moreover, broader exposure to indices eliminates the idiosyncratic risk of individual securities but aligns the portfolio with the systematic risk of the broader market.
Are Tighter Credit Spreads Spelling the Death of the 60/40 Portfolio?
The premise of bonds in a portfolio is to provide downside protection during a market correction. Bonds have an inverse relationship with interest rates: when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. Government bonds are considered “risk-free” because it is nearly impossible for governments to default. They are used to shelter portfolios in stock market downturns. Investors are typically compensated with a higher yield for holding longer-term bonds due to the additional risk. However, in the current environment, the spread between the Australian cash rate (4.35%) and a 10-year government bond yield (4.62%) is narrow. This has come as investors begin to expect central banks to ease interest rates in the coming years. This raises the question: are retirees adequately compensated for the long-term risk premium? The answer is likely no.
Why Private Markets and Alternatives?
Asset classes like private credit, and alternatives in general offer greater diversification benefits and higher yields compared to government bonds. A significant gap in the lending market has emerged since major Australian banks exited sectors like commercial loans and first-backed mortgages, which now yield approximately 7%-10% at short loan lengths, typically 9-18 months. This short loan duration is particularly important in managing risk, as it allows managers to nimbly allocate based on changes in the economy. While these are considered riskier due to varying levels of regulation (many providers are not ASIC-regulated) and differences in how loans are collateralized, they present attractive opportunities. Alternative asset classes vary widely in definition, including managed futures, hedge funds, long/short funds, and royalties. These assets often lack correlation with traditional public markets, providing a natural hedge against systematic risk. Additionally, they may exploit arbitrage opportunities in less efficient markets, even if they lack intrinsic value.
The evolution of financial products and the increasing integration of global markets have enhanced diversification opportunities for investors. This has benefited retirees by providing low-cost solutions for building diversified portfolios. However, the tradeoff is that markets are slower to react due to fewer agents competing on a fundamental basis, as ETFs now dominate global stock market ownership. Traditional fixed-income securities offer limited downside protection in the current climate. Interest rates have reverted to the mean, and narrow credit spreads fail to adequately compensate investors in a high-inflation environment. Private credit and alternative asset classes, by contrast, offer higher yields and the potential for substantial risk-adjusted outperformance in retirement portfolios.
