Stocks and bonds aren’t cheap yet

The author is founder and chief investment officer of AQR Capital Management.

My colleagues and I have said for years that traditional portfolios are expensive and therefore face low long-term prospective returns. In fact, the expected returns for such portfolios with 60 percent equity and 40 percent bond funds appear to have been hovering around record lows.

However, our prediction hadn’t come true, until recently (frankly, we’d rather it never did, we like the markets to go higher too). But that’s not surprising, as long-term predictions simply aren’t based on short-term market momentum.

Stocks, bonds and a range of other asset classes have struggled this year amid persistent inflation, aggressive central bank responses, geopolitical turmoil and recession concerns. Much of this is due to a reversal of the low and seemingly always falling real interest rates that kept markets high. The silver lining, some hope, is that after everything we’ve seen this year, markets may Finally be cheap

Unfortunately, they are not. Yes, the markets are not as expensive as they were at the beginning of the year, but a few months of cheapening after more than a decade of enrichment is a small drop in a terribly big bucket. We still live squarely in the world of low long-term expected returns for most traditional investments.

What is the solution? Something investors probably already know about, but may have abandoned during an unusually long bull market: diversification. But when it comes to diversification, we must be careful. Just because something looks different doesn’t mean it’s diversifying, and just because something is called an “alternative” doesn’t mean it’s not basically the same (private equity is still equity, for example).

The alternatives industry, while a diverse group, can be roughly categorized as 1) strategies where the majority of returns depend on exposure to market factors such as private equity and private credit and 2) Strategies where returns are largely unrelated to the overall performance of the capital markets, such as some macro hedge funds, equity market neutral strategies, and managed futures.

The first type, private, has seen extraordinary growth over the last decade, which is not surprising given that those strategies have generally posted very strong returns. But why? To be sure, many of these managers are skilled, but the historically strong environment in equities and bonds also helped. Any strategy with returns that are economically tied to the markets. should do well when the markets are doing well, particularly if the bets are leveraged.

Privates also benefited from reported volatility that often grossly understates the risk of real assets, something I’ve labeled (shamelessly) “volatility washout.”

Line chart of expected real returns on a 60% stock/40% bond (%) portfolio showing prospective 60/40 returns near record lows

This underestimation of risk has been so successful in attracting investors that it may have turned the typical illiquidity premium (the increased return on being willing to own illiquid assets) into a headwind. In effect, illiquidity has become a feature you’d pay for, not a mistake you’d need compensation for. However, a long-term underperforming environment for stocks cannot be hidden forever.

In comparison, the second type of alternatives have not had the same tailwinds. If anything, a strong final decade for stocks and bonds has led many to reduce their exposures to truly diversifying investment types due to disappointing relative returns (an unfair comparison, but that doesn’t mean it doesn’t happen). Collectively we seem to learn and unlearn these lessons in a painfully cyclical way.

Now back to today. The markets continue to offer much less than normal, and the first type of alternative is in this very boat. Frankly, many of the strategies that posted above-average returns over the past decade are more likely to underperform over the next decade.

However, this is not the case for the second type of alternative. Because they primarily try to generate returns regardless of market direction, these strategies may prove more valuable in the decade to come. Since these are our strategies, we are discussing here with obvious self-interest. But I would like to point out that market-neutral strategies that go long cheap stocks and short expensive stocks are actually at record levels of cheapness. Another self-serving acknowledgment should go to managed futures, which are often left behind when beta, or market-following, is king, but then shine when it’s not (as in 2022).

The current environment is giving many short-term and long-term reasons to diversify. When investors look for alternatives, just make sure they really are an alternative.

Leave a Reply

Your email address will not be published.