When valuations look stretched in many traditional markets, it can pay to seek out new or niche markets and strategies that are less crowded.
Some of these can be found in the hedge fund and uncorrelated-strategy worlds: insurance-linked securities are a good example of a market that moves according to its own cycle of reinsurance supply and demand, itself driven by the incidence of natural catastrophes rather than the ebbing and flowing of corporate and consumer balance sheets.
In private markets, while leverage and valuations in traditional U.S. buyout are still lower than we see in public markets, they are nonetheless touching all-time highs. Buyout certainly brings its own diversification benefits, such as greater exposure to operational improvements in businesses and innovative products, as well as lower mark-to-market volatility and an illiquidity premium. It also delivers cyclical diversification: some of the best returns to buyout funds have come from vintages raised when public markets were at their peak, because those commitments were put to work during the ensuing downturn. Nonetheless, further diversification is possible, not only by allocating to venture and growth-capital funds, or to the less-exuberant European buyout markets, but also by exploring idiosyncratic opportunities via co-investment and secondaries (which often come with more favorable fee structures), and by investing in cash flow-generative niches such as private debt, trademarks or royalty streams. Private markets allocations can also be a good way to underwrite particular investment themes through a cycle, and investment themes that are independent of the cycle.
Other less crowded paths include alternative ways of extracting returns from traditional asset classes. Alternative risk premia strategies are the obvious examples, but they would also include the writing of collateralized equity index put options. Over time, a “PutWrite” strategy can be shown to have delivered similar returns to its underlying equity market with around two-thirds of the volatility. Late in the cycle many investors are likely to tilt their equity allocation toward more defensive, income-generating stocks—but in an environment of low and rising bond yields there may be less appetite for the marginal interest-rate risk that entails: PutWrite is one way to add lower-volatility equity exposure without adding to interest-rate risk.
Finally, there are examples of entirely new asset classes. Still a largely European phenomenon, hybrids are very long-dated but callable subordinated bonds, whose coupon payments can be deferred just like dividend payments, which are mostly issued by large, high-quality telecom and utility companies. Hybrids have typically offered four to five times the spread of the same issuer’s senior bonds: as the cycle matures and low-quality balance sheets deteriorate, picking up extra spread by moving down the capital structure of a high-quality issuer may be less risky than chasing yield from lesser-quality issuers.