Alternative Investments – In Depth

• We think alternative investments have become a more important source of return for investors as the credit and business cycle matures.
• Despite a strong start to the year for risk assets, we expect to see an improvement in returns from shorting both equities and credit. In our opinion, this bodes well for Equity Hedge and Relative Value strategies.
• As the credit cycle progresses, we anticipate an increase in the number of stressed and distressed companies that should be ripe targets for Event Driven and Private Debt companies.
• Thematic opportunities exist for qualified Private Capital investors, where the focus is on small, niche, and distressed investing, in our opinion.

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In our November 2018 In Depth report, we suggested that alternative investments were entering a new era—one in which performance would benefit from an aging economic and credit cycle; changing global monetary policy dynamics; and a long-awaited increase in volatility and security dispersion. Since that time, we have seen a monumental dovish shift from the Federal Reserve (Fed); deceleration in global economic growth; a spike and collapse of credit and equity volatility; and further signals of a maturing credit and business cycle. Yet, despite these headwinds, first-quarter 2019 risk asset performance was among the highest on record. Does this mean we were early in our views last November, or even “off the mark”? Are we still in the post-crisis environment in which passive, long-only market exposure is more than adequate? Our answer to both questions is—no.

In the first quarter of 2019, the Hedge Fund industry posted its best quarterly return since 2009. We still believe that the role of alternative investments—both as a source of alpha¹ and as a tool to navigate late-cycle risks—likely will become more important from this point on.²

While portfolio diversification is a normally popular reason to invest in Hedge Funds, equally important is generating alpha. Too often, the term “alpha” is misunderstood as simply the return above and beyond an index. The missing ingredient from that definition is the risk—expressed as market exposure or beta³—that is required for that return. As we scan the landscape for alpha potential, we continue to find ourselves focused on strategies for which shorting is becoming more feasible—such as Equity Hedge and Relative Value—along with strategies that can capitalize on global credit-market dislocations, such as Event Driven.

Expectations for higher volatility, a decrease in correlations, and a broadening of dispersion bode well for Equity Hedge, in our opinion, and this plays a large part in our favorable outlook over the next three to five years. This can benefit long positions, and it also can ease the challenge of shorting equities that managers have faced for much of the post-crisis era. But we also acknowledge that the evolution of equity capital markets—namely, the proliferation of factor based investing, algorithmic trading, and the size of passively-managed assets—also must be carefully navigated by Long/Short Equity managers going forward.

Many of these same market drivers also influence the opportunity set for credit-oriented Hedge Funds. But in addition, the tremendous post-crisis growth of corporate and sovereign debt; deterioration in underwriting standards; utilization of debt for leveraged buyouts (LBOs) and other merger and acquisition (M&A) activity; and maturation of the credit cycle all lead us to our bias toward credit as the “epicenter” of Hedge Fund alpha today.

Chart 1. Leveraged loan being used for LBOs are growing in certain sectorsSources: Bloomberg, Strategas Research Partners, March 2019. For illustrative purposes only. High yield bonds - also known as junk bonds - are debt securities where the debt has a lower than investment grade rating (BBB/Baa). Leveraged Loans are loans to companies that typically already have a high amount of debt and are often characterized by lower credit ratings or higher interest rates. An LBO is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition generally using the assets of the company being acquired as collateral.

Our cyclical playbook for credit-oriented Hedge Funds involves two main strategies—Relative Value and Event Driven. Within those strategies, we remain focused on three sub-strategies (Long/Short Credit, Structured Credit, and Distressed). Much of our optimism relies on an illiquidity premium that private placements offer and liquid alternatives do not provide. Liquidity and volatility normally work in opposite directions, and a fund structure focused on providing its investors with daily liquidity is more challenged in capitalizing upon dislocations as they arise. This is why we maintain a neutral view on Relative Value and Event Driven liquid alternatives, and a more optimistic, favorable view for those same strategies in a Hedge Fund structure.

Although we currently maintain a neutral view on the Macro strategy, we would suggest that there is cautious optimism that conditions are ripening for the strategy, especially for Discretionary Macro. Not only is equity volatility expected to gradually rise, but interest-rate volatility is also ticking higher, largely driven by abrupt monetary policy reversals, periodically inverted yield curves, and geopolitical stress. We believe that commodity and currency markets also are more tradable then they were in previous years. When combined, we believe that these trends bode well for Discretionary Macro strategies, especially for those with a focus on relative value, as opposed to more directional, trades. It is too early to upgrade our cyclical view, but it is something that we are watching carefully.

We also expect that Hedge Fund performance is likely to show greater degrees of dispersion than in previous years. Even managers within a similar strategy, such as Relative Value (or Long/Short Credit, more specifically), are likely to generate very different results given the shift to more “alpha-centric” opportunities. This implies, to us, that manager selection is increasingly important, and that investors should focus their attention on their individual allocations.

We think that after nearly a decade of robust corporate debt issuance, fueled by an insatiable demand for “yield” from institutional and retail investors, has benefited “long” credit positions while significantly hampering the opportunity set for “shorting” credit. Moreover, in our view, there was little benefit in long credit selection as stable economic growth, an equity bull market, and a benign default environment benefited those with simple market exposure. We believe that environment is changing. We expect to see credit security selection being increasingly important going forward, and we also expect to see an easier, and more lucrative, environment for shorting credit. Several near-term catalysts exist that we believe will spark a multi-year opportunity for Long/Short Credit investing. First, we expect to see a decline in earnings as wage inflation impacts margins. In turn, leverage ratios are likely to increase, which could lead to ratings agency credit downgrades and a repricing of debt.

Second, we expect that the normal maturity of the business cycle will amplify weakness in more economically sensitive sectors over time, while highlighting the resiliency in non-cyclicals. Our time horizon for this view is three to five years. The retail sector is already under pressure, but we expect this weakness to extend to other areas as well (Chart 2). Finally, we believe that the structure of the credit markets has been severely affected by years of regulation, and that the credit market’s ability to absorb volatility spikes and price dislocations has been weakened. Air pockets, such as those experienced in December 2018, are likely to become more frequent. We believe that these developments will be a major source of alpha for Long/Short Credit managers able to be price “takers” when others are indiscriminate sellers.

Chart 2. Opportunities for distressed investing exist across multiple sectorsSource: Bloomberg, Strategas Research Partners, March 2019. 100 basis points equals 1%. Sectors are based on Bloomberg Industry Classification System (BICS) classification. For illustrative purposes only. Past performance is no guarantee of future results.

Given our views on the maturation of the corporate credit cycle and the aging of the business cycle, it should not be surprising that we remain constructive on Structured Credit. If the “collateral” for investment-grade or high-yield corporate credit is the health of corporate America, then the collateral for Structured Credit is the U.S. consumer. Upward trends in employment, wage gains, credit ratings, home prices, and sentiment all bode well for securities linked to residential mortgage-backed securities (RMBS), in our opinion.

Although certain core cities are facing pressure on commercial real estate prices, with vacancy rates trending lower and a supply/demand imbalance, we believe that fundamentals still support exposure to commercial mortgage-backed securities (CMBS). Importantly, due to the complexity of these securities, they often yield more than corporate credit of a similar rating. Said differently, investors can receive the same yield potential, or higher yield potential, with Structured Credit than they can with high-yield corporate credit, but with substantially different risks (in our view).

Chart 3. Relative value remains in CMBS versus high-yield debtSource: Credit Suisse. Spread between: CMBX BB.8 and CDX. HY; CMBX BBB-.8 and CDX. HY. Data as of April 1, 2019. For illustrative purposes only. The Markit CMBX Indices are a synthetic tradable index family that allows investors to gain/hedge exposure to CMBS collateral. Each index references 25 subprime CMBS deals/bonds satisfying a series of concentration and collateral criteria that were issued six months prior to each roll date. The use of the “8” in the index is simply the iteration of the index. In other words it is the 8th CMBX index created, since the underlying CMBS bonds mature and new indices need to be created reflecting new deals. The Markit CDX indices are a family of tradeable credit default swaps (CDS) indices covering North America. The indices roll semi-annually in March and September. Credit events that trigger settlement for individual components include bankruptcy and failure to pay, wherein credit events are settled via auctions. A tradable index is an index that can be traded through some type of derivative contract such as a futures contract. Please see important risk information regarding these securities at the end of this report. Past performance is no guarantee of future results.

The popular misconception is that Distressed investing relies heavily on the default cycle. While corporate defaults are an important indication of credit-market health, the reality is that “good” companies, with bad balance sheets, exist throughout the cycle. What is important, however, is the volume of stressed and distressed debt available. Here again, we find that there has not been enough stress within corporate credit markets for managers to exploit (with the exception of the energy sector in 2015 and 2016, and the retail sector more recently). We believe that this is changing. Distress ratios are beginning to increase across multiple sectors, and credit agency ratings are migrating lower.

At the end of February 2019, nearly 17% of both the food and energy sectors were trading at distressed levels.⁴ Furthermore, 13% of the transportation sector and 12% of the retail sector also were distressed. Corporate default rates, though low at the index level, are beginning to creep higher as well. This trend has been led by retail, which is already at a default rate of 8%. Of course, the well-publicized “fallen angel”⁵ opportunity set could be a key catalyst for alpha as well. The reality is that a multitude of “Distressed” strategies exist for various phases of the credit cycle, including rescue lending, distressed exchanges, debtor-in-possession (DIP) financing, bankruptcy reorganizations, liquidations, and dislocated credit. All of these strategies, in our view, are viable opportunities on a cyclical basis.

Chart 4. Stress to distress—opportunities throughout the cycleSources: Bloomberg, Strategas Research Partners, April 2019. The Stress ratio is calculated by dividing the total face value of bonds priced between $75 and 95 in the Merrill Lynch US High Yield Master II Index by the total face value of bonds within the index. The Distress ratio is calculated by dividing the total face value of bonds priced below $75 in the Merrill Lynch US High Yield Master II Index by the total face value of bonds within the index. For illustrative purposes only. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Although it is difficult to quantify Private Capital alpha versus public market indices*, we believe that “thematic alpha” exists for Private Capital investors throughout the cycle. Identifying cyclical and secular themes on a global basis and investing prudently in companies involved in those themes can be a source of returns that are independent of shorter-term, public market moves. Importantly, our preference is to focus on “the small, the weird, and the ugly.” With some of the risks we discuss in this report, we prefer smaller fund sizes that can capitalize on tremors, not earthquakes. Furthermore, focusing on off-the-fairway, niche opportunities can help to insulate the strategies in which we invest from some of the larger macro issues facing both public and private markets. Finally, we believe much of the opportunity set within Private Capital comes from locating the “ugly.” These are companies (or assets) that face a pricing dislocation, perhaps due to being misunderstood or mismanaged, yet offering restructuring potential.

Private Capital investments in Asia have grown by leaps and bounds over the past decades. Around the turn of the century, $35 billion was allocated in Asia by institutional investors worldwide, representing approximately 5% of all Private Capital. At year-end 2018, 18% of global Private Capital assets under management, nearly $1.2 trillion, has a focus in Asia.⁶

The exponential economic growth in the Asia region can be one of the main contributors to investors’ interests. Growing economies and globalization have opened a wide range of business investment opportunities in the region. The rising standard of living, along with wealth accumulation, has encouraged a new generation of entrepreneurs, creating even more opportunities for private equity and venture investments.

Particularly in the case of China, the estimated 2018 gross domestic product (GDP) is more than that of the five largest economies in Europe (Germany, the U.K., France, Italy, and Spain). With the exception of a pause in 2016, China has generated solid economic growth year after year. With this backdrop, it should not come as a surprise that 5 of the 10 largest “unicorns” globally originated from China.⁷ (Unicorns refer to privately held, venture-capital-backed companies with a valuation in excess of $1 billion.)

Chart 5. Private Capital assets under management by primary geographic focus (in billions of U.S. dollars)Source: Preqin, April 2019. For illustrative purposes only.
*Indices representing private equity utilize a modified private market equivalent (mPME) calculation as a way to replicate private investment performance under public market conditions. While traditional public market indices calculate an average annual compounded return (time weighted over specified time periods), private indexes measure performance using internal rates of return and multiples based on cash flows (money‐weighted returns). Internal Rate of Return ("IRR") is a time-weighted return expressed as a percentage. IRR uses the present sum of cash drawdowns (money invested), the present value of distributions (money returned from investments) and the current value of unrealized investments and applies a discount.

Health Care should continue to provide a rich opportunity set for Private Capital investors, with key areas including the intersection of biotechnology and pharmaceuticals (biopharmaceuticals), medical technology and equipment, and medical service providers (particularly in emerging markets). Venture investing in U.S. health care companies totaled $20.3 billion in 2018, an increase of 24% over the $16.3 billion in 2017 (according to PwC MoneyTree). Capital raising in biotechnology and related sectors has enjoyed an active IPO (initial public offering) market, continued investor confidence, and further scientific advances.

Key drivers include supply-side factors, such as the scientific advances of the genomics revolution, along with demand-side drivers, such as rising demand for quality health care in emerging markets and long-term global demographic trends. Private Capital plays a key role in driving this growth. Within private equity, we believe venture capitalists and growth equity managers likely will continue to fund early-stage companies commercializing promising technologies for diagnosis and treatments. These include gene therapy, with the potential to treat genetic illnesses (such as sickle-cell anemia and hemophilia) and new potential treatments for cardiovascular disease (through stem cells) as well as cancer. We believe these managers also should continue to invest in companies operating at the intersection of mobile technologies and health care, with key developments expected in e-health care and wearable devices. Buyout firms are expected to continue driving efficiencies of mature medical service providers, equipment manufacturers, and other health care businesses. Private Capital also provides unique access to early-stage biopharmaceutical and medical equipment firms through Private Debt and debt-like strategies that involve pharmaceutical royalties and Structured Debt financing. These strategies offer the promise of regular income, low correlation with public markets, and general seniority over equity exposure to the health care sector.

Chart 6. Three of the 10 largest economies are in AsiaSource: IMF World Economic Outlook Database, October 2018. CAGR (compound annualized growth rate) of 2000-2018 gross domestic product (GDP), calculated by Wells Fargo Investment Institute.

A particular opportunity set involves health care venture investing in Asia. Asia represented the world’s second most active region for health care venture investing in 2018, with $5.2 billion invested last year, compared to Europe’s $3.7 billion. The 2018 Asian total represented a 71% increase over the 2017 Asian total, suggesting a fresh influx of new health care companies and investors in the region (according to PwC Moneytree). While China, India, and many other Asian economies have witnessed strong economic growth over the past few decades, the health care sector has been relatively nascent and underinvested in most Asian countries. The demand for high quality health care has dramatically increased, due to spreading economic prosperity, rising household disposable incomes, changing lifestyles and demographics, and workforce urbanization. In particular, health care expenditures currently represent 17% of GDP in the U.S. and 10% in most other developed economies, but only approximately 6% in China and approximately 4% in India (according to the Organisation for Economic Co-operation and Development, or OECD).⁸

However, total health care spending in both China and India grew at compound annual growth rates of approximately 13% during the past decade. In fact, both GDP, and the percentage of health care expenditures per unit of GDP, are expected to exhibit continued secular growth in China, India, and many other Asian economies over the foreseeable future. Drivers of this growth in Asia include growing middle classes with rising incomes, aging populations, and greater urbanization and accessibility to sophisticated health care services. However, the supply of quality health care products and services in many Asian locales remains inadequate to meet the strong demand in terms of both quantity and quality. This should translate to a long-term secular growth trajectory for the Asian health care sector.

Among Private Debt strategies, we are most constructive on Distressed and Special Situation funds. These funds may focus on several types of corporate (and related) debt in a range of situations, and their strategies have been able to generate solid returns even in a relatively benign economic and credit environment. Through September 30, 2018, the ILPA Private Markets Benchmark Distressed Securities Index⁹ posted 3-year and 5-year annualized returns of 10.0% and 8.5%, respectively. During periods of high defaults and general volatility, this index historically has posted significantly higher returns. Within Private Debt, we focus on three main strategies—opportunistic credit, secondary debt trading, and distress-for-control.

Opportunistic credit funds may source, directly negotiate, structure, and originate nonsyndicated, debt-related instruments, perhaps with equity components, to stressed and distressed companies not readily able to obtain financing from traditional sources. These companies may be operationally sound, but may be undergoing balance sheet reorganization or seeking financing for acquisitions.

Other Private Debt funds acquire secondary debt assets on a trading basis, either individually or in bulk. Generally sub-performing or non-performing, these debt-related instruments may include debt or related securities, such as high-yield bonds, convertible securities, bank loans, collateralized loan obligations, and mortgage-backed securities, that are trading at meaningful discounts but are expected to appreciate in value.

A third category of distress-oriented Private Debt funds represents what may be the highest potential return strategy over time—the distress-for-control strategy. Funds utilizing this strategy target stressed and distressed corporate debt with the aim of obtaining equity control of a company after a bankruptcy or similar reorganization event—and then employing financial and operational improvement tools to increase value of the restructured company over time.

We see particular opportunities in secondary strategies, including the well-established “fund secondary” strategy and the newer “secondary direct” strategy. In 2018, global secondary market volume reached another record, with approximately $74 billion of activity (a 27% increase from the previous year), supported by solid macroeconomic and public market environments.¹⁰ This is more than triple the $20 billion of secondary volume in 2008.¹¹ Despite the dramatic growth in activity and growing size of secondary funds, secondary market pricing declined modestly in 2018—the average high secondary bid for all funds in 2018 was 92% of net asset value (NAV).¹² This was a decrease of 100 basis points from the previous year.¹³

We view funds investing in fund secondaries as a key building block for nascent Private Capital portfolios, because of their potential benefits, which include rapid diversification; mitigating blind pool risk; providing earlier expected cash flows compared to primary investments in funds; and the prospects of acquiring assets at discounts to NAV.

A related strategy to fund secondary investing is “secondary direct” investing. Secondary direct is a niche private equity strategy involving the acquisition or sale of minority equity stakes in private-equity-backed private companies from equity holders, which may include company founders, employees, angel investors, venture capital funds, or strategic investors seeking liquidity. Secondary direct funds typically are able to acquire equity stakes in promising companies at more attractive entry valuations and a shorter time to liquidity, compared to primary investors in the company.

A number of macroeconomic and geopolitical factors globally lead to the expectations for a rich opportunity set for Value-add and Opportunistic Private Real Estate funds over the next few years. Value-Add real estate strategies involve acquiring and improving existing assets with less-than-ideal occupancy rates (often in the 75-90% range); enhancing occupancy rates and rental rates through systematic capital expenditure and operational enhancement programs; and then selling the improved assets. Opportunistic real estate strategies typically involve acquiring assets with even lower occupancy rates (as low as 0% as in the case of development projects under construction); making significant capital expenditures to develop, redevelop, and reposition the asset, typically securing some occupants in (and income from) the assets; and then selling them. Some managers also include in Opportunistic Real Estate the acquisition of real estate from stressed, distressed, or otherwise motivated sellers, along with take-private transactions involving publicly-traded real estate investment trusts (REITs) or other public entities.

Bouts of public market volatility; monetary tightening in several economies; geopolitical uncertainty; and an aging U.S. economic recovery and credit cycle suggest that these funds will be able to execute on their strategy of acquiring distressed, out of favor and/or undermanaged properties at attractive valuations. In addition, changing population patterns and changing global business landscapes are creating demand for real estate in geographies and sectors that currently are undersupplied.

The success of active management, and the resulting ability to find and deliver alpha, is most dependent on the environment for security selection. While a late-cycle environment should—in theory—be quite fertile for Hedge Fund investing, we believe there are several challenges that need to be carefully navigated. True to form, these challenges also can be tremendous sources of opportunity for those qualified investors who are also skilled enough to anticipate and react accordingly.

A return to a “risk on, risk off” environment is certainly a possibility that needs to be guarded against. In this scenario, both markets and central bankers respond to one another, leading to dramatic volatility spikes, followed by equally abrupt collapses. Reminiscent of 2011 (one of the most challenging years for Hedge Funds in recent memory), negative market events often were met with a favorable policy response. Not only is this devastating to Trend Following strategies that continually get whipsawed, but managing net and gross exposure is extremely difficult for Equity Hedge and Relative Value strategies in this kind of environment. Indeed, it is often easier to ride out the storm by simply maintaining market exposure (beta) rather than try to navigate through it. Generating alpha is nearly impossible in such a scenario.

A similar, though slightly different concern, would be a rise in correlations to the point that security selection is rendered useless.¹⁴ Spikes in correlation generally occur during periods of panic. In our view, they can be amplified by the growth of passively managed assets and removal of proprietary trading desks as mechanisms to transfer risk between buyers and sellers. Correlation spikes are unavoidable, so the concern is around their duration. While attractive entry points can emerge for investors with patient capital—meaning that short-term correlation spikes actually can result in long-term alpha—should we enter an environment in which asset prices correlate for a prolonged period of time, we would expect to see Hedge Funds struggle.

Private Capital investors have a different set of challenges to navigate. The rising asset valuation in the decade since the 2008 financial crisis certainly has weighed on the minds of many Private Capital investors. A recent Preqin report indicated that more than 60% of fund managers and investors consider asset valuations as the key challenge for return generation in 2019.¹⁵ PitchBook data shows a steady uptrend in the median enterprise value/EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples since 2009, with European multiples catching up to the U.S. quickly in the past two years.¹⁶

Chart 7. Private Equity multiples are trending higherSource: PitchBook, April 2019. Data as of December 2018. EV=enterprise value. The EV/EBITDA ratio is a comparison of enterprise value and earnings before interest, taxes, depreciation and amortization. This is a very commonly used metric for estimating the business valuations. It compares the value of a company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses. This ratio is also known as “enterprise multiple” and “EBITDA multiple”. The enterprise multiple can be used compare the value of one company to the value of another company within the same industry. A lower enterprise multiple can be indicative of an undervaluation of a company.

The rising asset valuation has been partially fueled by the increasing level of “dry powder” across Private Capital funds. As a reminder, “dry powder” refers to the portion of capital raised by private capital fund managers that is yet to be invested. Preqin data clearly shows steady accumulation of dry powder. Particularly since 2014, both the absolute dollar amount of dry powder and its percentage of assets under management have been rising. Dry powder is a double-edged sword. On the one hand, the readily available capital can be quickly put to work when market dislocation occurs and undervalued investment opportunities emerge. On the other hand, above average levels of capital waiting to be deployed generally drives up asset valuation. Fund managers are under the mandate to put investors’ capital to work, and delayed investments can potentially weaken (or lower) managers’ performance metrics, such as IRR (internal rate of return). The accumulation of dry powder has added to the urgency of capital deployment, particularly for those funds with vintage years 2014-2015, which are in the latter stage of their allowed investment period. When many managers are under capital deployment pressure, and the amount of investment opportunities remains limited, asset valuations get pushed up.

In this context, selecting the right manager becomes more important than ever. We would caution against investment in the mega-buyout funds that focus on specific sectors, such as Information Technology. When a buyout fund raises tens of billions of dollars, its managers generally need to make investments in larger deals to ensure their successful investments can make a meaningful contribution to the total fund return. Consequently, these managers can end up paying a higher price for investments that already are at a very high valuation, and thereby became unintended contributors to an ever-rising asset valuation trend. Particularly for sectors such as Information Technology, assets already are valued at a much higher level than the historical average.¹⁷

Chart 8. Dry powder is trending higherSource: Preqin, April 2019. Data as of December 2018. AUM = assets under management.

We prefer to take extra caution and avoid sector concentration. Instead, we prefer managers that have gained experience over multiple market cycles and that have developed disciplines, and strategies, for investing in this type of high-valuation environment. Additionally, we actively search for opportunities that are “off the beaten path” and that we believe have potential to generate a substantial return on investment, such as emerging Asia growth equity and alternative income-generating investments.

While we have conviction in our current cyclical strategy outlooks, we remain cognizant of risks that could alter these views. These risks include a recession that could come sooner than is expected; the unpredictability of U.S. politics; markets’ reactive nature; a continuation (or resumption) of quantitative easing (QE); and unexpectedly sharp inflation increases. Of these four risks, a recession that came sooner than is expected would be most impactful to our outlook.

Wells Fargo Investment Institute anticipates U.S. economic growth of 2.1% this year, and we are not calling for an imminent threat of recession. Given this constructive capital market view, we remain favorable on more directional strategies, such as Equity Hedge and Structured Credit. We believe that these strategies can provide investors with the ability to participate in further market upside, yet protect (mitigate risk) in the event of episodic volatility. However, a recession would negatively impact our views of Structured Credit, leading to a possible downgrade from favorable to neutral or even to unfavorable—as a recession would directly impact consumers and businesses, whose cash flows drive the Structured Credit market.

The Systematic Macro (Trend Following) strategy has proven to be extremely vulnerable to abrupt trend reversals, as the strategy has frequently been whipsawed and has been unable to crystalize returns in the post-crisis era. However, during a recession, there likely would be more sustained trends, such as equity and energy market declines, along with risk-off bond market gains. These developments could allow this strategy to capture trends and provide valuable downside protection. If a recession were to be on the near-term horizon (not our base case), this could lead us to upgrade Systematic Macro from unfavorable to neutral.

Additionally, for the Equity Hedge strategy, while a recession likely would cause a sharp rise in correlations among stocks, this strategy historically has outperformed broader equity markets during recessionary periods, given its ability to protect through short exposure. This would reaffirm our favorable view of the Equity Hedge strategy, given the importance of downside protection over the long term.

Historically, some of the best periods of returns for Discretionary Macro traders have occurred when there was strong momentum in currency markets. These strong return periods were often associated with abrupt changes in politics and monetary policy. The growth of populism could lead to acute currency dislocations, providing ample opportunity for Discretionary Macro traders to potentially extract returns across developed market currency pairs.

Both the Distressed and Long/Short Credit opportunity sets are most conducive when there is pressure on debt-laden balance sheets. A return to QE (or additional rate cuts) could push out the timing of the next distressed cycle, due to less pressure on corporate borrowers from a continuation of low interest rates. Such an environment could lead us to downgrade both Distressed and Long/Short Credit strategies from favorable to neutral, as a return to more accommodative monetary policy could allow over-levered borrowers to amend and extend their debts. This scenario likely would reduce credit-market volatility and dislocations that Distressed and Long/Short Credit managers typically exploit.

A large increase in inflation likely would lead to heightened stock market volatility, similar to early 2018, as it would be a precursor to higher interest rates. During these periods of episodic volatility, there have been large increases in stock correlations, which is a headwind for the Equity Hedge strategy. Large correlation increases among stocks are a sign that fundamentals are not being reflected in prices, which could hinder opportunities for long and short alpha for managers. Such an environment could lead us to downgrade Equity Hedge from favorable to neutral.

Forecasting the investment environment, especially for alternative investments, is always challenging, and we believe it requires combining art and science. In our experience, hedge fund returns can vary significantly depending on the prevailing market. In the chart below, we look at three different scenarios: one where the rolling twelve month return of the S&P 500 is at least 3% or greater, one where the rolling twelve month return of the S&P 500 Index is between -3% and +3%, and one where the rolling twelve month return of the S&P 500 Index is -3% or less. Given their “hedged” nature, we would expect hedge funds to lag during a scenario when the market is up at least 3%. Historical analysis supports that view, which can be seen by comparing the blue bars in the chart. But, in our opinion, the value of hedge funds as the cycle matures can be seen by comparing the orange and gray bars which represent the other two scenarios. While we are not calling for an imminent recession or significant equity market weakness, we think it is important for investors to understand the environment that has historically been most conducive to hedge fund returns.

As for Private Capital, we believe that one of the keys to generating above average returns is isolating thematic opportunities and focusing on “the small, the weird, and the ugly.” By this we mean focusing on smaller fund sizes that can potentially capitalize on off-the-fairway, niche opportunities, especially among companies (or assets) facing a price dislocation. We see compelling opportunities in Asia, within stressed and distressed companies, in Opportunistic Real Estate, and in Secondaries. Global Alternative Investments will be focused on bringing funds dedicated to these opportunities to their qualified investors.

Chart 9. Relative performance of hedge funds historically improves as equity returns declineSource: Hedge Fund Research, Inc. Wells Fargo Investment Institute, April 2019. WFII = Wells Fargo Investment Institute. There are difficulties in assessing asset class performance, in general, and particularly during certain time periods or equity market environments in part because these results do not represent actual trading and cannot completely account for the impact financial risk has on actual trading. In addition, any actual portfolio or account will invest in different securities than those of an index. It is important to remember there is no guarantee any asset class will perform in a similar manner in the future or in other or different equity market environments than those shown in the chart even if it has done so historically. Asset class performance will fluctuate over time and depends in large part on the risks associated with the class, among other things. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. The historical returns of each index are provided for illustrative purposes only and do not predict or depict the performance of any investment or the likelihood of achieving any return on an investment. Nor do they constitute a recommendation to invest in any particular fund or strategy. Index returns reflect general market results, assume the reinvestment of dividends and other distributions and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. Unlike most asset class indices, HFR Index returns reflect deduction for fees. Because the HFR indices are calculated based on information that is voluntarily provided actual returns may be lower than those reported. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Please see the end of this report for the definitions of the indices and a description of the asset class risks. Additional performance information is below.

With opportunities come challenges, and there are several about which we should be mindful. A return of “risk on, risk off,” or a sustained correlation spike, could make security selection and active management very challenging. We caution Private Capital investors to be cognizant of valuations and the abundance of dry powder. A multitude of concerns exist as well, from the risk of an accelerated recession, to potential for the return of QE and rate cuts, to an inflation spike, and to uncertainty around Brexit and the U.S. elections. All of these issues require monitoring (among others), along with a willingness to adapt to new information. It is an exciting time to be investing, and we feel strongly that alternative investments have indeed entered a new era of opportunity.

Alternative investments are not suitable for all investors and are available only to persons who are “accredited investors” or “qualified purchasers” within the meaning of U.S. securities laws. They are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program.

¹ Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market’s movement as a whole.

² Hedge Fund Research Inc., April 2019.

³ Beta is a measure of the risk arising from exposure to general market movements (rather than from idiosyncratic factors).

⁴ We define this as any bond trading at more than 1000 basis points over the London Interbank Offered Rate, or LIBOR.

⁵ Fallen angels are companies that experience ratings downgrades that move their debt from investment grade to high yield.

⁶ Preqin, April 2019.

⁷ Ten largest unicorns globally as of July 2018. Source: Preqin Pro.

⁸ Organisation for Economic Co-operation and Development (OECD), Health spending (indicator), Accessed on April 22, 2019.

⁹ The ILPA Private Markets Benchmark Distressed Securities Index is a horizon calculation based on data compiled from 275 distressed securities funds, including fully liquidated partnerships, formed between 1987 and 2017. All returns are net of fees, expenses, and carried interest. Pooled return aggregates all cash flows and ending NAVs in a sample to calculate a dollar-weighted return. (minimum 3 funds). Past performance is no guarantee of future results.

¹⁰ Greenhill & Company, “Global Secondary Market Trends and Outlook”, January 2019.

¹¹ Ibid.

¹² Ibid.

¹³ One hundred basis points equal 1%.

¹⁴ Correlation is the extent to which the values of different types of investments move in tandem with one another in response to changing economic and market conditions.

¹⁵ Preqin Global Private Equity and Venture Capital Report, February 2019.

¹⁶ PitchBook Private Market Playbook, First Quarter, March 2019.

¹⁷ Preqin, April 2019

Commercial Mortgage Backed Securities (CMBS) are a type of mortgage-backed security backed by commercial mortgages rather than residential real estate. CMBS are subject to the risks associated with the underlying pool of assets in which the CMBS represents an interest; fluctuations in interest rates and to the spread between short-term and long-term bond rates; securities market risks; credit/default; declines in rental or occupancy rates, weakness in the real estate market, among others.

A Credit Default Swap is a derivative contract between two parties that exchange the risk of default associated with a loan (bond or other fixed-income security) for periodic income payments throughout the life of the loan. They involve the risks associated with changes in the returns of the underlying instruments, failure of counterparties to perform under the contract terms and the possible lack of liquidity with respect to the swap agreement. In addition, they may be difficult to value. There can be no assurance that the use of these derivatives will be successful.

Derivative prices depend on the performance of an underlying asset. A small movement in the price of the underlying asset may produce a disproportionate large movement whether favorable or unfavorable in the price of the derivative instrument. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, liquidity, counterparty and management risks. Investing in derivatives carries the risk of the underlying instrument as well as the derivative itself.

The environment defined by the 12-month return of the S&P 500 Index being at least 3% includes 267 data points from January 1990 through March 2019. The standard deviation of returns for those periods are as follows: S&P 500 Index of 9.6%; HFRI Fund Weighted Composite Index of 8.9%; HFRI Equity Hedge Total Index of 11.2%; HFRI Macro Total Index of 13.2%; HFRI Relative Value Total Index of 6.2%; and HFRI Event Driven Total Index of 8.6%.

The environment defined by the 12-month return of the S&P 500 Index being between -3% and +3% includes 21 data points from January 1990 through March 2019. The standard deviation of returns for those periods are as follows: S&P 500 Index of 1.3%; HFRI Fund Weighted Composite Index of 7.4%; HFRI Equity Hedge Total Index of 7.7%; HFRI Macro Total Index of 8.1%; HFRI Relative Value Total Index of 6.5%; and HFRI Event Driven Total Index of 7.9%.

The environment defined by the 12-month return of the S&P 500 Index being less than -3% includes 52 data points from January 1990 through March 2019. The standard deviation of returns for those periods are as follows: S&P 500 Index of 10.6%; HFRI Fund Weighted Composite Index of 7.5%; HFRI Equity Hedge Total Index of 9.9%; HFRI Macro Total Index of 4.7%; HFRI Relative Value Total Index of 8.5%; and HFRI Event Driven Total Index of 9.7%.

General Alternative Risks: Alternative investments, such as hedge funds, private capital, private debt and private real estate funds are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of the U.S. securities laws. They are speculative, highly illiquid, and are designed for long-term investment, and not as trading vehicles. There is no assurance that any investment strategy will be successful or that a fund will achieve its intended objective. Investments in these funds entail significant risks, volatility and capital loss including the loss of the entire amount invested. The increased risk of investment lost is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. The high expenses associated with alternative investments must be offset by trading profits and other income which may not be realized. Unlike mutual funds, alternative investments are not subject to some of the regulations designed to protect investors and are not required to provide the same level of disclosure as would be received from a mutual fund. They trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the fund and the investor. An investment in these funds involve the risks inherent in an investment in securities and can include losses associated with speculative investment practices, including hedging and leveraging through derivatives, such as futures, options, swaps, short selling, investments in non-U.S. securities, “junk” bonds and illiquid investments. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. Other risks can include those associated with potential lack of diversification, restrictions on transferring interests, no available secondary market, complex tax structures, delays in tax reporting, valuation of securities and pricing.

Strategy Risks: Alternative investment strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, are speculative and involve a high degree of risk. These strategies may expose investors to risks such as short selling, leverage risk, counterparty risk, liquidity risk, volatility risk, and other significant risks. In addition, they engage in derivative transactions. Short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss to a portfolio. In addition, taking short positions in securities is a form of leverage which may cause a portfolio to be more volatile. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks which may negatively affect a portfolio’s performance. The use of derivatives for other than hedging purposes is considered speculative and involves greater risks than those associated with hedging. Equity Hedge strategies maintain positions both long and short in primarily equity and equity derivative securities. Event Driven strategies involve investing in opportunities created by significant transactional events, such as spinoffs, mergers and acquisitions, bankruptcy reorganization, recapitalization and share buybacks. Managers who use such strategies may invest in, and might sell short, the securities of companies where the security's price has been, or is expected to be, affected by a distressed situation. Also, these securities may be illiquid and have low trading volumes. Macro managers trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Relative value strategies focus on exploiting perceived imbalances or valuation discrepancies between related markets or instruments. They involve investments in instruments such as convertible bonds, preferred securities and the use of derivative transactions which may include options, swaps and other derivatives.

Distressed securities are “below investment grade” obligations of issuers in weak financial condition, experiencing poor operating results, having substantial capital needs or negative net worth. Such securities are therefore considered speculative. They often face special competitive or product obsolescence problems and may be involved in bankruptcy or other reorganization and liquidation proceedings. Distressed-for-control investments (e.g., convertible debt, convertible preferred, debt with warrants, etc.) are structured with the intent of gaining control of a company on favorable terms, non-performing loan (NPL) portfolios (either in default or close to it) that can be purchased at deep discounts, and rescue financing or other special situations. Investing in distressed companies is speculative and involves a high degree of risk. Because of their distressed situation, these securities may be illiquid, have low trading volumes, and be subject to substantial interest rate and credit risks.

Long/short credit strategies seek to mitigate interest rate and credit risks regardless of market environment through investment in credit-related and structured debt vehicles. These strategies involve the use of market hedges and involve risks such as derivatives, fixed income, foreign investment, currency, hedging, leverage, liquidity, short sales, loss of principal and other material risks.

Private debt strategies seek to actively improve the capital structure of a company often through debt restructuring and deleveraging measures. In private debt investments, an investor acts as a lender to private companies and loans have specific contractual interest rate terms and repayment schedules. Such investments are subject to potential default, limited liquidity, the creditworthiness of the private company, and the infrequent availability of independent credit ratings for them. Because of their distressed situation, private debt funds may be illiquid, have low trading volumes, and be subject to substantial interest rate and credit risks. These funds often demand long holding periods to allow for the end of the debt’s term or an exit strategy via the secondary market which is not guaranteed to exist or develop. Other material risks include capital loss and the potential loss of the entire amount invested.

Structured credit strategies aim to generate returns via positions in the credit sensitive area of the fixed income markets. The strategy generally involves the purchase of corporate bonds with hedging of interest rate exposure. The use of alternative investment strategies may require a manager’s skill in assessing corporate events, the anticipation of future movements in securities prices, interest rates, or other economic factors.

Private equity secondary strategy involves a significant degree of risk. Funds investing in a secondary strategy bear their direct expenses and management costs, as well as its pro rata share of the expenses and management costs incurred by the underlying funds in which it invests. This may result in more expenses being borne by the Limited Partners than if the Limited Partners were able to invest directly in the underlying funds. The secondary strategy investments are expected to include underlying funds and indirectly underlying portfolio companies whose capital structures may have significant financial leverage. The leveraged capital structure of such investments will increase the exposure of such investments to adverse economic factors such as rising interest rates, downturns in the economy or deteriorations in the condition of an underlying portfolio entity or its industry. The activity of identifying, completing and realizing attractive secondary investments is highly competitive and involves a high degree of uncertainty. Over the past several years, both the number of competitors for secondary investments and their available capital have increased, and additional capital will likely be directed at this sector in the future. As a result, it is possible that competition for appropriate investment opportunities may increase, thus reducing the number of investment opportunities available.

Special Situations strategies employ an investment process primarily focused on opportunities in equity and equity related instruments of companies which are currently engaged in a corporate transaction, security issuance/repurchase, asset sales, division spin-off or other catalyst oriented situation. These involve both announced transactions as well as situations which pre- or post-date or situations in which no formal announcement is expected to occur. Strategies employ an investment process focusing broadly on a wide spectrum of corporate life cycle investing, including but not limited to distressed, bankruptcy and post-bankruptcy security issuance, announced acquisitions and corporate division spin-offs, asset sales and other security issuance impacting an individual capital structure focusing primarily on situations identified via fundamental research which are likely to result in a corporate transactions or other realization of shareholder value through the occurrence of some identifiable catalyst. There is no guarantee that the specific event will occur or that the market will react as expected with respect to such events. In addition, the securities of such companies may lose more value that the securities of more stable companies which can result in greater share price volatility.

Real Estate Strategies: The value-added strategy seeks to add value by making enhancements to properties. These properties may have operational issues and usually require additional leverage to acquire. There is no guarantee value appreciation will be achieved and the operating company may be forced to sell properties at a lower price than anticipated. An opportunistic investment style bears the highest level of risk among real estate strategies as it typically involve a significant amount of “value creation” through the development of underperforming properties in less competitive markets or other properties with unsustainable capital structures. Although these investments have the potential to generate income, there is no guarantee they will do so over their investment time periods. In addition, private real estate is considered illiquid, there is no assurance a secondary market will exist and there may be restrictions on transferring interests. Since the opportunistic properties have little to no cash flows at time of acquisition, higher leverage is often employed and sponsors may be subject to less favorable debt terms and higher interest rates than more stabilized properties. All investments may be negatively impacted by varied economic and market condition which may be unpredictable.

The S&P 500 Index is a market capitalization-weighted index composed of 500 stocks generally considered representative of the US stock market.

HFRI Fund Weighted Composite Index: The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in US dollars and have a minimum of $50 Million under management or a twelve (12) month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.

HFRX Equity Hedge (Total) Index: Equity Hedge strategies maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. Equity Hedge managers would typically maintain at least 50%, and may in some cases be substantially entirely invested in equities, both long and short.

HFRI Macro (Total) Index is composed of a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency, and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top-down and bottom-up theses, quantitative and fundamental approaches, and long- and short-term holding periods. Although some strategies employ Relative Value (RV) techniques, macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments rather than realization of a valuation discrepancy between securities.

HFRI Relative Value (Total) Index maintains positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative, or other security types.

HFRI Event Driven (Total) Index -- Event-Driven Investment Managers who maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.

The Merrill Lynch US High Yield Master II Index (H0A0) is a commonly used benchmark index for high-yield corporate bonds. It is administered by Merrill Lynch. The Master II is a measure of the broad high yield market, unlike the Merrill Lynch BB/B Index, which excludes lower-rated securities.

An index is unmanaged and not available for direct investment.

Global Investment Strategy (GIS) and Global Alternative Investments are divisions of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

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