Investment Strategy

An era of growth in alternative investments

Historically the realm of institutional or ultra-high net worth investors, the world of alternative investments today is more accessible to the average investor and increasingly thought of as a core component of any well-diversified portfolio. Alternative investments consist of two broad categories of strategies, 1.) private capital, and 2.) hedge funds.

Private capital strategies may include Private Equity, Private Credit, Private Real Estate, and Private Infrastructure. The landscape of private capital markets encompasses over 87% of the businesses with revenues greater than $100 million¹ and over $22 trillion of a $24 trillion U.S. commercial real estate market.² Moreover, as public markets have become increasingly driven by a select few mega-cap technology-oriented companies, the vast opportunity set in private capital markets may help investors construct more diversified portfolios and potentially gain exposure to rapidly growing businesses.

Hedge funds can include a mix of liquid and illiquid investments, yet generally possess flexibility to express views (both positive and negative) on the economy, markets, companies, or commodities. As the name implies, many of these strategies employ hedging techniques that may also serve to mitigate the impact of declining markets and/or reduce unintended risks.

The rise in demand of alternative investment strategies can be partially attributed to the increased accessibility for retail investors. Yet another contributing factor to growth in alternative assets (see chart 1) is the growing realization of some of the potential benefits alternatives may offer in building long-term wealth, preserving capital in challenging markets, and generating income to meet spending needs.

Chart 1. Growth in private capital and global hedge fund assetsSource: Preqin. Data as of June 30, 2024.

Understanding the role of alternative strategies

The various alternative strategies may serve distinct roles in a portfolio. While Private Equity strategies typically seek to generate higher returns than have been achieved in the public markets historically, other strategies such as Private Debt may help to diversify an investors’ sources of income by originating direct loans to small and mid-sized businesses. Moreover, we believe incorporating hedge funds in a portfolio of traditional stocks and bonds may help to reduce risk (as measured by portfolio volatility) or potentially contribute to improved risk-adjusted performance over time. For other strategies such as Exchange Funds, seeking to manage the risks involved in holding concentrated stock positions and mitigating the impact of taxes is a primary consideration.

We believe alternative strategies may serve a unique role in a well-diversified portfolio. As investors carefully construct a diversified portfolio of alternative investments to complement their current mix of traditional stocks and/or bonds, understanding the unique attributes and roles each investment plays in the overall portfolio may be a key aspect. We believe an optimal blend of alternative strategies should help account for return targets, income needs, risk tolerance, and investment horizon to help investors achieve their long-term financial goals.

While many investors have yet to incorporate alternative strategies in their portfolios, 2025 may be the year for investors to consider a new investing resolution and learn how alternative strategies may help build a portfolio better suited to meet their unique needs.

Table 1. Various roles and strategy types that may help achieve investment objectives

Role	Objective	Strategy-type
Performance	Expand opportunity set and provide the potential for greater absolute and/or risk-adjusted returns	Private Equity, Private Debt, Private Real Estate, Hedge Funds
Diversification	Build a more resilient portfolio by combining uncorrelated assets	Private Infrastructure, Private Real Estate, Hedge Funds
Income	Diversify income sources	Private Infrastructure, Private Debt, Private Real Estate
Tax efficiency	Mitigate the impact of taxes on portfolio returns	Exchange Funds, 1031 Exchange Funds

Source: Wells Fargo Investment Institute.

Alternative investments, such as hedge funds, private equity, private debt, and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

¹ Capital IQ, Data as of September 2024.

² Blackstone, Federal Reserve, as of June 30, 2023.

California wildfires: Insurance losses and market impact

The devastating January 7, 2025 California wildfires, fueled by strong Santa Ana winds and pre-existing dry conditions, have burned tens of thousands of acres, including high-value properties. According to AccuWeather, estimated economic losses range up to $100 billion, with insured losses between $20 – $30 billion — comparable to some of the most destructive major U.S. hurricanes.³

We believe losses will be distributed among stakeholders, including the California Fair Access to Insurance Requirements (FAIR) Plan, commercial and homeowners’ insurers, as well as those insurers that specialize in high-value excess and surplus.

The frequency of severe natural disasters has increased in recent years, prompting major insurers to reduce their exposure in California and in other parts of the U.S. prone to large-scale disasters. Larger insurers, backed by strong capital reserves, have increased rates, strengthened reinsurance programs, and limited new policies and policy renewals to mitigate exposure in the state. We believe regulatory changes just prior to the fires, specifically the ability for underwriters to use forward-looking climate-based models to inform policy pricing, could encourage insurers to reenter the California market or expand coverage to more homeowners, albeit at likely higher rates.

While unfortunate events like these can create challenges, we do not anticipate a material impact on the majority of insurers and maintain a favorable outlook on the Property & Casualty Insurance sub-sector.

Insured property losses, inflation adjusted ($ million)Sources: Insurance Business Magazine and Wells Fargo Investment Institute. Data as of May 17, 2024. Ongoing California wildfires indicated by bar with lines.

³ “$30B California Fire Loss Seems Possible,” Wells Fargo Securities, January 12, 2025.

Municipal tax exemption under the microscope

Interest on municipal bonds has been exempt from federal income tax since the tax’s inception in 1913. Since that time, the topic of ending the exemption has come up dozens of times. However, the most recent escalation of the issue could potentially have more support than in recent years as Congress is contemplating how to generate additional revenue should provisions within the Tax Cuts and Jobs Act of 2017 be extended.

For as much support as the elimination may garner, we believe there will be at least an equal amount of opposition from state and local borrowers and those organizations representing them. The Securities Industry and Financial Markets Association (SIFMA) has already said that advocacy for the maintenance of the tax-exempt status will be a priority going forward. The Public Finance Network’s current estimates predict the elimination of the tax-exemption would raise borrowing costs $824 billion over 10 years while saving the federal government $364 billion during that same time. Even more precisely, this translates to an estimated cost of more than $5,000 per U.S. taxpayer.

Projected cumulative borrowing costs, 2026 – 2035 (in billions)Source: The Public Finance Network, “Protecting Bonds to Build Infrastructure and Create Jobs”, January 15, 2025. Forecasts are not guaranteed and based on certain assumptions and on views of market and economic conditions which are subject to change.

States and local governments account for 90% of all public-sector construction spending with most funds provided through municipal bonds. Tax savings in the billions over the next 10 years would have to be absorbed by taxpayers of both political parties in the event the exemption is removed. For these reasons, we ultimately expect that the status quo is maintained for state and local government tax exemption. However, we acknowledge that there may be more risk to the exemption for private-activity bonds and other non-municipal borrowers.

The impact of expanding Alaska’s oil

On January 20, 2025, President Trump signed the “Unleashing Alaska’s Extraordinary Resource Potential” executive order, reopening leasing and permitting activity for oil and gas production along the coastal plain of the Arctic National Wildlife Refuge (ANWR). Given the high cost of producing oil today and the historical lack of interest in the area, we are skeptical that U.S. production would be impacted anytime soon.

The coastal plain of the ANWR is home to 10.4 billion barrels of crude oil reserves, according to the U.S. Geological Survey (USGS). For perspective, if ANWR were a country, its reserves would rank 17th largest in the world, ahead of Mexico and Norway. Reserves, of course, are not the same as production. Mexico and Norway rank as the world’s 11th and 12th largest producers, while ANWR has yet to produce a drop of oil.

ANWR has been a hotly contested area for potential oil and gas drilling for decades. It has largely gone untouched, but President Trump changed that in 2017 by opening up ANWR to potential oil and gas drilling. The first sale in the region was held in 2021 but garnered minimal interest, receiving bids on 11 plots from three entities. Ultimately, two canceled their leases, while a 2023 executive order canceled the remaining lease. Bidding was also opened in 2024, but no sales took place (see chart below).

Bidding and sales on land leases in ANWR have never amounted to much, in large part because of the area’s relatively dim drilling economics. The Energy Information Administration’s most recent study on the region came in 2018, and it estimated that production would not begin until 2031, assuming leases were granted in 2021, and that peak production would not occur for at least another 10 years. These economics stand in stark contrast to the U.S.’s most successful oil-producing shale basins.

The bottom line is that ANWR has significant oil reserves, and more bidding on land leases appears likely in the coming years. That said, we remain skeptical that ANWR will produce much oil for the U.S. anytime soon.

Alaska’s oil production continued to decline despite lease salesSources: Energy Information Administration and Bureau of Land Management (BLM). Annual data is from 1999 – 2024. Land plots (tracts) receiving bids in the National Petroleum Reserve of Alaska and ANWR are shown above. In 2021 and 2023, bidding was only opened for the ANWR. 2024 production is taken as a 12-month average from October, given that November and December data has not been released.

Cash Alternatives and Fixed Income

Equities

Real Assets

Alternative Investments**

Source: Wells Fargo Investment Institute, February 3, 2025.

*Tactical horizon is 6-18 months

**Alternative investments are not appropriate for all investors. They are speculative and involve a high degree of risk that is appropriate 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. Please see end of report for important definitions and disclosures.

Each asset class has its own risk and return characteristics. 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. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation, and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is appropriate 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. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

Global Investment Strategy (GIS) is a division 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.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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