OUR CURRENT STANCE
Investors are welcoming a new era where they can pursue target returns without taking on undue illiquidity or complexity. Given higher interest rates, returns from lower risk investments are much more worthy of consideration in today’s market. For example, we have been able to shift assets from more volatile “bond-replacement” investments such as real estate, hedge funds and dividend stocks, and back into traditional bonds.
We welcome this return to more typical levels of interest rates and a more rational cost of capital, which should benefit bottom-up fundamental investors that focus on quality, cash flow and other factors that were de-emphasized in the era of “free” money.
While the risk of recession in 2024 appears to be falling, it is far from gone, and our expectations for equity returns going forward are still muted—simply because the strong equity returns of 2023 were largely the result of expanding multiples rather than earnings growth. We have modestly reduced our equity allocations, trimming most notably from the richly valued U.S. large-cap growth segment.
EQUITIES
With higher interest rates, cash flows and leverage become larger drivers of performance for equities, and this is especially true in a highly concentrated market being carried by a high-flying subset of stocks.
Valuations in the U.S. are broadly “elevated,” but there is a clear dichotomy, with the Magnificent Seven stocks trading at nearly 50x earnings at the end of 2023, while the rest of the U.S. large-cap market traded at a more down-to-earth 18x multiple.
When looking at smaller companies in the U.S., valuations appear lower than their long-term averages. Valuations in Europe and Asia are also more attractive. This valuation backdrop is informing several of our equity allocation stances.
Overweight U.S. small-cap: We typically maintain an overweight to smaller companies, which generally outperform larger company stocks over time, and which often fly under the radar of Wall Street research coverage. The recent underperformance of small-caps has made this segment even more attractive due to relative valuation. If the U.S. does avoid a recession, we would expect this allocation to meaningfully outperform the broader market.
Modest tilt to value within equities: We have had this “tilt” in place for a year or more; given the relative underperformance of value stocks in 2023, this valuation gap has only widened and value stocks therefore remain attractive to us. We would expect value stocks to be buoyed if the U.S. economy stays strong in 2024.
Infrastructure and energy transition: We still see value in allocating to infrastructure. These are high-quality, long-life assets that provide mission-critical products and services with monopoly-like characteristics. These assets facilitate the movement and storage of energy, water, freight, passengers and data. Even if inflation continues to cool, it remains well above long-term averages, and we appreciate the consistent inflation-linked cash flows of many infrastructure companies. Furthermore, the “non-deferrable” demand for these assets helps protect revenues in periods of economic weakness. We also see meaningful opportunities for capital investment through a greater demand for assets that transmit and store data, renewables in the quest for decarbonization as well as the reshoring of physical assets largely described as deglobalization. Finally, valuations have also come down materially, presenting an attractive entry point for allocations here.
Globally-oriented European exposure: Though economic risks are certainly present, our managers are finding selective opportunities to invest in leading global companies that are trading at discounted valuations because of their European domicile. Europe is home to preeminent names in aerospace, finance, consumer staples and luxury brands; thanks to inflation, sluggish European growth and the ripple effects of the Ukraine war, many of these names have underperformed the broader market—despite generating much of their revenues from outside Europe.
“Pan-Asian” exposure with reduced weighting in China: Chinese stocks disappointed investors in 2023; the reopening of the Chinese economy did not spur growth as many had hoped. China’s massive real estate sector is burdened by declining home sales, falling prices and the bankruptcy of some of the country’s largest real estate developers. Political and regulatory uncertainty also remains high, increasing the risk of investments in China.
Meanwhile, growth has remained strong in India, and Japan has made major progress in terms of both profitability and better governance. On the margin, we’ve been shifting capital out of China to more pan-Asian strategies, and we’ve seen many of our Asia managers de-emphasize China as well. In our view, the market clearly still represents massive potential, and we will continue seeking out ways to capture its opportunities without exposing ourselves to undue political and economic risk.
FIXED INCOME
After years of meaningful underweights, most of our client portfolios are now at or above our long-term targets for bonds, and portfolio durations have been extended (despite still being relatively short compared to fixed-income benchmarks). We are unlikely to match the duration of the bond market, which has extended materially in recent years as companies locked in lower yields with longer-maturity bonds.
At or above target weight to fixed income: We have funded our “re-allocation” to bonds from areas like real estate, hedge funds and dividend stocks (in “lean” years when bonds offered paltry returns, these higher-risk areas helped provide the yield and diversification that bonds traditionally offer).
Gradual extension of duration: Our latest increases in duration occurred as the 10-year Treasury yield approached 5%; after subtracting long-term inflation expectations of 2%, the 10-year presented an attractive real yield of nearly 3%, which is the highest we’ve seen in 20 years. While there is certainly a scenario in which rates move higher again, we believe the current yield on our bond portfolios should provide ample protection against that.
Selected opportunities in credit: In 2023, credit markets repeatedly offered us equity-like returns with lower risk. Whether one compares bonds vs. stocks, private credit vs. private equity, or real estate debt vs. real estate equity, we are broadly seeing better risk-adjusted returns from certain credit investments than from equity counterparts; importantly, we find that solid, bottom-up credit research is an essential step in unearthing and vetting these opportunities.
PRIVATE INVESTMENTS
Public markets are reaching all-time highs, but private markets are lagging in this new regime of higher interest rates. There is always a delay in how private investments respond to market conditions, but the lag has been especially pronounced in this cycle. Fundraising and deal activity levels are near the lows reached in 2009, despite a strong economy and healthy public markets.
While we don’t think this “reset” stage is quite finished, we do believe we’re setting up for what will eventually be a strong period of private market returns. Market timing in private markets is nearly impossible, and we believe that consistency with one’s commitments is the key to long-term success. We are favoring credit commitments over equity, and have slowed down in real estate, but we are not skipping vintages from our most important manager relationships. As deal activity has slowed, we are feeling more confident that these managers will be able to pace their investments over a longer multiyear period in keeping with historical norms. When clients commit to these funds today, they are committing to investments that may occur five years from now—perhaps at more compelling prices.
Venture capital: As the cost of capital has risen and investors are hyper-focused on cash flow and path to profitability, venture funding has dried up and valuations have come down. We expect 2024 to be a crucial year in venture capital; companies that raised large war chests in the past will need to raise more money, and deals may occur at more attractive valuations as a result. More venture-backed companies are likely to fail this year, as investors will be more reluctant to continue funding companies with weaker business models or operations. Additionally, we expect a moderate shakeout in the sector as some venture firms close and non-traditional participants (e.g., mutual funds and hedge funds) retreat. The ongoing retrenchment is likely to lead to a healthier and more attractive investment environment for our clients, and we are glad for opportunities to re-up with our highest-conviction managers when they come to market, especially with regard to earlier-stage venture managers.
Lower middle market: We tend to favor lower middle market strategies in private equity—typically these are smaller managers who write smaller checks and generally use less leverage to generate returns. This approach makes even more sense in the current environment, where leverage is much more expensive. A number of our managers specialize in adding value operationally, and many of them have expertise in turnarounds that may be quite helpful in a more challenging environment for levered businesses.
Private credit/income: Returns in private credit are likely to be buoyed by higher interest rates in the coming years. Most of these are floating-rate loans, benchmarked to overnight lending rates of 5.0%. With banks pulling back from lending in the wake of Silicon Valley Bank’s collapse, lenders have more bargaining power these days and terms have also improved.
We acknowledge that the private credit space has experienced enormous AUM growth in recent years, but we believe that potential returns in this space could exceed 12%, which compensates us, in our view, for the risk that perhaps too much capital is chasing these opportunities.
Real estate: This sector has been very quiet as the big move in interest rates has severely curtailed deal activity. When deals are being done, some are driven by distress, such as a need to refinance or to inject required capital into a property. While we continue to back our longest-standing relationships in this space and will not be skipping vintages, we have downsized our commitments to real estate equity, to make room for compelling opportunities in real estate debt. Much like with private credit, we are simply seeing more opportunities to generate equity-like returns in real estate debt, presenting a more attractive risk-adjusted return compared to real estate equity.
HEDGE FUNDS
Are hedge funds back? Returns were disappointing for many years after the 2008-09 credit crisis, but perhaps the sector has turned a corner. Ever since the “meme stock” craze of 2021, where managers suffered mightily shorting stocks like GameStop, industry performance has been quite strong.
Higher interest rates have led to two big benefits for hedge fund investors: 1) yields exceeding 5% on the cash they receive when the fund shorts stocks and 2) the return of short selling as a fruitful endeavor, thanks to the end of the “free money” era and a decline in individual stock correlations as a result. The year 2023 may go down as our best year in this space since 2007, in both absolute and relative terms.
Despite all of this, we need to temper optimism for the sector with prudence in our asset allocation thinking. For a number of clients, reducing hedge fund exposure makes more sense now that they can earn 5% on short-term deposits.
Smaller, nimbler equity long-short managers: This represents a growing percentage of our allocation in recent years. Fund size tends to be the enemy of performance when shorting stocks, as many of the best shorting opportunities are in small-cap or mid-cap companies. The vast majority of our long/short equity managers today are running strategies with <$5 billion in assets, giving them the flexibility to short these smaller companies.
Diversifying exposure to healthcare/biotech specialists: We launched a dedicated life sciences fund portfolio in 2022, the Brown Advisory Biotechnology Partners Fund; the idea may have been early, but we don’t think it was wrong and we added it to our allocations in 2023. We think good stock-pickers can thrive in this space, as most investors shy away from investing in companies that require specific scientific knowledge and bear the risk of drug approvals. This is precisely why we like the sector: the dearth of informed investor competition. This sector today remains relatively inexpensive by historical standards, and large-cap pharma companies remain flush with cash for acquisitions, which are increasing in number and size.
Long/short credit, distressed and multi-strategy managers: We expect long/short credit managers may see more opportunities as levered companies struggle with higher costs of capital. We’ve seen excellent results from these managers in recent years and a new distressed cycle could further enhance their opportunity set.
Multi-managers: Over time, we have limited investment in multi-manager hedge funds (multiple portfolio managers running their own portfolios, typically with tight risk management and a market-neutral stance) due to high fees and low transparency, for the most part. In recent years, however, a new group of these funds started to offer more palatable fees and much better transparency. When managed well, the results of these multi-manager funds can really help portfolios with their low volatility and low correlation to core asset classes. We believe they were, in many ways, the best replacement for bonds during the long, low-rate environment of the past few decades. While we may have less of a need for these strategies thanks to higher interest rates, we do think these funds can play an important role.
Note: All commentary sourced from Brown Advisory as of 12/31/23 unless otherwise noted. Alternative Investments may be available for Qualified Purchasers or Accredited Investors only. Click here for important disclosures, and for a complete list of terms and definitions.