- Chinese property credit risk and Fed tapering both hit equity markets last week.
- UBS said investors should consider diversifying into alternative assets ahead of Q4.
- Insider breaks down the bank’s top three alternative sources of return.
Stock markets were roiled last week when China’s second-largest property developer Evergrande struggled to cover liabilities of $300 billion and the Federal Reserve announced it will begin scaling back asset purchases “soon”.
Both events point to looming stock market risks, according to Mark Haefele, the chief investment officer at the Swiss investment bank UBS – the world’s biggest asset manager.
“Markets were volatile last week, as investors wrestled with worries over credit risk in China’s property market and Fed tapering,” Haefele said in a recent research note. “With various risks on the horizon, investors can consider diversifying their sources of risk and return in the final quarter of the year.”
UBS said although both events had injected some volatility into global markets, there remained potential upside for equities.
“While evolving events could prompt further bouts of volatility, we don’t see a broad systemic risk that would cause investors to underweight China, or equities more widely,” Haefele said. “We advise caution only in affected sectors like Chinese property and financials.”
However, with equity markets still close to record highs, the bank said now is the perfect time for investors to diversify their portfolios.
"Alternatives can offer a way to potentially enhance portfolio returns and increase diversification," Haefele said. "We believe investors should consider a range of alternative sources of return as we approach the fourth quarter."
Insider breaks down UBS's three preferred alternative investment strategies.
Put options and structured products
A put option gives its owner the right to sell a specified amount of a stock when it reaches a certain price. These tend to increase in value as an asset's volatility rises.
UBS said options strategies currently represent an attractive alternative to bonds as a hedge against stock market declines.
"The demand for put options, which help protect against equity market declines, has increased," analysts said. "Investors looking to hedge equity exposure should consider put spreads, or similar structures, that combine both long and short positions to cheapen protection."
The bank also recommended retail investors look into structured products. These offer access to derivatives, which are financial contracts between multiple parties.
"Investors who would like to participate in further upside, but fear short-term pullbacks could consider using structured investments with levered upside and downside protection characteristics," UBS said. "The elevated skew enables them to benefit from payoff asymmetry."
Hedge funds
A hedge fund is an actively managed investment vehicle available to wealthy investors.
"Historically, hedge funds have both suffered smaller drawdowns and recovered faster than equities during crises," Haefele said. "Data since 1990 suggests adding hedge fund exposure has improved the risk-return profile of a multi-asset portfolio."
After the sector posted double-digit returns in 2020, the average hedge fund has returned between 5% and 10% so far this year, compared with a 16% return for the S&P 500, according to HFR indexes. Total inflows for 2021 stand at $18 billion.
UBS said hedge funds will particularly help to diversify an investor's portfolio if the Evergrande debt crisis and a shift in Federal Reserve monetary policy continue to cause increased market volatility.
"Although hedge funds have only outperformed a rising equity market three times in the past two decades, in almost every year that equities have fallen, hedge funds have outperformed stocks," the bank said.
Private markets
Private markets, consisting of private equity and private real estate, are defined as capital that is not listed on a public exchange. These types of investments have historically outperformed stocks but are not always easily accessible to all investors.
"Over the next few market cycles, we expect private equity and private real estate to return 9.5% and 7.6%, respectively, versus just 6.6% per year for US large-cap stocks," Haefele said.
UBS said investing in private markets created alternative sources of growth. Private equity funds invest in small- and mid-level companies, offering greater exposure to emerging markets.
"497,000 tech companies globally are privately held, compared with just 8,100 that are listed on public exchanges," analysts said. "Private equity investors are particularly active in fintech, digital subscriptions, healthcare, and in sectors benefiting from the shift to more sustainable economies."
"Private markets can offer a potential way of enhancing portfolio returns, and increasing diversification," they added.