The value potential of alternative investments
Alternative investments, including private capital and hedge funds, continued to gain traction among high-net-worth investors. According to Preqin, private capital asset under management has soared from under $1 trillion in 2003 to over $15 trillion in 2023. Many qualified investors are drawn to alternatives for potential diversification benefits and differentiated strategies available.
- Diversification benefits: Alternative investments often focus on opportunities not available in public markets. For example, private equity and private credit managers own or lend to privately held companies that are not traded on stock exchanges. These companies jointly account for a majority of companies created and represent diverse industries and sectors. This feature contrasts with a shrinking public market universe, the returns of which are increasingly driven by a handful of mega-cap technology companies in recent years. Alternatives’ diversification benefit potential are also evidenced by a lower correlation to public assets and a lower return standard deviation (volatility) compared with similar public assets (chart 1). These diversification attributes can help mitigate pullbacks in public markets and thereby smooth an investor’s return experience.
- Differentiated value propositions: Venture capital may enjoy favorable return potential, and private debt may offer incomes, as they capitalize on taking ownership of early-stage, high-growth companies or financing mid-sized companies. In contrast, infrastructure strategies provide investors access to public service entities’ stable cash flows, characterized by limited competition and relatively inelastic demand. Therefore, infrastructure returns are often defensive to economic downturns and can offer a buffer from elevated inflation. This diverse set of investment opportunities is also reflected in the wide range of historical returns. As shown in chart 1, Private Equity led the group with an impressive 15% average return over the 10-year period ending September 30, 2023, followed by other private capital asset classes’ near 10% annual profits, with many of them outperforming similar public assets.
Chart 1. Historical private and public asset class average return and standard deviationSources: Wells Fargo Investment Institute, Pitchbook, and Bloomberg. Data as of September 30, 2023. Average annualized returns depicted are calculated over a 10-year period spanning Q4 2013 to Q3 2023. Private equities: Pitchbook Private Equity Index. Private debt: Pitchbook Private Debt Index. Private Real Estate: Pitchbook Private Real Estate Index. Hedge fund: HFRI Fund Weighted Composite Index. Public equity: MSCI All-Country World Index. High-yield fixed income: Bloomberg U.S. Corporate High Yield Index. Public Real Estate: FTSE NAREIT All Equity REITs Index. See back of report for index definitions. An index is unmanaged and not available for direct investment.
Past performance is no guarantee of future results.
Given these potential benefits, our illiquid strategic allocation designed for qualified investors allocates 10% to 25% to alternatives. Over the 10-year period ending September 30, 2023, adding 20% alternative investments to a blend of stocks and bonds resulted in more favorable portfolio risks and returns (chart 2).
Another driver that has fueled the growth of alternatives is innovation. New strategies and products have been developed through the years to satisfy the needs of private businesses and investors alike.
- New strategy trends: Direct lending witnessed rapid growth in recent years, as private lenders provided desired financing certainty and speed. Direct lending also helped fill the financing gap created by banks’ withdrawal from lending to many private companies due to regulatory and business reasons. Secondaries is another growing strategy that offers much-needed liquidity in private markets, where liquidity has been constrained by macro uncertainties and soft exit activities. Finally, infrastructure funds gained renewed interests, driven by policy supports and the need to electrify and digitize our society.
- Semi-liquid products: A new breed of products are increasingly available across private capital asset classes. Unlike traditional drawdown structures, these semi-liquid funds offer greater accessibility and allow periodic liquidity, immediate capital deployment, simplified tax reporting, and a potential lower investment minimum. According to Preqin, there are over 500 semi-liquid funds available globally, representing at least $350 billion in assets. Many products are tailored to high-net-worth investors.
We consider alternatives long-term investments, which can help improve investors’ return and risk experience and increase the probability of achieving financial goals. To invest in alternatives, qualified investors should develop a diversified allocation based on liquidity need, time horizon consideration, and product vehicle preference.
Chart 2. Historical portfolio return and risk standard deviation with and without alternative investmentsSources: Wells Fargo Investment Institute, Pitchbook, and Bloomberg. Data as of September 30, 2023. Average annualized returns depicted are calculated over a 10-year period spanning fourth quarter (Q4) 2013 to Q3 2023. The figures along the lines represent the respective weights of the stock/bond or stock/bond/alternative mix. The 20% alternatives added are equally distributed across the four alternative asset classes, specifically 5% in private equity, 5% in private debt, 5% in private real estate, and 5% in hedge funds.
Private equities: Pitchbook Private Equity Index. Private debt: Pitchbook Private Debt Index. Private real estate: Pitchbook Private Real Estate Index. Hedge fund: HFRI Fund Weighted Composite Index. Public equity: MSCI All-Country World Index. High-yield fixed income: Bloomberg U.S. Corporate High Yield Index. Public real estate: FTSE NAREIT All-Equity REITs Index. An index is unmanaged and not available for direct investment.
call out “For all your days prepare, and meet them ever alike.”
— Edwin Markham end call out
Target change recap
We introduced our 2025 equity earnings and price targets while simultaneously raising some of our 2024 targets in response to our improved economic outlook. We summarize the updates below.
For S&P 500 Index constituents, we believe supply chain issues are mostly in the rearview mirror; wage increases are moderating; labor efficiency (that is, sales per employee) is at an all-time high and may trend higher; and interest costs appear manageable. We believe positive economic growth should drive sales (see chart) while cost control should help anchor company profit margins. We expect S&P 500 Index earnings per share (EPS) to improve from $240 in 2024 to $260 in 2025.
Equity markets may have already priced in much of 2024’s good news, however. We suspect that markets may struggle to advance meaningfully past recent highs while uncertainties persist surrounding the path of inflation, as well as the timing and magnitude of Fed rate cuts. Still, we would view periods of equity market weakness as opportunities, given that our outlook through 2025 supports improved revenue growth and expanding margins. We project the S&P 500 Index will likely end 2024 between 5100 and 5300 before resuming the trend higher to end 2025 between 5600 and 5800.
We continue to prefer a quality-based approach to portfolio positioning and remain favorable U.S. Large Cap Equities, as we view the group as the highest-quality major equity asset class due to strong company balance sheets, durable pricing power, and resilient growth potential. We believe these characteristics should help U.S. Large Cap Equities manage disappointments to sentiment more effectively than other domestic and international asset classes.
Higher GDP has generally translated into higher sales growthSources: Bloomberg and Wells Fargo Investment Institute. Quarterly data: March 31, 2001 – December 31, 2023. The trailing 12-month S&P 500 Index sales data is moved back 6 months. GDP = gross domestic product. Nominal GDP axis truncated at 12%. An index is unmanaged and not available for direct investment.
Past performance is no guarantee of future results.
10-year yields — A look back
10-year U.S. Treasury yields have experienced significant volatility since we first established a year-end 2024 target over 16 months ago. In our view there are three clear and distinct periods over this timeframe.
10-Year Treasury YieldSources: Wells Fargo Investment Institute (WFII) and Bloomberg, as of April 9, 2024.
- The Fed last increased the short-term federal funds rate on July 26, 2023, yet 10-year Treasury yields continued to trend higher through mid-October 2023 as inflation proved more stubborn to bring down than most market participants had expected.
- Falling inflation, weakening economic data, and concerns the Fed had gone too far began to emerge in the fall of 2023, and by the end of the year, markets were expecting six to seven 0.25% Fed rate cuts in 2024. During this period, 10-year Treasury yields fell dramatically from almost 5.00% to a low of 3.80% near year-end 2023.
- Year-to-date, 10-year Treasury yields have been on an upward trajectory as the economy has proven more resilient than most market participants have expected, and inflation has continued to run above Fed targets. We believe the market now expects just two or three Fed rate cuts this year. We just reduced our expectation from three Fed rate cuts in 2024 to two, and if the economy continues to remain resilient, we would not be surprised if the Fed leaves rates unchanged through year-end.
Until we see more evidence of economic slowing and moderating inflation, we believe that the near-term trend for longer-term rates is biased higher. 10-year Treasury yields are near the mid-point of our year-end target last week and a re-test of the October 2023 highs cannot be ruled out. We remain convicted that the Fed will eventually be successful in lowering inflation closer to its stated 2% goal, and we view levels near or above the upper-end of our 2024 target range of 4.25% – 4.75% as attractive levels to term out rate exposure.
Gold hitting new all-time highs – Raising targets
Gold did it again last week, on April 9, closing at another new all-time high. We say “again” because last week’s new high, at $2353 per troy ounce, marked the 16th time this year that gold has closed at a new all-time high. Not surprisingly, its 14% return so far in 2024 has handily outpaced the 5.7% return of the broader Bloomberg Commodity Index (BCOM).
We believe gold owes its stellar start to the year to both technical and fundamental reasons. On the technical front, a string of new all-time highs by an asset is often viewed positively by investors. When the series of new all-time highs is accompanied by strong trading volumes, it can be especially attractive to long-term investors. The reason is that it often signals broad investor recognition that fundamental trends are strong, and the future looks bright. From what we see today, gold appears to have both strong fundamental trends and a bright future.
In our view, the main positive fundamental trends driving gold prices today are: 1) persistent purchases from global central banks, 2) growing demand from emerging market consumers, 3) stagnating supply growth, and 4) heightened geopolitical tensions. We do not anticipate these trends changing anytime soon.
As for gold’s future over the next 6 to 18 months, we believe the shifting interest rate landscape could be a particularly powerful tailwind. While it is no secret that the Fed wants to cut interest rates later this year (if economic data permits), not as well-known is the fact that some of gold’s strongest past performances have come during Fed rate-cut cycles. The chart shows the price of gold rising 20%, on average, in the 24 months following the start of Fed rate-cut cycles. Of course, past performance is not a guarantee of future results.
The bottom line is that we have been favorable on gold since 2022, so it is encouraging to see prices finally reflecting fundamentals. For this reason, we raised our 2024 forecast to $2,300 – $2,400 per troy ounce, and even higher to $2,400 — $2,500 per troy ounce for 2025. Worth noting is that we suspect gold may need to take a breather before it moves higher through 2025. Gold’s 14% gain so far in 2024, as of April 9, is its best start to a year since 2012.
Gold’s performance around Federal Reserve easing cyclesSources: Bloomberg, Ned Davis Research, and Wells Fargo Investment Institute. Monthly data is from November 1969 – June 2021. The gold spot price (XAU) was used to measure performance.
Past performance is no guarantee of future results.
Cash Alternatives and Fixed Income
Most Unfavorable |
Unfavorable |
Neutral |
Favorable |
Most Favorable |
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- High Yield Taxable Fixed Income
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- Cash Alternatives
- Developed Market Ex-U.S. Fixed Income
- Emerging Market Fixed Income
- U.S. Long Term Taxable Fixed Income
- U.S. Intermediate Term Taxable Fixed Income
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- U.S. Taxable Investment Grade Fixed Income
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- U.S. Short Term Taxable Fixed Income
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Equities
Most Unfavorable |
Unfavorable |
Neutral |
Favorable |
Most Favorable |
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- U.S. Mid Cap Equities
- Developed Market Ex-U.S. Equities
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Real Assets
Most Unfavorable |
Unfavorable |
Neutral |
Favorable |
Most Favorable |
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Alternative Investments**
Most Unfavorable |
Unfavorable |
Neutral |
Favorable |
Most Favorable |
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- Hedge Funds—Event Driven
- Hedge Funds—Equity Hedge
- Private Equity
- Private Debt
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- Hedge Funds—Relative Value
- Hedge Funds—Macro
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Source: Wells Fargo Investment Institute, April 15, 2024.
*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.