In the fourth installment in the Alternatives Watch Outlook Series, we discuss how market shifts are affecting investments for non-profits through the lens of an outsourced CIO (OCIO) specialist.
Jim Dunn, the CEO and CIO at Verger Capital is well known in investor circles from his time as the CIO at Wake Forest University. Prior to that, he was a managing director at Wilshire Associates and the CIO and portfolio manager for Wilshire Funds Management.
Verger Capital spun out of the Wake Forest University Office of Investments in 2014 with the aim of exclusively serving non-profit organizations including endowments and foundations, most primarily focused on educational institutions, non-profit healthcare entities and community and cultural foundations.
Indeed, the firm is known for being an early adopter of ESG and diversity screening its external managers. Here Dunn discusses what investors can realistically expect from private markets this year.
Over the next 12 months, how are you formulating your portfolio allocations? What is top of mind?
Verger has the privilege of serving long-term investors — non-profit endowments and foundations with perpetual time horizons. While we remain cognizant of trends and economic indicators, we don’t make predictions or attempt to time markets. The past two years have demonstrated that markets aren’t always linear or predictable, so we believe it is essential to build portfolios that are resilient in all market environments.
Entering 2022, we believe markets are in a much different position compared to the past several years as exemplified by recent market volatility, rising inflation, and the broad consensus that return expectations across the entire spectrum of asset classes are likely to be lower going forward.
Our view is that we are in an environment where market risk is high for many traditional assets while at the same time the expected return for many risk assets is declining. The past decade has generally provided accommodating conditions for stocks and bonds, but the triumvirate of lower expected returns, lower rates, and higher inflation makes it difficult to envision outsized returns going forward. Moving forward, it will be imperative to look beyond a traditional 60/40 portfolio and reframe investor’s ideas about what diversification really means.
Calendar year 2021 returns from some of our managers indicate opportunity in more niche markets for active managers to add value, such as U.S. small cap value and emerging markets small cap. We also believe resource related equities (e.g., agriculture, industrials, precious metals, energy, real estate, and infrastructure) may provide diversification benefits, especially during periods of rising inflation. In an anticipated environment of lower expected returns and higher volatility, we believe various hedged strategies (e.g., multi strategy) are also attractive compliments to an overall portfolio. Finally, it is our view that non-traditional fixed income (e.g., non-agency mortgages, long/short credit, emerging markets) is more attractive than U.S. investment grade and high yield.
As we approach the third year of the pandemic, what are your thoughts about the macroeconomic picture?
The Fed has begun tapering its bond purchases and has stated its intent to raise rates over the next several quarters. As rates rise and there is less access to cheap capital, we could see multiple expansion slow and more muted equity returns going forward. Things could potentially be even worse for fixed income. Inflation is now outpacing rates significantly and negative real rates are a real possibility for the foreseeable future. This isn’t to say that last year’s inflation rate of 7% is the new norm, but it’s likely that inflation will be elevated above what we saw pre-pandemic.
While the recent stock market sell-off has been generally attributed to the emergence of the Omicron variant, the bond market suggests it is more likely that investors are starting to question the long-term growth outlook. With Fed policy becoming more restrictive — which is the prevailing sentiment surrounding the end of quantitative easing — attention may be turning to the fiscal and regulatory side of the growth equation. On that front, we see little in the pending legislation that directly addresses our long-standing economic shortcomings.
There is also the small matter of the ongoing upheaval in China which seems to have the potential for a large, negative impact on the global economy. Every day China is looking more like Japan at the end of the 1980’s. That isn’t necessarily negative for the rest of the global economy — just as the end of Japan’s boom was not — but it adds an element of ambiguity that did not exist until recently.
What role do you see private capital playing in your portfolio going forward?
By almost every measure, 2021 was an extraordinary year for private strategies. Following the markets’ rapid recovery in the second half of 2020, private equity broke many records in 2021, including, fundraising, deal making, pay pressure, capital velocity, and time constrained due diligence, among others.
One may argue that private asset valuations are reaching troublingly high levels and that leverage and valuation are, once again, creeping into dangerous territory, especially given the 2022 outlook for slower global economic growth and rising interest rates.
We remain cautiously optimistic, having witnessed the resilience of private equity over the last 30 years, along with its tendency to outperform most other asset classes during volatile or contracting periods. We believe it is imperative to stay disciplined and avoid chasing performance and will continue to allocate capital to these strategies in the same measured and deliberate way that we have since our inception. This includes an emphasis on managing liquidity and sizing commitments appropriately as well as painstakingly underwriting every opportunity regardless of whether it is a new manager or one with whom we have invested over several fundraising cycles. The ability to identify and invest in top quartile managers within private equity will continue to be a significant driver of an investor’s ability to outperform going forward.