Morgan Stanley IM: Hybrid/Opportunistic Funds Offer Risk-Adjusted Returns

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Traditional long-only public market investments are facing pressure from multiple forces ranging from rising interest rates and asset class correlations to inflation and economic slowdown, following years of success amid relatively liberal capital markets and suppressed volatility. The shift has prompted investors to reconsider how to rebalance and optimize portfolios and examine a variety of new approaches from asset type utilization to reviewing strategic and tactical allocations. This trend is causing a transition from liquid public markets to alternative private investments. Public equity markets have been offering increasingly narrow exposure across fewer long-standing names. Private markets supplement and complement that contraction. To a lesser degree, credit investors are entering private markets to achieve a truly diversified portfolio of yield, a migration that started with the zero interest rate policies during the global financial crisis and that has continued into the current rising rate environment, which favors shorter duration and floating rate instruments, among other investments. Investors who have preferred neatly categorized formal portfolio allocations are now questioning whether they should consider broadening their investment options, and in this paper we examine some of the opportunities offered through private hybrid/ opportunistic funds to lessen the impact of current market challenges.

Key Takeaways

• Current environment forcing a reconsideration of traditional asset allocation
• Hybrid funds may provide differentiated sources of return taking advantage of supply-demand imbalances
• Post-GFC specialized hybrid funds are benefitting from the flow of investments which historically may have been owned by the proprietary investment teams at investment banks
• Various market conditions may be favoring this type of investment style

Understanding Hybrid/ Opportunistic Funds

Hybrid/opportunistic funds encompass a wide range of asset classes and instruments aimed at decreasing portfolio volatility and reducing market beta. In general, these funds have more liberal mandates to invest across asset classes and to utilize specific instruments that may not fit into a current investment category or traditional investment mandate. While traditional investing may simplify portfolio allocations, the undercapitalized, underrecognized, un-catalogued, and under-pursued investment opportunities can offer the highest risk-adjusted returns. Hybrid/ opportunistic funds act as customized capital solutions providers to companies with unique liquidity needs. These funds are advantageous because they can invest across the capital structure and use a variety and combination of investment instruments to create unique risk-reward profiles.

Historically, these types of capital solutions were provided by proprietary desks at investment banks, which were able to offer flexible solutions and capital efficiently because their mandates were so broad. The banks themselves ultimately benefitted from these investments. Capital provision by proprietary desks ceased after the global financial crisis, when the banks reverted to their core banking businesses. Subsequently, these bespoke capital solutions are now offered to those with capital or liquidity needs by private funds, which enable their investors to benefit from this flexible investing style.

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