Less conventional asset classes including Real Estate, Natural Resources and Alternatives helped insulate our portfolios in an incredibly challenging market environment last year.

By most measures, 2022 was a challenging year for financial markets. Scratch that… “challenging” doesn’t quite do it justice. Painstaking? Frustrating? Agonizing? We’ll let you choose your own adjective but suffice it to say the year was hard and left few places to hide as far as returns go. Want some numbers to back that up? For the S&P 500 Index, it was the fourth-worst calendar year performance since the index was reconstituted in 1957. Foreign Equities1 managed to perform only modestly better than their U.S. counterparts, but still ended the year down 16%. For bonds, as measured by the Bloomberg U.S. Aggregate Bond Index, it was the worst year in history. Not surprisingly, this means that for a “diversified” 60/402 portfolio this past year marked the second worst annual returns since data has been tracked – second only to 2008. But it wasn’t all bad news. At Osborne Partners, we have long touted the virtues of having exposure to complementary asset classes like Real Estate, Natural Resources, and Alternatives – and within these asset classes there was some positive news to share. In this article, we’ll share some of these positive developments, reiterate why these smaller asset classes can have larger impacts on your portfolio, and offer a brief glimpse at what may be in store for these investments in 2023.

Let’s start by taking a look at Real Estate. Like many other “risk” asset classes, it was a difficult year overall. Returns were modestly worse than global equity markets as rising interest rates, inflation, and broader worries around the health of the global economy weighed on performance. Within U.S. and Global REITs (Real Estate Investment Trusts), more defensive parts of the market held up admirably (healthcare, lodging, timber) while some cyclical end markets saw more notable pressure (apartments, industrial, office). Within homebuilding, solid fundamentals met head-on with rapidly rising interest rates, resulting in a volatile year for the group. Companies involved in commercial real estate services saw similar dynamics, with investors doing their best to assess the impact of higher rates on a still‑recovering commercial real estate market.

Despite the various headwinds, the Real Estate asset class still provided value to portfolios. How? First, our diversified REIT exposure helped with income generation driven by the roughly 4% yield these investments offer. Second, our skilled nursing facility exposure via Omega Healthcare3 (ticker: OHI), finished the year up nearly 4%, outpacing the benchmark by over 25%. Lastly, after being down sharply through the middle of June, our homebuilding exposure via Lennar Corporation (ticker: LEN) saw a notable inflection, rallying over 32% from its June bottom through year end. As far as 2023 goes, our team expects another volatile year for this asset class. As opposed to 2022, which saw a major valuation reset alongside more stable fundamentals – 2023 could bring more pressure to fundamentals. Although, importantly, valuations have already been recalibrated and interest rates should be less of a headwind. As such, after being net sellers of this asset class for the past year and a half, we are starting to see attractive opportunities emerge which could result in opportunistically increasing exposure.

In prior years, our team has written about the importance of having exposure to asset classes with low correlations to the rest of your portfolio. If this sounds familiar, it is probably because this is one of the core tenets of diversification. For some, diversification simply means adding some bonds to a portfolio of stocks and stopping there. But in years like 2022 that saw multi-decade highs in inflation and one of the fastest Federal Reserve hiking cycles in history, this approach clearly falls short. This is why our Investment Team has stressed the importance of holding assets that perform well in a much wider variety of economic environments – including the one we saw last year. And there is no better example of this than Natural Resources. After being the worst performing asset class for much of the last decade, it has become the best performing asset class over the last two years, and the only asset class outside of cash and alternatives to record positive returns last year (the Bloomberg Commodity Index finished the year up 16.1%). After leaving the asset class for dead, many investment managers are just now waking up to the realization that Natural Resources deserves a role in portfolios.  But surely after two stellar years, 2023 is poised to be a disaster for this asset class, right? Not so fast. In the wake of the COVID-19 outbreak, the initial surge in commodity prices was catalyzed by stimulus-fueled demand outpacing structurally constrained supply. This was largely true across the entire commodity complex – everything from grains to gasoline. This imbalance led to outsized appreciation in commodity prices and contributed to the inflation dynamics we are still grappling with today. But in more recent months, we have seen a moderation in demand across many commodities in conjunction with normalizing supply conditions. The result of this has been significant declines in most commodity prices since the highs we saw last summer. In 2023, many commodities need to see further demand destruction to balance the still off-balance supply-demand picture. As such, we think this asset class could once again play a valuable role in a truly diversified portfolio.

Source: Last two years ending 12/31/22. OPCM. Commodities: Bloomberg Commodity Index, U.S. Equities: S&P 500 Index, International Equities: MSCI All Country World Ex-US Index, Fixed Income: Bloomberg Aggregate Bond Index
 

Across all the asset classes we invest in, Alternatives will typically be the one that is least
correlated with the rest of the portfolio. And while the asset class may be relatively small, its role in the portfolio is not, serving as a hedge against outsized moves in key variables like interest rates and the U.S. dollar, or providing niche exposure to assets like merger arbitrage, private equity and distressed securities. Our exposure to these hedging and niche baskets will vary over the economic cycle and, in general, will lean more heavily towards “niche” exposure very early through the middle phase of economic cycles, and will lean more heavily towards hedges from the middle through the late phase of the economic cycle. You may have noticed this dynamic starting to manifest in portfolios this year. Throughout the course of 2022, we exited our interest rate hedge, trimmed our U.S. dollar hedge – both of which were two of our best-performing positions – while also exiting our S&P 500 Index hedge. In total, our Alternatives finished the year in positive territory and accomplished its primary job – helping insulate the portfolio during a year that saw a constant barrage of headwinds. So, what’s next? While increased exposure to portfolio hedges can be viewed as risk mitigation, it’s possible that in 2023 a greater portion of this asset class will be comprised of pro-risk niche investments that attempt to take advantage of dislocation in asset prices. As usual, any changes we make won’t happen overnight and will be driven by our team’s time-tested discipline and process.

2022 was a great reminder of the significance of complementary asset classes like Real Estate, Natural Resources, and Alternatives in a diversified portfolio. Hedging against key variables, enhancing the income generation of portfolios and performing well in a high-inflation, high-interest rate environment are just a few of the many beneficial characteristics these asset classes possess. As our Investment Team looks ahead to 2023, we expect another active year within these asset classes, as well as across client portfolios, and we look forward to sharing our thoughts and commentary with you as we navigate what we expect will be another eventful year. As always, thank you for placing your trust in Osborne Partners – we look forward to engaging with each of you soon!