In the current high-interest rate environment of 2024, investors' expectations for returns have shifted significantly compared to a decade ago. This report examines the evolving landscape of expected returns, with a focus on preferred returns and market expectations for 2024.
Shifting Expectations in a High-Interest Rate Environment
Historical Context
Ten years ago, a 6% return was considered reasonable for many investment strategies. However, the financial landscape has undergone substantial changes since then, primarily due to prolonged periods of low interest rates followed by recent aggressive rate hikes by central banks to combat inflation.
Current Market Dynamics
As we navigate through 2024, investors are adjusting their expectations in response to the higher interest rate environment:
- Higher Baseline Returns: With risk-free rates (such as Treasury yields) elevated, investors now expect higher returns across all asset classes to compensate for the increased opportunity cost.
- Recalibrated Risk Premiums: The spread between risk-free rates and expected returns for riskier assets has narrowed, as investors demand more compensation for taking on additional risk.
- Increased Volatility: Higher interest rates have led to increased market volatility, particularly in long-duration assets like growth stocks and long-term bonds.
Preferred Returns in 2024
Preferred returns, commonly used in private equity and real estate investments, have also adapted to the new interest rate environment:
Definition and Structure
A preferred return is a profit distribution preference that rewards investors with a minimum return before the investment sponsor can participate in profits. Typically expressed as a percentage, preferred returns are designed to align interests between investors and sponsors.
Current Preferred Return Rates
In 2024, preferred return rates have adjusted upward:
- Private Equity and Real Estate: While 8-10% was common in the past, many deals now offer preferred returns in the 10-12% range to remain attractive to investors.
- Venture Capital: Some VC funds are offering preferred returns of 12-15% to early or substantial investors, reflecting the higher risk profile of startup investments.
Factors Influencing Preferred Returns
- Interest Rate Environment: As risk-free rates have increased, preferred returns have adjusted upward to maintain their appeal.
- Investment Risk: Higher-risk investments typically offer higher preferred returns to compensate investors.
- Fund Size and Strategy: Larger funds or those with more conservative strategies may offer lower preferred returns compared to smaller or more aggressive funds.
Market Expectations for 2024
Equity Markets
- Positive Outlook: Morgan Stanley's research suggests global equities will bring positive returns in 2024, with particularly strong potential in European and Japanese markets[1].
- Sector Focus: Investors should look for stocks inversely correlated to bond yields (e.g., real estate, utilities) and quality growth sectors (e.g., software, pharmaceuticals)[1].
Fixed Income
- Attractive Opportunities: As central banks begin to cut rates, fixed income assets are expected to find support. Mortgage-backed securities, leveraged loans, and investment-grade corporate bonds are considered attractive[1].
- Yield Curve Positioning: An active approach to curve positioning could be beneficial, given the potential for rapid shifts in interest rate expectations.
Alternative Investments
- Continued Relevance: Despite the potential comeback of bonds, alternative investments are expected to deliver competitive returns while providing risk diversification.
- Liquid Alternatives: Strategies such as equity market neutral and systematic multi-strategy funds have shown resilience and may continue to attract investor interest.
Conclusion
As we progress through 2024, investors must adjust their return expectations to account for the higher interest rate environment. While a 6% return may have been satisfactory a decade ago, today's market demands higher returns to compensate for increased opportunity costs and risks. Preferred returns in private equity and real estate have similarly adjusted upward, with rates of 10-12% becoming more common.
The outlook for 2024 remains largely positive across various asset classes, with opportunities in both equity and fixed income markets. However, investors should remain vigilant and consider diversifying their portfolios with alternative investments to manage risk effectively in this evolving financial landscape.