Rebalancing for resilience

The end of the Great Moderation

Inflation, once a long-tail risk to developed world economies, is now the primary risk facing many markets. Figure 1 highlights the volatility of U.S. inflation-adjusted gross domestic product (“real GDP”) and inflation since 1965. During the period of the Great Moderation, real GDP growth was relatively stable and inflation uncertainty remained benign. Inflation hovered in a tight band of approximately 1-2% on average. However, this wasn’t always the case.

Figure 1: The end of the Great Moderation
Volatility of U.S. GDP and CPI, 1965-2022

If we look back to the mid-1960s to 1980s, we see a distinct period where both growth and inflation were more volatile. In 2022, that volatility spiked, and investors are arguably entering a period where growth and inflation may be out-of-sync at times. Policymakers face tougher trade-offs in a world of greater inflation sensitivity. Reining in inflation comes at much greater cost to growth. Preserving growth comes with much higher inflation. As a result, the macroeconomic environment is likely to be much more unstable than in the past which is likely to reverberate through financial markets and create a higher level of volatility.

The portfolio pivot to private markets

During this time period, some institutional investors increased private market allocations in their portfolios. According to our most recent institutional investor asset allocation study, 43% of respondents planned to increase their allocation to private equity and credit during 2021 (Figure 2).²

Figure 2: Institutional investors intend to add private markets
Percentage of respondents intending to increase/decrease private asset allocations

Private assets through a risk lens

This shift in asset allocation to private markets has potentially significant implications for the overall mix of risk in a portfolio. To understand this, we go beyond asset class labels and instead view assets through a risk factor lens. Risk factors are broad and persistently rewarded drivers of return that can help explain an asset class’s historical return.³ Using this perspective, we can attribute return outcomes to their exposure to macro risk factors: inflation, real rates, credit, economic growth, emerging markets, commodity, foreign exchange (FX) and alternative.⁴

Decomposing the risk factors of private assets, both equity and credit, reveals that they may introduce a greater level of absolute risk to portfolios that is highly related to economic growth risk that drives equity markets. In fact, the long-term correlations of private equity and private credit to public equities have been +0.86 and +0.74, respectively.⁵ A deeper look at the underlying risk factors that make up these asset classes can help explain why this has been the case.

Figure 3 compares public equity and private equity based on risk factor exposure given a historical lookback period of over 20 years. What is immediately clear is that private equity comes with an even larger concentration in “economic growth” risk than is already present in public equities. Although it does introduce a new source of return categorized as “alternative” which can entail several factors not quantifiable by the risk modelling process such as idiosyncratic, illiquidity or complexity risk premium.⁶ A look at credit reveals a similar outcome with “economic growth” risk being injected into the mix when you move from public to private market exposure. However, unlike equity, U.S. credit in isolation has very low exposure to the economic growth factor.

Figure 3: Private assets may double down on equity-like risks
Risk factor exposure comparison

Consequently, if investors are swapping public assets for private assets, they are potentially introducing more equity-related risk—essentially doubling down on the dominant driver of their asset allocations. This can help accelerate returns in most environments when economic growth is strong, but the greater risk exposure may have the reverse effect during economic shocks. These potentially enhanced returns may come at the cost of reduced total portfolio diversification.

Liquidity constraints - What the risk lens cannot see

Like most risk models, our analysis does not specifically quantify the liquidity premium associated with private assets. Liquidity risk is very difficult to measure and quantify. Furthermore, liquidity needs can be highly dynamic and often needed most when it is scarcest.

Lagged valuations for private assets can further obscure a portfolio’s liquidity profile. Sharp declines for public securities can leave investors with outsized allocations to private assets — commonly referred to as the “denominator effect.” This occurs when shrinking values in one asset class pull down the overall value of the portfolio. Simultaneously, the numerator (private assets), which did not decrease in value, now represent a larger portion of the total portfolio. These mismatches in pricing efficiency can make maintaining portfolio balance during periods of elevated volatility complex, and potentially lead to costly portfolio rebalancing at inopportune times.

From a purely qualitative perspective, liquidity constraints on private assets are highly variable as well. Each come with a unique set of constraints and requirements depending on the terms of the investment. Often, they have a set “lock up” period where capital cannot be accessed once invested—ranging from 5 years, 10 years or as long as 12 years.⁷ For those that are more “open-ended”, there is also a wide level of differentiation, and the terms can differ depending on if you are subscribing or redeeming. More opened-ended strategies can have a mix of monthly, quarterly, or annual subscription/redemptions terms. 

The BlackRock Investment Institute ran an analysis of the percentage of private asset investments most institutional investors could take on depending on individual objectives, risk tolerance and annual cash flow needs. The results showed those with low liquidity requirements could comfortably move up to 40% into private assets. For institutions with lower risk tolerance and less predictable or high liquidity needs, that number can drop to 10%.⁸

While pursing greater long-term return potential through private assets, investors should consider their unique circumstances when determining the portion of the portfolio that must be liquid for future funding requirements.

Rebalancing for resilience

So how do investors balance the needs to generate greater long-term return potential, diversify portfolio risk exposures, and maintain an adequate liquidity profile? In our view, liquid alternatives can provide the balance against private markets to bring back diversification, hit return targets, and not have significant portfolio capital locked up.

Many hedge funds claim to target both higher returns and downside risk mitigation, which in theory makes them an excellent solution to address both the return and portfolio diversification challenges faced by institutional investors.  However, in our experience, many of these strategies have delivered investment outcomes that make the same market risk/return trade-off as traditional long-only asset classes—where strong performing strategies come with high correlations to equity markets.

Figure 4 shows the risk exposure of the Hedge Fund Research Index Composite which represents the average of 500 strategies including Equity Hedge, Event Driven, Macro and Relative Value Arbitrage funds. While idiosyncratic risk (captured here as “alternative”) makes up a sizeable portion of return contribution, over 60% of returns can be explained by exposure to economic growth risk. In the aggregate, hedge funds have delivered the same directional risk exposures investors were likely trying to avoid in the first place. We believe hedge funds that derive a larger portion of returns from idiosyncratic risk are more likely to meet the return and diversification outcomes that many institutions need from a liquid alternative strategy. 

Figure 4: Hedge funds have largely delivered the same equity-like risk/return outcomes
Macro risk factor contribution

Selecting a liquid alternative to rebalance risk assets

Private assets are already playing the role of enhancing return potential—and with it, they bring the dominance of equity-related risk factors. Thus, in our opinion, the liquid alternative should play the primary role of portfolio diversifier—helping to dampen equity-like risks, but still delivering a potentially attractive return stream. Identifying strategies that can perform these dual outcomes requires a careful set of considerations. We believe liquid alternative strategies that are designed to balance out private asset allocations should exhibit a balance of three unique characteristics: (1) meaningful diversification versus risky assets, (2) durable alpha generation in up and down markets, and (3) defensive behavior when markets are under stress.

Diversification

First, does the strategy offer diversification benefits? A telling characteristic to look for is low correlations to other broad asset classes in your portfolio—think risky assets like U.S. and global equities, high yield bonds, or private markets. Many alternative strategies offer attractive returns, but with very high correlation to equity-like assets—essentially doubling down on the pre-dominant risk in many portfolios. Others offer more modest returns but deliver them without the same level of equity-related risk.

Durable Alpha

Second, does the strategy have a history of skilled alpha generation? As a long-term holding in an asset allocation, it is our belief that capital should be put to the most efficient use to produce positive returns. Consistent returns with relatively low volatility can help balance out the loss of return from other low risk asset classes like core bonds, but still deliver the stability that has made core bond allocations attractive in the past. Risk-adjusted return measures such as Sharpe and Treynor ratio can provide a top-level indicator of efficient risk usage. Furthermore, a positively skewed upside/downside capture ratio can signal that the strategy is not just providing a watered-downed version of market beta, but rather, demonstrating skilled alpha generation.

Defensiveness

Finally, is the strategy defensive when investors need it? The timing of returns matter. Potential ways to gauge if a strategy is truly defensive is by looking at how the strategy has historically performed in significantly negative equity markets of 5, 10 or even 15%—the time when defense is needed most. A strategy may not always exhibit defensiveness across all market environments or events, but what is essential is the strategy diversifying behavior doesn’t consistently disappear at the same time other assets in a portfolio are selling off. A strategy that is defensive when other risk assets are under pressure may allow the total portfolio to better weather different market environments.

Conclusion

The Great Moderation has ended, and we believe we are entering a new regime of higher macro uncertainty that will translate into more volatile capital market returns. Private assets have gained momentum as a valuable tool to help boost long-term return potential, but their equity-like risks and liquidity characteristics can create new portfolio challenges that must be managed. Liquid alternatives may help boost flagging portfolio returns and better diversify the equity-like risks that already dominate most investors’ portfolios.