Multi-asset class investors must be vigilant of the probable degree of correlation with equities during late-cycle, warns bfinance

This is particularly significant during the later stages of market cycles when returns compress and market participants come under pressure to maintain performance, says bfinance.

In its white paper, Five Levers for Reducing Equity Risk, bfinance argues that there is no ‘silver bullet’ for improving portfolio diversification or resilience to crashes. Instead, investors should consider an approach which is:

(a) multi-faceted; and

(b) sensitive to current market conditions or implementation practicalities.

The paper goes on to outline several currently popular methods, including two real estate-related strategies: increasing illiquid and liquid alternatives.

Bfinance says investors and stakeholders should distinguish between the two key objectives of diversification: improving long-term risk adjusted returns and achieving resilience during market downturns. These two objectives are not synchronous and can conflict with each other.

In order to enable a better understanding of diversification, many sophisticated pension funds and other asset owners now seek to view their portfolios through a risk factor lens rather than relying on more conventional asset allocation strategies. This task is not straightforward: risk factor models vary greatly in their complexity and scope. They also differ in their applicability, with private market risk exposures proving particularly problematic.

Lever 1: illiquid alternatives

Private market investments such as infrastructure, private debt and real estate have perhaps, been the most popular diversifying “lever” of the past decade. In part, this trend has been anchored in the promise of diversification. Yet market dynamics have encouraged a drift towards equity risk, both through visible strategic shifts and less visible style drift within similarly-labelled strategies.

The attractiveness of this lever is, however, enhanced by the growing breadth of opportunities and strategies available: there are now more managers, sub-sectors, geographies and implementation approaches available to investors than ever before.

Lever 2: liquid alternatives

Although private markets have been the chief beneficiary of the trend away from ‘traditional’ asset classes, alternative strategies in liquid markets provide different and more explicit forms of diversification.

Liquid alternatives encompass an exceptionally broad range of strategies, asset classes and instruments, varying not only greatly in terms of the liquidity of the vehicles in which they are packaged, but also in terms of the correlation with equites.

Investor appetite is particularly strong in two major areas: hedge funds with very explicit convex returns profile (e.g. CTAs, Global Macro), and lower cost strategies (e.g. Alternative Risk Premia).

Toby Goodworth, Managing Director, Head of Risk and Diversifying Strategies, explains:

“Appropriate diversification for a particular institutional investor depends on so many things – the current exposures, the ability tolerate downturns, the factor-sensitivity of their liabilities, the real (as opposed to risk-adjusted) return requirements, to name just a few. It is important to understand that diversification is often expected to accomplish different – and potentially competing – objectives, and that a portfolio may be ‘well-diversified”’ from one perspective but not from other perspectives: you cannot eat good Sharpe ratios, as the maxim goes. This is really an issue of good governance as well as robust portfolio construction.”

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