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Optimizing outcomes through alternatives:
Applying a risk-based approach to optimization
A risk-based approach to optimization
We share our recommendations for building efficient income-generating multi-asset portfolios by focusing on risk factors.
Constructing a portfolio that efficiently accesses the idiosyncratic risks that drive returns in alternatives and stitches them together in a coherent way is no simple task. If done incorrectly, investors risk negating some of the diversification benefits that make alternatives such valuable contributors to stronger, more resilient portfolios.
Based on our extensive research into multi-asset portfolio construction and our work with institutional investors globally, we think institutions can optimize their ability to harness the income-generating potential of alternatives by using a risk factor-based approach to portfolio construction.
Know what risks drive return
While the previous sections focused on the idiosyncratic risks that drive returns in each of the highlighted asset classes, it is important to note that each of these asset classes has significant exposure, in varying degrees, to three core, broad-based risk factors: equity, credit spread and rate duration.
As Figure 12 illustrates, idiosyncratic risks account for less than 60% of the contribution to total risk in most of the alternative asset classes included in the chart. With emerging markets debt, for example, equity risk accounts for 36% of the total risk and credit risk accounts for an additional 33%, according to Bloomberg data and Nuveen’s analysis. It is especially interesting to look at the risk decomposition of preferreds, which some investors consider to be more like an equity instrument while others consider them to be more like fixed income. This debate is easily settled when viewed through a risk decomposition lens, which shows that equity risk and idiosyncratic risk account for the totality of risk for preferreds.
This isn’t to imply that emerging markets debt and preferreds aren’t valuable diversifiers. Rather, it is to highlight that unless an investor decomposes the risk contributors, a portfolio could end up with significantly more exposure to equity, credit or rate risk than the investor bargained for.
This phenomenon is reflected in the example below, which shows endowments’ average asset allocations along with the actual risk allocations. Even though more than 50% of this hypothetical portfolio is allocated to alternatives, equity risk accounts for 94% of the total risk while idiosyncratic risk accounts for just 4%, according to Nuveen’s analysis.
Allocate to risk factors, not asset classes
Investors are compensated for owning risks, not asset classes. We believe that their portfolio construction processes should reflect this.
We recommend that investors start by decomposing the risk factors that contribute to the performance of each asset class. Then investors should determine which risk factors they want to own based on how the market is currently rewarding those risks and the investor’s unique objectives and constraints. Only then should investors begin thinking about the most efficient way to own those risks.
When using this process, asset allocation becomes a byproduct of risk allocation. We believe that this approach provides multiple benefits for investors:
Reduces the risk of overconcentration among risk factors
As noted, one of the biggest dangers of the traditional asset allocation approach to portfolio construction is that it can mask overlapping risk exposures and undermine the diversification benefits investors seek from alternatives. Taking a top-down view of the risks across the entire portfolio allows investors to ensure that their risk allocation aligns with their objectives and constraints.
Encourages a nimbler approach to pursuing enhanced yield
To achieve the income and returns needed in today’s low yield environment, institutional investors need to be dynamic and flexible in pursuing opportunities among alternatives. The relationships among the risk factors and thus the relationships among the asset classes are constantly evolving — and the degree to which the market is compensating various risks is always changing. Figure 14 illustrates how asset classes tend to cluster around each of the three core risk factors and how these relationships migrate over time, especially in times of volatility as we saw between December 2019 and March 2020. Predefined asset allocation constraints limit an investor’s ability to exploit these changes and manage risk.
Fosters a more nuanced approach to managing liquidity
Liquidity risk is just one of the idiosyncratic risks of an investment. But when using alternatives to generate income and cash flows needed to fund a set liability, liquidity becomes the idiosyncratic risk that institutions need to understand the best. One of the many benefits of taking a risk-first approach to multiasset portfolio construction is that it frees an investor to take a more nuanced and sophisticated approach to managing liquidity risk — not just with alternatives, but across the entire portfolio.
Take a 3D view of liquidity
Properly analyzing liquidity risk — and its corollary, the illiquidity premium — in a multi-asset portfolio requires an appreciation of the following:
- Illiquidity isn't binary: It is easy to see why investors may view publicly traded asset classes as being “liquidity on” and private alternatives as being “liquidity off.” But the reality is much more nuanced. Within the broader world of private alternatives where illiquidity is explicit, there are differences in how quickly an investor can exit an asset; this depends largely on vehicle type. Many publicly traded assets have an implicit degree of liquidity risk. Owners of high yield corporate bonds received a harsh reminder of this in March 2020. Similarly, small-cap equities carry a degree of liquidity risk.
- Illiquidity premia vary over time: The compensation that investors receive for having their capital locked up in a specific asset class is not static. Just like the market is willing to reward growth-oriented companies more when growth is scarce, capital flows to more liquid investments when cash is more valuable, as in the height of the Global Financial Crisis or the coronavirus pandemic. As a result, the illiquidity premium ebbs and flows.
- Illiquidity premia vary within alternatives: Clearly, the illiquidity premium of private real estate relative to publicly traded REITs is different than the degree of compensation investors receive for investing in private credits relative to publicly traded senior loans. But the differences go much deeper than that. There are significant differences within these asset classes depending on the submarket or investment vehicle. Within private real estate, for example, the illiquidity premium for direct deals may differ significantly from the illiquidity premium for a private REIT.
Putting it all together: How we approach constructing multi-asset portfolios
The discussions, debate and research about factor investing over the last decade have helped institutional investors take a more nuanced view of risk allocation. We believe that this progress can be further enhanced by adopting a portfolio construction process that better reflects the primacy of allocating to risks rather than to asset classes.
This approach to portfolio construction can play an essential role in allowing institutional investors to efficiently harness the income-generating potential of alternatives.
All market and economic data from Bloomberg, FactSet and Morningstar.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature.
Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, or liability for, decisions based on such information, and it should not be relied on as such.
A word on risk
All investments carry a certain degree of risk, and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. In portfolios that include lower-rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties. Socially Responsible Investments are subject to Social Criteria Risk, namely the risk that because social criteria exclude securities of certain issuers for nonfinancial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies. Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not suitable for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. The historical returns achieved by alternative asset vehicles is not a prediction of future performance or a guarantee of future results, and there can be no assurance that comparable returns will be achieved by any strategy.
Nuveen provides investment advisory services through its investment specialists.