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Asset allocation

Think portfolio construction

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Using a factors-first lens to find opportunities in today’s alternatives market

A factors-first approach reveals how traditional asset allocation can mask a portfolio’s risk exposures. For example, even though the average endowment has more than 50% of its portfolio allocated to alternatives, equity risk accounts for 95% of the total risk while idiosyncratic risk accounts for less than 4%, according to our analysis. Our research explores this factors-first concept by examining how risk-factor exposures and the income-generating characteristics of alternatives have evolved through the pandemic and recovery. Nuveen experts also share their perspectives on where they are finding the most attractive relative value opportunities as we transition into an environment of rising interest rates and increasing inflation concerns. 

A risk factor-based approach for portfolio optimization allows institutional investors a much deeper understanding of risk and whether they are being compensated for owning those risks. This paper examines rates duration, credit, equity and idiosyncratic as risk factors and considers the degrees of exposure offered by the alternative sectors of fixed income, private credit, real assets and real estate.  

FIGURE 13: Focusing on asset allocation can lead to an imbalance of risk

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Fixed income

  • The nontraditional, or “plus,” sectors of fixed income — preferred securities, emerging markets debt, high yield corporates and leveraged loans — present attractive yields for investors seeking enhanced income.
  • While the U.S. Federal Reserve shored up high-quality securitized credit with the TALF program, that did not carry over to BBB- and BB-rated collateralized securities, creating opportunities for higher yields.
  • Preferreds performed better during the recent downturn than they did during the Global Financial Crisis because they are now largely issued by today’s highly regulated U.S. banks, which maintained healthy capitalization levels throughout the pandemic. 
  • Emerging market debt remains relatively cheap, and the broader reflation trade should provide fundamental support for the asset class as improving global growth, a steepening yield curve and higher commodities prices have historically boosted emerging markets.


Figure 1: Traditional income sources are lacking

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Private credit

  • With improving global growth and rising rates, investors should consider increasing exposure to credit risk while decreasing exposure to rates risk with assets like leveraged loans, high-yield bonds and private credit.
  • Middle market private lending has surged in popularity since the Global Financial Crisis — and the asset class’s relatively strong performance throughout the COVID-19 pandemic and unique risk profile has reinforced investor demand.
  • Middle market loans are typically more conservatively structured than broadly syndicated loans, and they don’t trade making them more stable. However, the pandemic highlighted the importance of evaluating both the sponsor and covenant documentation when investing in this asset class.


FIGURE 5: Risk measures vary by asset class

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Real assets

  • Real assets, including farmland, timberland and private equity infrastructure investments, historically have generated relatively attractive and stable levels of current income.
  • The risk factors associated with real assets are highly idiosyncratic, as they are tied to different types of crops, operating structures, contractual agreements and geographies, for example.
  • Exposure to global real assets may add another layer of hedging against factors like climate change and shifting trade agreements.


FIGURE 6: Real assets exhibit low correlations to other asset classes — and to each other

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Real estate

  • With yields that significantly outpace government bond yields and lease terms that vary in length, real estate can serve as an essential component of diversified income portfolios and a valuable hedge against inflation. 
  • Near- and medium-term prospects for real estate returns vary significantly by region and sector, with relative value opportunities in China and many other Asian countries as well as U.S. suburbs and new micro-urban centers, such as Austin, Nashville and other Sun Belt cities.
  • Alternative real estate sectors, including healthcare, alternative housing, and technology, are poised for a bigger role in portfolios based on longer-term demographic trends as well as pandemic-related changes in how people live and work.


FIGURE 9: Global real estate offers an income premium over other asset classes

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A risk-based approach to optimization

  • Investors are compensated for owning risks, not asset classes. We believe that their portfolio construction processes should reflect this.
  • A risk factors-based analysis reveals the nature of risk offered by different asset classes and in portfolios, highlighting unintended risk concentrations or opportunities to increase exposure. 
  • 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.


FIGURE 12: Decomposing risks across asset classes

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About the authors

Additional asset allocation insights

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Explore a range of views across public and private asset classes for short and long-term challenges faced by institutions.
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Dimitrios N. Stathopoulos
Head of Americas Institutional Advisory Services

Endnotes

Sources

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.

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