bfinance, the consultant advising pension funds and other institutional investors, has published a White Paper on the need to assess and control exposure to equity risk as an increasingly important priority for sophisticated asset owners.
Titled Five Levers for Reducing Equity Risk, the White Paper suggests that there is no 'silver bullet' for improving portfolio diversification or resilience to market crashes, but that instead, investors should consider a multi-faceted approach that is sensitive to current market conditions and implementation practicalities. It outlines five key methods that currently are popular with investors for achieving these objectives: increasing illiquid alternatives, increasing liquid alternatives, improving the resilience of the equity portfolio, adding equity risk overlays and rotating towards bonds.
Investors need to start by understanding what their existing exposures are, becuase the term 'well diversified' is over-used and "often lazily applied", bfinance argues.
Diversification should aim for two objectives that do not clash: improving long-term risk adjusted returns and achieving resilience during market downturns. This requires use of the five levers outlined in the Paper:
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 (eg, alternative risk premia).
Lever 3: Equity overlays
The last two years have seen greater appetite for more explicit safeguards as the era of artificially stimulated asset prices stutters amid disappointing growth figures, geopolitical tensions and trade war concerns.
Motivations for applying equity overlays vary considerably, ranging from low stakeholder tolerance for losses to technical considerations such as capital calls. Investors opting for this approach must bear in mind several key considerations: length of protection, level of manager discretion, cost, how collateral is handled and more.
Lever 4: Resilient equities
While the prior sections have largely focused on reducing equity risk, investors have also been adjusting equity portfolio composition.
The investor's particular diversification priorities - "maximising long-term risk-adjusted return" versus "improving resilience to downturns" - are highly relevant here. Two lenses are considered: the long-term correlation between different equity indices (quality, value, emerging markets, small cap and others) and the specific performance of those indices during equity downturns. Certain sectors that are particularly attractive for maximising long-term risk-adjusted returns (eg, emerging markets) tend to underperform during downturns; certain sectors that provide resilience in downturns do not provide meaningful long-term diversification (quality).
Private equity can also provide meaningful intra-equity diversification, and should be considered in the context of building resilient equity portfolios.
Lever 5: Fixed income
Much has been written on the changing profile of fixed income as a diversifier against equities.
Highly rated sovereigns still provide one of the more effective sources of diversification in the event of equity market downturns, although increased government debt across developed markets and other macroeconomic forces have affected this picture. Moreover, even where diversification characteristics remain strong, low rates have lessened their efficacy as a tool to improve risk-adjusted returns.
The post-global financial crisis phase has seen more investors taking on more credit risk into their portfolio, as well as alternative credit, high yield bonds, loans, convertibles and emerging market debt all undergoing stronger investor appetite amid the now cliché ‘hunt for yield'.
However the last 12-18 months appear to have brought a change in tone. New fixed income mandates, from bfinance clients demonstrate a shift in favour of investment grade bonds - sovereign, corporate and aggregate - at the expense of lower rated counter parts.
Toby Goodworth, managing director, head of Risk and Diversifying Strategies, said: "What this paper really seeks to highlight is that diversification is a personal property. 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."
Ruben Mutsaers, manager - Risk Solutions, said: "Investors are more and more aware that portfolios which appear to be well-diversified from an asset class perspective are often still highly concentrated from a risk perspective. Equity risk still dominates the typical DB scheme. At bfinance we've put a great deal of energy into developing and refining our risk analytics services in order to help clients with understanding and controlling their exposures more effectively."
To read the full White Paper, visit: https://www.bfinance.com/insights/five-levers-for-reducing-equity-risk/