Bfinance: Reducing exposure to equity downturn is key priority for sophisticated investors in 2019

16 aug 2019

bfinance’s white paper: ‘Five Levers for Reducing Equity Risk’ concludes that assessing and controlling exposure to equity risk is an increasingly important priority for sophisticated asset owners in 2019. The emphasis on this subject has increased as equity markets have risen in the first half of the year. The paper 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 five of the methods that are currently most popular: increasing illiquid alternatives, increasing liquid alternatives, improving the resilience of the equity portfolio, adding equity risk overlays and rotating towards bonds.

Understanding risk exposures is key

It is key to note that the term ‘well-diversified’ is over-used, often lazily applied. While high quality risk analytics can help to provide clarity, 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).

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 (e.g. 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.