Investors explore new allocation approaches to diversify risk

Portfolio managers at the recent BNP Paribas Global Markets Conference APAC explained how they were seeking more diversification and flexibility.

If many investors were already moving away from the traditional 60/40 equities/fixed income allocation of a balanced investment strategy, last year’s simultaneous plunge in bond and equity markets was another blow to long-established portfolio theory.

While BNP Paribas feels the approach retains many of its merits, investors are increasingly looking at new ways to diversify their portfolios and spread risk. So said executives from the French bank and fund managers from prominent insurance firms, retirement schemes and sovereign wealth funds at the latest BNP Paribas Global Markets Conference APAC in Singapore in late November.

Given widespread expectations of persistent inflation and further – though smaller – interest rate rises, and with the global economy headed for weak or negative growth in 2023, portfolio managers are feeling compelled to expand their toolkits to maintain returns.

“Clearly, there has been a move to find an alternative to bonds over the last 12 to 18 months,” said Timothy Parker, BNP Paribas’ Head of Institutional Equity Derivatives Sales for Asia ex Japan. “A number of papers have been written on potential solutions, and most seek to combine different asset classes in order to target both positive carry and a depression hedge. Suggestions range from credit and inflation-linked bonds to gold and commodities, to tail [risk] hedges and liquid alternatives. There are pros and cons of employing each of these.

For instance, while interest in tail risk hedging spiked in 2020 after the Covid pandemic hit markets, volatility-focused strategies have been among the worst performing positions in portfolios over the past 18 months, Parker said during a panel moderated by Olivia Frieser, BNP Paribas’ Head of Global Markets for Southeast Asia, India & Australia. Tail risk hedging entails seeking to defend against market shocks such as by weighting portfolios towards more stable sectors or using derivatives.

Broadening the base

Yet before investors turn to derivatives or systematic trading strategies to protect portfolios, they might consider enhancing the traditional 60/40 approach by incorporating a broader range of asset types within it. A more flexible and effective target is to hold roughly 60% equity-like risk and 40% liability duration-like risk. Within these buckets, there is considerable scope to diversify exposure further.

One way to do this is by further increasing exposure to private markets – such as unlisted equity, infrastructure or real estate – which have seen a big rise in popularity in recent years. Private market assets under management grew to an all-time high of US$9.8 trillion as of July 2021, up from US$7.4 trillion the year before, according to a McKinsey report published in March.

Such investments already play an important role in institutional portfolios and still offer strong growth potential, both in terms of structural returns and fund managers’ ability to identify alpha opportunities, said speakers at the conference. They can also, in the case of real assets, offer long-term stable cash flows.

However, private assets can carry considerable liquidity risk because they are harder to price and typically trade less frequently than public market assets. In addition, embedding them in big portfolios run by insurance firms, pension schemes and sovereign wealth funds is especially challenging.

That said, there is now greater clarity around the cost of taking positions in private assets.The regular liquidity crunches seen even in usually liquid public markets since 2020, led to transaction costs being analysed and reflected in models more accurately. As another speaker noted, there is a constant feedback loop that dynamically updates models as implementation costs change, meaning institutions are rarely caught out by faulty assumptions about costs and liquidity premia.

Establishing new time frames

What’s more, asset managers have responded to recent market conditions by introducing strategies for varying time frames. One speaker said his firm had adopted a new, shorter-term asset allocation process that offered more flexibility in pursuing opportunities from temporary dislocations and emerging trends. The freedom the firm now has to deviate from the long-term allocation will be essential to its effective functioning over the coming decades, the executive added.

Meanwhile, another fund manager said that while it could be important to hold onto positions even in the face of extreme volatility, he acknowledged the need for flexibility. His firm has created a medium-term tactical asset allocation approach to complement its shorter-term quant model, paving the way, for instance, to take opportunistic positions in the lead up to an expected US recession.

Adopting greater flexibility in respect of investment time frames can also help investors develop strategies to address issues such as geopolitics, argued the sovereign wealth fund executive. Whereas intermittent periods of geopolitical tension were perhaps typically seen as buying opportunities he added, geopolitical risk is now more of a chronic problem.

Big-picture problems

Investors can best address geopolitical risk using a two-pronged approach. Over a shorter time frame, tail risk hedging makes sense and could help generate liquidity and optionality to redeploy assets. Over the longer term, asset managers may need to undertake structural changes, such as redesigning investment benchmarks to account for the new geopolitical landscape.

A further reflection of how investors’ approaches to asset allocation have evolved in recent years – and of just how pressing the need for effective portfolio diversification has become – is the return to favour of commodities in some quarters.

“It’s interesting that, in a world where sustainability is a key topic, we’re often seeing investors who’ve closed commodities programmes re-assessing that decision and looking to reopen them again,” noted Parker.

“The underlying tone is that most investors are moving to a broader toolkit of assets – everything from liquid alternatives to derivative-based strategies,” he added. “Asset allocation models evolve, and how you implement those within a wider portfolio is the key challenge for everyone here.”

And it is one that many are rising to.

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