After the alarming stock market wobble at the back end of last year, performance in the first half of 2019 provided welcome good cheer, notwithstanding a minor correction in May. But amid concerns about the US-China trade war and the bond market’s yield curve inversion signalling the possibility of recession in the US and UK, markets tumbled again this week. The only certainty is uncertainty, as markets swing wildly from pessimism to optimism and back again.
Against this backdrop, it comes as little surprise that a report published this week by consultancy bfinance identified controlling exposure to equity risk as a key priority for its clients in 2019. This sentiment is widely shared. In a survey of investors by BlackRock in January, 68 percent of US and Canadian LPs, and 51 percent of investors overall, said they wanted to reduce their exposure to equities.
Thoughts are thus turning to ways in which investors might diversify their portfolios. The bfinance report identifies five main “levers”, the most popular of which are illiquid alternatives, which include private debt as well as infrastructure and real estate. Illiquid alternatives have for some time been the diversification method of choice. However, the report warns that market dynamics today are, somewhat ironically, nudging investors in the space closer to the equity risks that they are seeking to avoid.
The reason for this is that, at what many consider to be a late stage of the cycle, returns are being compressed and market participants are prioritising the short-term pressure of maintaining performance over the longer-term benefits of a diversified portfolio. Consequently, real estate is seeing a shift from core to value add, while private debt is seeing a transition from senior debt to mezzanine and quasi-mezzanine strategies.
In order to preserve a desired return profile, some managers appear to be engaging in strategic drift. Moreover, the report suggests, managers have little incentive to understand how their approaches are affecting their investors’ equity risk weighting. Investors, meanwhile, may have little notion that very different manager approaches to risk may be present under the same strategic label (‘core infrastructure’, for instance), and are therefore caught unawares as equity risk escalates.
The bfinance report says the proliferation of managers, sub-sectors, geographies and approaches to implementation mean investors have more choice than ever. Today, investors can access credible strategies, such as infrastructure mezzanine debt, that were not available to large institutions five or ten years ago. It seems reasonable to assume that this larger menu means diversification is now easier to achieve.
However, bfinance also points out that new ‘niche’ strategies are likely to be less well understood from a risk viewpoint than more mainstream ones, and that increased diversification can bring with it greater uncertainty. Navigating away from the storms of the stock market to calmer waters is an entirely sensible undertaking, but the hazards lying in wait on the journey should not be underestimated.
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