Factors First: A Risk-based Approach to Harnessing Alternative Sources of Income

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Staff Report From NUVEEN/Nuveen

The income-generating potential of alternatives seems to be largely underappreciated, despite the trend toward larger allocations to alternative asset classes in institutional portfolios and the quest for yield in a low-rate environment. When we ask institutional investors what roles they look for alternatives to play in a multi-asset portfolio, diversification is the top priority, followed closely by total return. Income generation usually is a distant third.

Institutional investors can enhance their ability to capitalize on the yield and diversification benefits of alternatives by focusing on the risks that drive returns in each specific segment of the alternatives universe. This approach allows investors to stitch together multi-asset portfolios in a more efficient, coherent way.

Executing this, however, is no simple task. If done incorrectly, investors risk negating some of the diversification benefits that make alternatives such valuable contributors to stronger, more resilient portfolios.

Know what risk factors drive return

Alternative asset classes such as private credit, real assets (farmland, timberland and private equity infrastructure investments) as well as non-traditional sectors of fixed income (preferred securities, emerging markets debt, high yield corporate debt and leveraged loans) present attractive income-generating potential.

Idiosyncratic risks play a vital role in driving returns in each of these asset classes — and these risks are what institutional investors should be trying to harness in an income-generating multi-asset portfolio. But it is important to note that each of these asset classes has significant exposure, in varying degrees, to the core, broad-based risk factors: equity, credit spread and rate duration.

As the chart below illustrates, idiosyncratic risks account for less than 60% of the contribution to total risk in all of the alternative asset classes included in the chart, except for real estate. With emerging markets debt, for example, equity risk accounts for 36% of the total risk and credit risk accounts for an additional 33%.

Preferreds are also an interesting case. Some investors consider them to be more like an equity instrument while others consider them to be more like fixed income. This debate is easily settled when viewed through a risk decomposition lens, which shows that equity risk and idiosyncratic risk account for the totality of risk for preferreds.

Click chart to enlarge.

This isn’t to imply that emerging markets debt and infrastructure aren’t valuable diversifiers. Rather, it is to highlight that unless an investor decomposes the risk contributors, a portfolio could end up with significantly more exposure to equity, credit or rate risk than the investor bargained for.

Allocate to risk factors, not asset classes

Investors are compensated for owning risk, not asset classes. We believe that their portfolio construction processes should reflect this and we have developed a five-step approach to do just that:

1. Decompose risk factors driving the performance of asset classes
2. Analyze how the market is compensating those risk factors
3. Determine which risks need to be owned to fulfill investment objectives and constraints
4. Determine which asset classes and vehicles will achieve the desired risk exposures
5. Monitor risk and asset class relationships and how the market is compensating risks

The benefits of a risk-first approach

This framework puts risk at the heart of constructing multi-asset portfolios and delivers multiple benefits to investors. As already noted, it reduces the risk of overconcentration of risk factors in a portfolio, which could undermine the diversification benefits investors seek from alternatives.

It also encourages a more nimble approach to pursuing yield. The relationships among the risk factors and thus the relationships among the asset classes are constantly evolving — and the degree to which the market is compensating various risks is always changing. Predefined asset allocation constraints limit an investor’s ability to exploit these changes and manage risk.

The framework fosters a more nuanced approach to managing liquidity. Liquidity risk is just one of the idiosyncratic risks of an investment. But when using alternatives to generate income and cash flows needed to fund a set liability, liquidity becomes the idiosyncratic risk that institutions need to understand the best. Taking a risk-first approach to multi-asset portfolio construction frees an investor to take a more nuanced and sophisticated approach to managing liquidity risk — not just with alternatives, but across the entire portfolio.

Learn more about harnessing alternative sources of income

The full paper with complete disclosures can be found at Nuveen.com. 

Nuveen is an Associate Member of TEXPERS. The views expressed in this article are those of the authors and not necessarily Nuveen nor TEXPERS. 

Sources
All market and economic data from Bloomberg, FactSet and Morningstar.