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

Image by Arek Socha from Pixabay 

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.

Themes for the Second Half of 2020

Image by Fathromi Ramdlon from Pixabay 

By KEVIN BARRY & SAM KIRBY/CAPTRUST

After its longest-ever period of growth, U.S. economic activity and markets collapsed during the first quarter in response to the initial pandemic shock and stay-at-home mandates. However, as shown in Figure One, major asset classes posted significant gains fueled by historic levels of policy support and reopening optimism during the second quarter. 

Source: Bloomberg. Click chart to enlarge.

The forces that drove markets so far in 2020 are powerful, including both the negative impacts of the virus and the positive impact of monumental stimulus and relief programs. By far, the greatest issue facing capital markets for the second half of the year is success in solving the medical crisis. Until effective treatments and vaccines are available, the economy and especially impacted industries such as travel, leisure, and hospitality will be unable to return to anything approaching normal.

But the hope is that more targeted policies can bridge the gap and contain the risks of overloaded health systems until medical solutions become available, with less severe disruption to the economy, education system, and daily life.

Policy Cushions Blow

The fiscal and monetary stimulus unleashed within the U.S. since March is not only the largest in history, it also arrived quickly, despite a fractious political environment. The combination of central bank liquidity programs and fiscal relief packages is estimated to exceed $9.5 trillion—a staggering number that represents more than 40 percent of U.S. gross domestic product (GDP).

An important driver of the future path of the recovery will be avoiding policy mistakes of the past, such as stopping stimulus too quickly during or after a crisis. Examples include the Great Depression, when monetary policy errors prolonged the crisis; the European response to the global Financial Crisis; and Japan’s Lost Decade of the 1990s.

As a result, all eyes are now on the next round of fiscal stimulus, which is expected before September.  

Labor Market Stress

The initial, heart-stopping spike of job losses in March drove the unemployment rate to 14.7 percent—the highest level since the Great Depression. As states have begun to reopen, we have seen significant improvement as workers sidelined by lockdown restrictions have been recalled. But despite these gains, the unemployment rate remains at a highly elevated and worrisome level of 10.2 percent.

Labor market recovery is a critical precursor for limiting the damage of this recession. For the remainder of 2020, we will watch closely for signs that effective virus containment efforts can coexist with job recovery, as well as any signs of increases in permanent layoffs as businesses adjust to the post-pandemic business environment. 

Balance Sheet Health

The virus isn’t the only health concern on the minds of investors and policymakers; the financial health of corporations is also in focus. We entered 2020 with storm clouds on the horizon in the form of elevated levels of corporate debt. Today, debt-saddled firms face an unprecedented revenue shock We have already seen many storied brands troubled sectors fall victim to the crisis, including Hertz, J. Crew, Gold’s Gym, Neiman Marcus, and Brooks Brothers. Already, the pace of bankruptcy filings has reached levels not seen since 2009, prompting some to fear that we could be on the brink of an avalanche of business failures.[1]

The unique nature of the current crisis does, however, allow room for optimism. During prior recessions, levels of economic activity were quick to fall, but slow to recover. This time, because the drop-off in activity was largely artificial—driven by lockdowns and social distancing requirements—we could see a sharper recovery once virus risks subside. Only time will tell. In the meantime, amid this uncertainty, it should come as no surprise that many firms have withdrawn future predictions of near-term business conditions, with more than 170 companies suspending earnings guidance over the past three months.[2] 

Election Season

Finally, markets will watch the election season unfold with great interest. This attention that will only intensify after party conventions. Although current polling suggests a lead for the Democratic challenger, we are still more than two months out from election day—an eternity in politics. Historically, presidential incumbents who faced a recession within two years of reelection have rarely won. However, this recession is anything but typical, and it remains to be seen whether this time will be different. We are mindful of the risks that a politically charged environment could slow or derail continued policy support for economic recovery and the potential escalation of trade disputes.

Investing Amid Uncertainty

The breathtaking drop and breakneck recovery we have witnessed over the past four months represents perhaps the hardest-but-greatest lesson of all time on the dangers of market timing. Those who moved to the sidelines in March missed a rally for the record books. However, investors, institutions, and retirement plan participants who stayed the course or took the opportunity to rebalance portfolios may have benefitted from some of the extreme price dislocations witnessed during the first quarter.

While we hope the next six months is a smoother ride than the last, we expect volatility to persist as markets react to the fast-changing medical, economic, and political conditions described above. This degree of uncertainty underscores the importance of risk tolerance, asset allocation, and portfolio diversification. These foundational principles can give retirement savers a greater ability to seek out the new opportunities that will undoubtedly emerge from the first global pandemic of the modern era.

Sources:

[1] Hill, Jeremy; Crombie, James “Big Bankruptcies Sweep the U.S. in Fastest Pace Since May 2009,” bloomberg.com, 2020

[2] Strategas, 2020

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

About the Authors:

Kevin Barry is CAPTRUST’s chief investment officer and leads the Investment Group, the team responsible for investment manager due diligence, asset allocation, and discretionary investment management for the firm’s wealth management and institutional advisory clients.

Sam Kirby is a leader with CAPTRUST’s Investment Strategist team. He works with the firm’s financial advisors to assist clients with investment strategy, portfolio construction, and monitoring. He has 15 years of financial services experience and is a CFA charterholder.

The pros and cons of buy and hold

By MARK SHORE/Coquest Advisors

The expression “buy and hold” is often mentioned in the equity markets. This means you buy a stock or a mutual fund and hold it for extended periods. It is a logical view as there is a growth component in the equity markets as an economy or firm may grow larger over time. However, what does that holding period look like over time when viewing portfolio metrics? The second question asks what does an investor experience when they buy and hold alternative investments? Indices of both asset classes are examined, and the results are shown below. 

Background

The motivation for this question is derived from holding any investment for various periods, what is the historical experience of doing so, and will it impact portfolio allocation decisions? Ibbotson and Kaplan (2000) conclude about 90% of a fund’s return variability is explained by asset allocation suggesting asset allocation policy is an important variable to consider.[i] 

The holding periods are defined as the following durations of rolling periods: Monthly, three months, six months, 12 months, 24 months, and 36 months. This implies for each rolling period, what was the maximum return, the average return, and the largest loss during each rolling period. 

Figure 1 notes the changes in maximum returns, minimum returns, and average returns of the S&P 500 Index (SPX)and the BarclayHedge Managed Futures (CTA) Index from January 1980 to April 2020. As any equity index is a portfolio of stocks, the managed futures index is a portfolio of managed futures funds. The four decades of data include economic expansions, contractions, bubbles, high-interest rates, low-interest rates, and many other events.

Study Summary

A few points to note from this study:

• The longer the positions are held, the larger the maximum return and average return for both indices. Similar to the results found with managed futures (Abrams, Bhaduri, & Flores, 2014).[ii]

• The maximum returns of managed futures always exceed the maximum return for the S&P 500 in every holding period. This may be due to the positive skewness of managed futures return distribution at 2.54 indicating positive return outliers versus the -0.64 skewness of SPX over the 40 years.

• In the rolling 24 and 36-month periods, the average return begins to see a small premium of the SPX relative to managed futures. 

• The SPX experienced larger minimum returns as the rolling duration expands from monthly data (-21%) to 36 months (-43%). Whereas the managed futures minimum return in those same periods stayed relatively stable from monthly (-10%) to 36 months (-9%). 
• The largest managed futures minimum returns are 3 and 6 months of -14% & -13%. The data suggests holding the investment for these short periods has potentially more downside variance. 
• The negative skewness of SPX is an indicator of the negative return outliers. 

Figure 1

Figure 2 examines the periods from a risk management perspective. If you look only at the downside of each holding period, the data suggest a growing differential between drawdowns of the two indices. The average SPX loss expands to about 40% when examining two or more years of holding periods. 

Uncertainty can increase when an investor looks longer out on the investment horizon. Over the last 40 years of SPX returns, on average a -13% min return is feasible over a 12-month rolling return. Over a 2 year or 3-year period, a -40% min return average is possible. The data suggests over any of the holding periods a 3% loss is possible in managed futures with a historical potential for a -14% min return.

Figure 3 shows the minimum returns in each holding period and when it occurred. The fourth and fifth columns note moments when similar returns occurred in the respective holding periods.

Figure 3: Occurrence of Minimum Returns

Conclusion

Examining monthly data for the last 40 years of the S&P 500 Index and the BarclayHedge CTA Index, gave some insight into what has been experienced on the upside and the downside of holding periods. The data suggests returns of both indices may grow over time and the managed futures maximum return exceeds SPX in every holding period.

From a risk management standpoint, the SPX minimum return of each holding period surpasses the managed futures min return. There appears to be a reduction in downside volatility when the managed futures holding period reaches 12 months.

If allocation policy is an important variable for portfolio returns, then over the longer-term, combining the two investments may reduce the negative tail risk when viewing long-term investment horizons.

If you have questions or would like to receive more information on this topic, please feel free to contact the author at mshore@coquest.com.

Sources

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[i] Ibbotson, R. G., & Kaplan, P. D. (2000). Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? Financial Analysts Journal, 56(1), 26–33.

[ii] Abrams, R., Bhaduri, R., & Flores, E. (2014, June). A Quantitative Analysis of Managed Futures Strategies. Retrieved from https://www.cmegroup.com/education/files/Lintner_Revisited_Quantitative_Analysis.pdf

 

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Coquest Advisors nor TEXPERS, and are subject to revision over time.

About the Author: