The steady increase in investors allocating more to private assets comes at the same time as a new period of heightened macro uncertainty including supply-driven inflation, less-credible central bank policy, rising real rates and slowing productivity growth.
Navigating these two challenges could require a fundamental evolution of the asset-allocation process, argue Grace Qiu Tiantian and Ding Li from Singapore’s GIC in a paper written with MSCI’s Peter Shepard entitled Building Balanced Portfolios for the Long Run.
Long term investors seeking to construct portfolios resilient to macro uncertainties should focus less on backward-looking, short-term risks, argue the authors in their latest paper, building on previous research into portfolio construction.
Instead, they should focus on understanding the long-horizon investment landscape, including the benevolent effects of mean reversion, a broader opportunity set of private assets, and the risks posed by potential regime shifts in the macro environment.
“This framework could provide long-term investors such as GIC with a consistent and long-horizon view spanning all asset classes, support with strategic portfolio positioning, and offer a practical tool to build greater macro resilience into portfolios,” say Qiu and Li, both senior vice presidents, total portfolio policy and allocation, economics and investment strategy at GIC, Singapore’s sovereign wealth fund with an estimated $799 billion assets under management. GIC doesn’t disclose its AUM.
Qiu, Li, and Shepard map five potential macro scenarios for the decades ahead focused on shocks impacting demand, supply, trend growth, central-bank policy, and long-term real rates. Their research then applies asset cash flows and discount rates to these underlying macroeconomic drivers. Next, they integrate macro risk into an allocation framework spanning public and private assets.
By putting public and private assets on the same footing, long-term risk and return may be systematically managed across the total portfolio. The underlying macroeconomic drivers provide a common lens to view all assets consistently and intuitively, allowing comparisons and trade-offs across public and private markets.
The multi-horizon nature of the framework also enables decision-making over different time horizons, potentially facilitating strategic and tactical positioning. The long-horizon view also allows asset-allocation decisions to more closely align with investors’ mandates to meet liabilities and preserve wealth over the long run.
Qiu, Li, (pictured) and Shepard construct a hypothetical macro-resilient portfolio, able to withstand long-term macro risks while maintaining the same level of expected returns as a portfolio optimised to a shorter horizon. The macro-resilient portfolio has less exposure to nominal bonds and more to real assets and the equity risk premium.
The authors also generate a macro-resilient efficient frontier, demonstrating how asset allocations may vary according to the level of tolerance for long-term macro risks. The new frontier lies above the expanded mean-variance frontier, suggesting that by accepting more short-term volatility, long term investors can align with their long-term objectives.
The expanded mean-variance portfolio substitutes public equity for equity-like private assets (private equity and equity-like infrastructure). Government bonds continue to play the role of portfolio diversifier, even though a portion of bonds are replaced by real estate.
For the same level of volatility as in a 60-40 portfolio, the expanded mean-variance portfolio has a much higher expected return (4.8 per cent annual real return versus 3.1 per cent for the 60-40), predominantly driven by the assumed private-asset returns. But it is still largely a barbell portfolio, loading up high-risk, high return asset classes and using bond-like assets to balance the risk profile.
The macro resilient allocation is constructed to have the same expected return as the expanded mean-variance portfolio while minimising long-term macro risk rather than volatility. In this example, the authors measure long-term macro risk as the real-return impact at the 10-year horizon, averaged over the five key macro scenarios.
Investors can choose a different time horizon to align with their mandate or assign different weightings among the macro scenarios to reflect a view of their likelihood and importance.
Private assets are not uncorrelated over a long horizon, but their spectrum of exposures to macro risks may enable them to be used to help manage long-term risks across the total portfolio. In addition, while equity is highly volatile over a short horizon, the authors find that volatility driven by fluctuating equity risk premia may be much milder for the long-term investor.
Good beta bad beta
Long-term investors stand to benefit by allocating more to the return opportunities that are typically riskier for short-horizon investors. For example, market dynamics like discount-rate shocks and mean reversion tend to benefit long-term investors.
Higher discount rates typically lead to lower asset prices in the near term – but also lead to higher expected returns. A long-term investor benefits by harvesting the higher returns and can eventually come out better off in the long run, they explain. Discount-rate risk therefore tends to be much more benign to a long-horizon investor and is an example of the concept of “good beta/bad beta.”
However, long-term investors are more exposed to other types of risk. They are vulnerable to the risk of a persistent economic slowdown or a trend growth shock. This may have only small, short-horizon effects but can build up gradually to significantly impact the long-horizon investor.
Secular change and regime shifts are also risks for long-term investors. Today, potential regime shifts include the effects of deglobalisation and the decarbonisation of the economy which require a fundamentally forward-looking asset-allocation process. Elsewhere, many investors are considering the possibility that new levels of high inflation could persist and worsen into stagflation, they conclude.