The need for creativity in portfolio construction

Key takeaways

• Traditional asset allocation in the post-GFC environment largely worked because record accommodative monetary policy rewarded risk assets of nearly any sort.
• Going forward, we believe investors need a far more robust approach, including comparing private and public asset classes across fundamental characteristics.
• Given a starting point of higher interest rate and increased capital calls relative to distributions, we believe embracing evolving fund structures and emerging innovations like tokenization will be critical in optimizing portfolios.

Introduction

Optimal portfolio allocations have become a particularly vexing topic for institutional investors. With the rapid expansion into private markets during a period of historically low interest rates and increased appetite for risk we have seen many institutions utilizing a barbell approach. This involves shifting much of their traditional exposure from active into passive—with the “return-seeking” component being dominated by private market (illiquid) exposure. When the Federal Reserve (Fed) embarked on an aggressive tightening policy to combat inflation, there was a dramatic change in the market regime in 2022. We saw increased cross-asset correlations. For example, and most dramatically, private credit exhibited an average correlation of negative 6% with US aggregate bonds from September 2004 to March 2024; however, this correlation surged to 97% in 2022. We also saw pressure on the exit environment for private equity (PE) as evidenced by the significant drop in the investment to exit ratio (to .37x at the end of 2023 from a high of .52x in 2014).

While interest rates may begin another downward path in the near term, investors should more carefully consider how to best deliver against return expectations in a market likely to see a sustained higher costs of capital relative to the near zero levels post GFC. Investors need to evaluate how a manager has generated their historical return and closely assess their ability to meet their return expectations going forward. Elements of a strategy such as operational value creation expertise, or an edge in structuring investments, will be paramount, in our view. One needs to understand how a manager will drive return outside of the favorable financial backdrop of the recent past where an unusually low cost of capital and a benevolent valuation environment enabled many managers to essentially “financially engineer” their returns. Many private managers across the debt and equity spectrum were formed following the global financial crisis (GFC). Many may be smaller organizations without restructuring capabilities or experience or the ability to provide more complicated or comprehensive solutions to the issuers. We believe investors should place a higher value on institutional experience in the current environment.

In this paper, we look at the two most notable market shocks in recent history, 2008 and 2022. There are lessons to be learned from both periods that can help to gain a better understanding of how to approach today’s environment.