Are you testing the traditional 60/40 allocation for 2023?
The basic premise of portfolio construction was coined by major marketing departments in the late 1970’s and 1980’s when interest rates were extremely stable and would earn enough interest income to cover all equity losses in seven years and compensate for inflation. However, the forty-year bull market in interest rates combined by the unprecedented global coordinated quantitative easing strategy which brought short-term rates to zero has forced a new review. In trying to provide greater yield than simple government debt, assets have been reconstituted to broaden the investor base, providing liquidity and yield by segmenting cash flow and changing liquidity. The wealth accumulated over the past decade seems to have increased investors’ level of risk for outsized returns and reduced liquidity needs. The long-standing mantra of a “60-40 portfolio” has gradually become less valuable as an overall guard rail for investment policy statements. Whether it is due to sophisticated algorithmic utilization or more holistic government intervention, we believe that the migration is to look at the fixed income allocation and perhaps redefine that asset class. Enter center stage for the growing interest in Alternative Investments – new and creative ways to direct cash flow payments and increase the ability for a greater number of investors to participate in opportunities that had prior been only available to the largest investors.
Over the years, there have been many evolutions in fixed income assets. The securitization of mortgages was followed by other securitized products – cars, credit cards, life insurance policies and many others – where interest income and paydowns are directed to different investor classes or tranches at different points in time and credit support. On a parallel path with investor interest has been the governmental involvement with lending institutions and the risks they may or may not be able to hedge and thus become a national issue, an example being the impact of the Dodd Frank rules determining asset coverage and increased reserve limits by banks to avoid another financial crisis similar to 2007-2010. Although the changes in risk management by banks were designed to provide greater asset coverage to offset potential liabilities, in reality, it gave greater motivation and opportunities for new innovation in private lending. There has been a massive increase in BDC’s, SPACS and the funding flexibility for the private equity and credit market.
As we enter 2023, one question is how should a portfolio view asset allocations and true liquidity? Is a portfolio a long term structure or one that can be closed in a day, week or month? Do portfolio’s change their fixed income holdings as frequently as equity weightings?
Clearbrook has been adding alternative investment strategies to provide income alternatives to traditional bond holdings. We believe it will continue to be the major change in the industry: Portfolio Allocation 2.0.
Not all Alt’s are created equally or appropriate across the board. Clearbrook strives to apply the same comprehensive review process to Alts as it does to traditional asset managers. Alternative investments are a very broad category that often gets lumped into a specific bucket of exposure usually starting with hedge funds, private equity, private credit and real estate. However, under each of those topics are a broad array of distinct strategies that behave uniquely in different market environments.
All asset classes have a history and Alt’s started in the hedge fund category where very loosely written investment guidelines and objectives were applied to managers who felt they had a formula to take advantage of market dislocations, apply a strategy and then add leverage. Only very large investors were allowed to invest, the information on trading was almost non-existent and was frequently referred to as “a club investment.” As time passed by, the traders who were actually making the trades left to start their own firms and the traditional HF were often seen as essentially training programs. When they left, the traditional HF would often be the first investor or seed capital. Many may remember the “tiger cubs” from Tiger Asset Management owned by Julian Robertson who passed away this summer at 89 years old. After the failure of Long-Term Capital, which was essentially a situation where mathematical surety did not correctly understand liquidity, investors demanded more visibility. The solution was VAR – value at risk. This was still an imperfect calculation.
Concurrent with the questions on HF’s was the backdrop where equities have actually provided a very positive return historically over the past thirty years. But fixed income options have lagged in many people’s minds even though they have done what was asked – provide stability in unstable periods.
As an advisory firm, Clearbrook benefits from having a significantly diverse client base, requiring us to be knowledgeable on a vast range of options. It is simply fundamental research done by people asking the right questions beyond what is provided by alternative managers. Clearbrook begins the process by understanding the objective of the HF’s strategy – what has to go right and what can go wrong and how well the manger monitors both tools. One of the most integral understandings is whether the structure of the investment vehicle is supported by the underlying assets. Whereas leverage was the old tool, the growing strategy now focuses on structure. Lastly, Clearbrook spends time understanding if the environment is proper for the strategy. Once we come to a conclusion, we review who else might find the information helpful either as an investment or just educational.
Where do you begin?
Perhaps the most common elements in alternatives include a lock-up of capital for a specified period of time, leverage and private markets. Usually, these components are somewhat reverse engineered to determine the greatest likelihood of success. There has also been a belief that investors and alternative managers are mutually aligned as only success provides incentive compensation. This can be viewed negatively when the incentive fees earned are large, but success is success. Perhaps the key questions pertain to are you getting the results you wanted relative to other options and was the risk commensurate with the return?
One of the greatest challenges in researching alternatives is determining if the past performance is indeed repeatable or if it was based on a dislocation that no longer exists. This is an area where Clearbrook’s experience and knowledge is applied. For example, long/short strategies have become much more difficult with the explosion of ETFs and specific sector ETF’s where “the rising tide lifts all boats.” Many hedge fund strategies feed on market volatility which has been saddled the past year for over extension of liquidity by the FOMC.
Another key differentiating factor is the pipeline of product applicable to a strategy. Especially in the private markets, the network of each manager is the life support of a strategy. Sourcing the best deals and investing capital in a relatively short period of time can be very challenging in real estate and private equity, though not as much for hedge funds.
Lastly, the period of time capital is put to work can be the very determination of performance for longer lock-up vehicles. Essentially, investments are made in similar market cycles and investments are then termed a certain “vintage.” Evaluations cannot be done across long periods of time unless the strategy is more liquid and positions change frequently.
No one was prepared for the global reaction to Covid nor the massive monetary support given to protect the financial system. No one could have hypothesized the response to the massive market moves either but some investors were able to capitalize on the volatility. In many aspects, global economies experienced an entire market cycle of scarce liquidity followed almost instantaneously with massive liquidity which catapulted the strongest companies to higher valuations. The financial industry machine has begun to take advantage of the appreciation in equities to launch into proposing increasing exposure to Alternative investments. The “rebalance” mantra is in full swing.
The overall bias always begins with the specific client’s needs, purpose, risk tolerance and existing portfolio. While alternatives can sound very intriguing, they can also be an issue if not properly approached. Clearbrook is always happy to educate and discuss new ideas to see if or how an investment can be used.