- Head of Multi-Asset Strategy
United States, Institutional
Change
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When we polled 170 asset owners recently, more than a third said they were unusually anxious about their portfolio positioning. Geopolitical risk, market concentration, and equity valuations/credit spreads were the top sources of angst, but the list was long and varied.
To help, I want to offer some thoughts on worries that may be worthy of attention. I’ve divided my observations and suggestions into two categories:
1. Learning to live with an uncomfortable investment backdrop, which I define as one in which market behavior is being driven by new or unusual phenomena (e.g., deglobalization). Here, I consider the choice between cutting risk broadly, carrying on as usual, or finding a happy medium, which might include portfolio tilts to defensive or dynamic investment strategies. I also offer some specific thoughts on navigating the “Magnificent Seven” era of market concentration.
2. Adapting to a world where some investing rules of thumb may be broken, including rules related to the value of diversification, the ability of private equity distributions to fund future commitments, and the cyclical nature of investment performance in areas like growth and value. I offer a four-step process to help asset owners determine where their portfolios stand relative to these rules and assess their confidence in the rules going forward.
Learning to live with an uncomfortable investment backdrop
I see several factors contributing to an uncomfortable backdrop today:
Concentrated markets — There have been periods of concentration in the US equity market before, but the current level among large-cap stocks is higher than at any time since the 1970s (Figure 1). Rising levels of concentration pose a headwind for active managers, who tend to be overweight their favored stocks and underweight many or most of the largest stocks in the index.
Figure 1
Deglobalization and geopolitical uncertainty — In recent years, and especially since the COVID pandemic, we’ve seen a reversal in the globalization trend that dominated the twentieth century. Deglobalization can be unsettling in its own right, but it is also a symptom of broader geopolitical uncertainty. As Wellington Geopolitical Strategist Thomas Mucha has noted, the world faces an overwhelming number of geopolitical policy challenges, further complicated by technological disruption and climate change. Many of the foreign policy experts he speaks to compare the complexity and risk of the current environment to two of the most troubling times in modern history: 1913, when we were on the verge of World War I, and 1939, when World War II was underway.
Market stability — In some respects, we’ve been in an exceptionally stable period for the markets, and that may be leaving some asset owners more sensitive to economic and geopolitical uncertainty, as they wait for another shoe to drop. To illustrate the point, we looked at the number of trading days between 2% declines in the S&P 500 (Figure 2). Over the past several decades, the average was 30 trading days. But this past August, we saw the end of a period of more than 350 trading days without a 2% decline, one of the longest such periods in recent memory.
Figure 2
So, how can asset owners cope with the discomfort? I think it boils down to three basic choices:
1. Cut risk
I’m not a big proponent of this option. Cutting risk by selling more economically sensitive or otherwise volatile exposures is challenging. Asset owners who act too early could miss out on meaningful gains. They also have to get a second decision right: when to re-risk. Not all organizations have the tools, team, or processes in place to make these decisions well. And currently, in my estimation, there aren’t many signs of the sort of near-term market/economic collapse that would justify such a move. Indeed, at the time of this writing, Wellington’s Multi-Asset team was leaning into equity exposure in our near-term outlook.
2. Carry on as usual
I’m more sympathetic to this option. I think some elements of the current uncomfortable backdrop are simply an ever-present part of long-term investing. Geopolitical turmoil may be heightened today, for example, but I would classify that as a perennial risk. (For example, a terrorist attack can roil the market at any point.) There may be a degree of recency bias in the anxiety some are feeling about the current risks. There’s also an argument for diversification as the first line of defense for mitigating the risks in the current backdrop.
3. Tilt to defensive or dynamic strategies
For asset owners who aren’t comfortable just carrying on but also aren’t looking to broadly cut risk, I think there are several types of strategies worth considering:
- Defensive active strategies seek to outperform a benchmark over time, but relatively more of the alpha is expected to come in periods when markets are underperforming. These strategies may be able to limit the “return drag” that can come from simply cutting risk (as described above), making them a potentially attractive alternative.
- Rotational active strategies may be able to opportunistically cut risk ahead of a sell-off and add it back afterward. That’s not easy to do, as I noted, but there are portfolio managers who have made this a fundamental part of their philosophy and process and focus on this type of positioning day in and day out.
- Active risk control is a dynamic strategy that seeks to actively adjust portfolio hedges as the perceived probability of a market decline fluctuates. For example, if the risk of a near-term drawdown appears elevated, protective strategies such as options and beta hedging may be implemented temporarily to help mitigate the downside risk.
I also think asset owners should have a playbook for a sell-off that considers what happens after the downturn. That might be the time to add risk and lean into areas of opportunity where an asset owner had previously hesitated.
Thoughts on living with market concentration
Rising market concentration poses a unique set of challenges to asset owners, and while the Magnificent Seven’s fundamentals generally remain strong, I believe today’s markets warrant a specific response. Asset owners should consider:
Adding strategies that can navigate market concentration — Long/short hedge funds can pursue alpha in stocks without having to underweight the largest names to own the stocks they want to own. In a similar vein, extended (140/40) strategies may be able to navigate the “Magnificent Seven” era well by using short exposure to fund more long exposure. This affords portfolio managers more flexibility to own the largest benchmark names at a market-cap weight if they do not have a differentiated view on the companies, while still allowing them to be highly active in the remainder of their opportunity set.
Focusing active risk in a portfolio on manager overweights — Here the idea is to look at how much of a portfolio’s active risk is coming from being overweight the managers’ highest-conviction names (which is how they typically expect to add value) rather than from being underweight the largest names in the index (not necessarily a conscious decision by PMs). In some cases, adding to mega-cap exposure (e.g., through an index-completion “sleeve”) could help balance the active risk budget so that more of the risk is coming from the overweights. This will tend to bring down total tracking risk (reducing one driver of manager alpha) but hopefully offset that by focusing tracking risk on managers’ best ideas.
Adapting to a world where investing rules of thumb may be broken
Asset owners often rely on rules of thumb, derived over years of investing experience, to help them navigate periods of uncertainty. When trusted rules of thumb seemingly break down, it can undercut confidence in core investment tenets, complicate decision making, and lead to ill-advised shifts in long-term policy.
I’ll touch on three rules of thumb that have been called into question in my discussions with asset owners recently:
“Investment diversification adds value.”
Recent market results have challenged conventional wisdom here, both within equities (e.g., why invest outside the US?) and broadly across asset classes. Figure 3 offers a simple illustration. The top table shows two approaches to a 60% equity/40% fixed income asset allocation. The first uses the S&P 500 Index for equities and the second uses the more diversified MSCI All Country World Index. (Both use the Barclays US Aggregate Index for fixed income.) In every period shown, going back to 1988, the less diversified mix using the S&P 500 outperformed. And while the S&P 500 mix had higher volatility in some of the intermediate periods shown, it had lower volatility for the full period as indicated in the bottom table. So, more diversification translated to less return and more risk — not what investors would expect from this rule of thumb.
Figure 3
“Private equity distributions can fund future commitments.”
Turning to private equity, Figure 4 shows capital calls (dark-blue bars) and capital distributions (light-blue bars). The orange line is the net of those two. It dipped around 2008, during the global financial crisis, but recently it has really plunged. We saw meaningful years of capital calls leading up to 2020 and pretty meager distributions over the last two years. The data I’ve seen for 2024 so far looks similar. In short, asset owners haven’t been able to rely on distributions to fund ongoing private equity commitments.
Figure 4
It’s important to remember that as long as private equity is generating healthy returns, it should be able to return capital in time. We’ve seen some positive signs, including the US IPO market beginning to open up. Federal Reserve easing could help by boosting investor optimism and openness to funding new deals. So this rule of thumb may not be broken, but it’s not holding up well at the moment.
“Winning investments of the last decade rarely outperform in the next one.”
I first shared Figure 5 in 2020. It compares the trailing 10-year relative performance of value and growth stocks (x-axis) with the forward 10-year relative performance (y-axis). Each dot represents a month of observations. As indicated by the orange oval, a 10-year period of value outperformance has tended to be followed by a 10-year period of growth outperformance. The results in the green oval are even more compelling: Following 10-year periods when growth beat value, the worst that value did in the next decade was to outperform growth by 2% a year.
But the way the data has evolved in recent years does not present a pretty picture. As indicated by the blue oval, since I first produced this chart, we have had multiple instances of one 10-year period of growth outperformance being followed by another — a clear challenge to this rule of thumb.
Figure 5
How should asset owners respond if there are questions about the rules of thumb they rely on? I think they should still lean on the rules. Rules of thumb generally reflect long-term history — much longer than in the charts above — and are often supported by academic research, insights on human behavior, and logic/intuition. I also think asset owners’ antennae should go up any time they hear the phrase “this time is different.” The pioneering investor Sir John Templeton called those the “four most dangerous words in investing.”
That said, sometimes “this time” is different. Not every rule will hold forever. With that in mind, I’ve proposed a four-step process to help asset owners think about managing a portfolio when some rules of thumb are open to question:
1. Know where you stand. The question here is whether a portfolio is currently positioned so that it will do better if the rule works again or if the rule is, in fact, broken. For example, a portfolio benchmarked to a market-cap-weighted global index is already tilted toward the idea that the “diversification adds value” rule is broken. Consider the weight of the US in the MSCI World Index: Over the past half century, it averaged 52%. Today, it’s above 70%, so the index and portfolios benchmarked to it are significantly less diversified. Or to offer another example, a portfolio that is currently “style balanced” between growth and value is effectively neutral relative to the rule that winning investments of the last decade rarely outperform in the next one.
2. Where you have confidence, tilt toward the rule. My bias is to bet against the idea that “this time is different” and to tilt toward the rules where asset owners have confidence. My confidence in the value of global diversification over time is relatively high, for example. Thinking back to the late 1980s, Japan had become a disproportionately large weight in the global market, not unlike the US today. At the time, it wasn’t difficult to make a case for a large allocation to Japanese equities, but it turned out that investors were well served by having a diversified portfolio in the decades that followed.
Asset owners looking to diversify globally today could consider adding broad non-US equity allocations (here I see a case for pursuing both beta and alpha), targeted emerging market allocations, or exposure to individual countries that may be attractive, such as Japan and India.
When it comes to growth and value stocks, I still have medium to high confidence in the rule that investments don’t generally repeat their success over consecutive decades, despite the recent exception to the rule shown in Figure 5. For asset owners who agree and want to lean into value after a long stretch of growth outperformance, I would consider value strategies that are index-agnostic or are benchmarked to a core index (avoiding the baggage of sector concentration that can come with a value index). I also think value may have a bit more runway in markets outside the US, which don’t have the same uphill battle against the mega-cap tech sector. Finally, quality value allocations may be worth a look — even if the value/growth cycle continues to tilt away from value, quality exposure could be another potential portfolio driver. (On a related note, my colleagues recently took on some of the rules of thumb often applied to value stocks in particular.)
3. Consider the risk of being wrong. Asset owners should manage positions to account for the possibility that “this time is different” for some rules. Let me give two examples. First, on the private equity side, I expect, as noted, that distributions will eventually get back to levels that can fund capital calls. But to account for short-term periods where this isn’t the case, asset owners may want to do more modeling and stress testing of capital calls and returns to help ensure a robust private equity program. They might also consider adding shorter-lived private equity exposures to the mix, such as investments in secondaries or late-stage venture capital. I would also prioritize vintage-year diversification. While there may be a distribution/capital call mismatch now, the risk of not making private equity allocations and missing a year could be significant.
Second, asset owners who lean into the rule that “winning investments from one decade rarely outperform in the next one” should bear in mind they may be adding exposure to structurally challenged allocations or at least fighting strong short- and medium-term momentum. This could be the case not just in value, but in areas like non-US and small-cap equities. In a sense, leaning heavily into all of those areas could amount to one big bet against the continued run-up in US mega-cap stocks. I am not arguing against making those tilts, but investors should size their total exposures to ensure they don’t suffer disproportionately if the current market climate prevails for longer than they expect.
4. Prioritize education and governance. Assessing whether these rules of thumb are broken will require a degree of patience, so this may be a moment to focus on education with a board or governance team — to re-underwrite the organization’s confidence in each rule and comfort level with the possibility of being wrong.
A few final tips on dealing with anxiety
This isn’t the first time asset owners have felt the effects of market uncertainty and it won’t be the last. For any anxiety-provoking environments, I would offer three suggestions:
Overprepare — Be creative and think about where we could be one, three, and five years from now and the portfolio implications. Take the time to review and refresh your risk practices as well.
Overcommunicate — Review the investment philosophy and positioning with key stakeholders and keep the lines of communication open.
“Phone a friend” — Most organizations are wrestling with the same questions. Discussions with peers and managers can be valuable and reassuring in uncertain times.
We would welcome the opportunity to engage in such a discussion — on the ideas I’ve offered here or others geared toward a specific challenge in what is unquestionably a tricky period for asset owners to navigate.
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