Investing today – how asset allocation strategies have changed

Jonah Friedman • July 12, 2024

Asset managers have adapted their traditional asset allocation strategies in response to changing market conditions in recent years. What are these changes and how have they impacted investment strategies? We’ll take a look at some of the ‘traditional’ asset allocation strategies and explain why and how they’ve been modified to help protect investors’ returns in today’s market.

Traditional asset allocation: the 60/40 rule

Investors who have a long-term investment horizon, seek moderate growth, and can tolerate some short-term price fluctuation, have typically abided by the 60/40 rule of thumb for asset allocation. The strategy would allow the investor to target and hopefully achieve a stable rate of return while preserving capital.

The 60/40 rule states a well-diversified portfolio should hold 60 per cent in equities and 40 per cent in fixed income instruments. This split would allow the investor to capture the upside potential of equities while using fixed income to reduce risk and volatility.

Changing conditions call for a change in approach

In recent years, certain factors have presented challenges to the 60/40 strategy’s ability to achieve the desired results. For example, in the 21st century, there have been significant fluctuations in interest rates, which impact both short-term and long-term bond yields. Further, the stock market has been volatile, oscillating between strong and poor stretches for much of the past five to ten years. Investors using the 60/40 approach may have earned decent overall returns in the long run, but in the interim would have had to tolerate significant swings in their net worth.

In response to the volatile conditions, asset managers at major institutions have trended toward reallocating funds to investments outside the traditional public equity and fixed income markets. Alternative investments such as private equity and debt, real estate, infrastructure, and hedge funds may provide higher returns than publicly traded equity and fixed income instruments while being diversified (uncorrelated) from the public equity market.

The Ontario Teachers’ Pension Plan (OTPP)

In the early 2020s, The OTPP, one of the largest pension plans in Canada, announced plans to invest $70 billion in private markets over the following five years. Specifically, OTPP has placed investments in real estate, infrastructure, and equity and debt instruments of privately-owned companies. This new commitment was in addition to the $45 billion that OTPP already had invested in the private sector, which represents approximately 20 per cent of the plan’s total assets. The president of OTPP referred to the desire to achieve stronger returns and have a more balanced portfolio when explaining the company’s new investment plans.

Harvard University endowment

The Harvard University endowment is another large institutional investor that places a focus on private and alternative investments. Managed by Harvard Management Company (HMC), it is the largest academic endowment in the world. In the previous decade, HMC determined its investment strategies were outdated and underperforming, and after hiring a new CEO in 2016, emphasized increasing its exposure to private equity investments and hedge funds. In the following years, Harvard Financial Reports show that private equity allocation increased from 16 per cent to 23 per cent, while hedge fund allocation increased from 21 per cent to 36 per cent. The CEO stated that the hedge fund portfolio is designed to reduce exposure to public equity markets.

Investing in non-traditional asset classes

As demonstrated by OTPP and HMC, alternative and private asset classes are commonly used by institutions to target strong returns while managing risk. Fuller Landau Family Office invests client capital with a similar approach, and while investments do not always fit neatly into one specific category, three main asset classes are broadly used to categorize fund allocations:

 1. Hedge fund investing

Hedge funds differ from traditional funds by using a mix of long and short positions to “hedge” against the risk that the market, or certain sectors of it will perform poorly.

While a long position is a traditional investment that involves buying a security (i.e. a stock) and hoping that it increases in value, a short position involves making a profit when a stock decreases in value.

The goal of hedge investing is to limit downside in turbulent markets and achieve an absolute positive return in any market environment. Depending on the balance between long and short positions, a hedge fund portfolio may be described as “market-neutral” or “long-biased”.

Two common methods of taking a short position are executing a short sale and purchasing a put option.

Executing a short sale

  • A fund manager will borrow the stock from a financial institution for a fee, and then sell the borrowed stock on the stock exchange at its market price.
  • If the stock’s market value decreases as expected, the hedge fund manager will purchase the stock at the new, lower market rate to close out its position. They will then repay the financial institution with the newly purchased stock.
  • If executed successfully, the hedge fund will have made a profit of the difference between the price at which they sold the stock, and the price at which it was later repurchased, less the fee paid to the financial institution to borrow the stock.
  • A short sale can result in an unfavourable outcome if the price of the underlying stock rises, meaning the fund manager may have to buy back the stock at a higher price than they sold it for and close out their position at a loss.

Purchasing a put option

  • A derivative instrument where the investor has the right, but not the obligation, to sell a specific stock at a pre-determined price (the exercise price) before a specified date (the expiration date).
  • If the price of the underlying stock falls below the exercise price prior to the expiration date, the put option is “in the money”, which means the investor can purchase the stock at the lower price, and then exercise the put option to sell the stock at the higher exercise price.

Aside from taking short positions, hedge funds are also unique because they can use leverage, meaning they can borrow funds and invest them. If the rate of return on the investment exceeds the interest rate on the borrowed capital, the hedge fund will have effectively leveraged its portfolio.

2.  Non-correlated investing

While a traditional 60/40 portfolio is positively correlated to the public equity and fixed income markets, many investment managers are investing in assets that are unaffected by the economic factors that cause the stock and bond markets to fluctuate (i.e. “non-correlated” asset class). Like a hedge fund, the goal of non-correlated investing is to earn a consistent return through all economic conditions. While a hedge fund uses financial instruments for downside protection and to manage volatility, non-correlated assets are independent of financial markets and use unique strategies to generate absolute returns.

Examples

Litigation finance is a non-correlated investment strategy that invests in commercial lawsuits that are deemed likely to have a favourable outcome in court (via verdict or settlement) based on merit but are unable to proceed without financial backing. By design, the success of this opportunity does not correlate with how the public market, both stocks and bonds, are performing, therefore making it a good option to be part of a diversified portfolio to reduce market exposure.

Life settlements are a non-correlated strategy that involves purchasing a group of individual life insurance policies prior to maturity from the policy holders, who would rather receive cash proceeds upfront to fund vacations, medical assistance, or other lifestyle expenses. The investor is responsible for making all future premium payments and receives the death benefit when the insured passes.

3. Private equity investing

Financial institutions often seek out opportunities to invest in private equity (PE). PE firms look to purchase an equity position in privately held companies, grow the business, and then ultimately divest their ownership in the future at a higher valuation. A liquidity event usually takes the form of a sale to another organization, merging with another company, or going public via an initial public offering (IPO).

Institutional investors like OTPP and HMC are attracted to PE investments as they aim to yield significantly higher returns, typically greater than 10 per cent, when compared to publicly traded equities. Therefore, investing in PE can raise the overall expected rate of return on a portfolio, while also providing diversification away from public markets. PE investors are willing to accept that their funds will be locked in for a several year period (the illiquidity risk premium) until the liquidity event, in exchange for this higher targeted return. These investors should determine that they have sufficient liquidity in the other areas of their portfolio to meet future cash flow requirements.

Two common investing strategies or asset classes that fit under the PE umbrella are leveraged buyouts (LBOs) and venture capital (VC).

A PE firm executes an LBO by financing the acquisition of a private company through bank debt. The debt is collateralized (secured) by the assets of the acquired company. With leveraged transactions, as long as the rate of return is higher than the cost of borrowing (interest rate), the return is multiplied; therefore, an LBO has a higher potential return than a purchase funded with investor capital. Leveraging the transaction also comes with downside, as the negative returns will be multiplied if the investment does not perform well.

Venture capital firms, like general PE firms, look to acquire a stake in a private business. VC differs in that the targeted companies are usually in their earlier, less mature stages (i.e. a startup or scale-up), and the investor is betting on the potential for the company to grow significantly. Unlike traditional private equity, VC fundraising usually involves multiple investors acquiring a non-controlling stake in the company, while the founders retain control. Like PE, the goal of VC investing is reaching a successful liquidity event; being acquired by a larger company, or going public via an IPO. VC investments tend to have much higher risk than traditional private equity because the probability of early-stage companies becoming successful is low and it takes a long period of time; however, the returns can be extremely high if the company succeeds.

While there is still a place in portfolios for traditional public securities, large institutional investors like OTPP and HMC have prioritized diversifying their vast portfolios into alternatives that, on aggregate, can achieve targeted returns while minimizing volatility. Hedge funds, non-correlated investments, and private equity are three key alternative asset classes that Fuller Landau Family Office considers when building client portfolios that are in line with its institutional and modern investing approach.

About the author

Jonah Friedman CPA, CA is Associate Director in our Family Office group. He can be reached at 416-645-6518 or jfriedman@fullerllp.com.

 

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