Quick Clips

Quick Clips: New Rules of Diversification

How to Prep Your Portfolio for a Different Kind of Recession Risk

Topics - Portfolio Construction Portfolio Risk and Performance Asset Allocation Alternative Investing Macroeconomics

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Quick Clips: New Rules of Diversification

The first half of 2022 brought sustained losses for both stocks and bonds, an outcome not seen for more than 40 years. Near-term inflation forecasts were still being revised up, even as growth forecasts were steadily revised down. Economists are divided on the appropriate policy response, and central banks face tougher choices than they have for decades.

Have prospects improved for stocks and bonds?

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Stock and bond markets are both cheaper now than they were when the year began. But how much cheaper? Not much. A portion of the last few decades’ stock and bond returns were ‘borrowed from the future’ in the form of falling yields, in other words, rising valuations. As of the 3rd quarter, those borrowed returns are not even close to being fully paid back. Much more cheapening of stock and bond markets would be needed for yield-based expected returns to regain historical average levels.


The macroeconomic environment remains unfavorable for traditional portfolios with heightened risks from continuing inflation uncertainty, growth headwinds and tightening monetary policy. 


Are macroeconomic headwinds easing?

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Macroeconomic storm clouds are still gathering. Even if the level of inflation has peaked in some markets, there’s still room for upside surprises if inflation remains high for longer than the market expects. And if there is a recession, central banks won’t be able to ride to the rescue as they have in the past. Finally, we show that periods of monetary policy tightening have been challenging for both stocks and bonds.

Investors have flocked to private assets in recent years, seeking higher returns and diversification, but many of the headwinds faced by public assets apply also to their private counterparts, albeit with some smoothing due to private investments being infrequently marked to market. The key tail risk for private assets is a sustained period of low growth and poor market performance, where smoothing does not help and underlying economic exposures (‘slow beta’) materialize. For investors with substantial allocations to private assets, the most valuable diversifier is a strategy expected to outperform specifically during these prolonged bear market scenarios.

 

How might investors mitigate tail risk associated with private assets?

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If there is a prolonged bear market, there is nowhere to hide… Even for privates. How can investors mitigate this tail risk associated with their large private allocations? Trend following. A prolonged bear market is just another way of saying a sustained, downward trend… Which a trend following strategy is designed to profit from.


The formidable headwinds for traditional assets – low expected returns and heightened macro risks – may tip the balance in favor of a liquid alternatives allocation. 


How should investors seeking true diversifiers navigate the complex world of liquid alternatives? 

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The right liquid alternative for you will depend on your objectives. In the case of inflation protection, you are going to want to have a larger allocation to trend and macro and commodities. If you are more interested in recession protection, trend and macro will still be beneficial to overweight, but you’re also going to want to have more market neutral multi-Strat and alternative risk premia strategies.

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The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

 

Hypothetical performance results have many inherent limitations, some of which, but not all, are described herein. The hypothetical performance shown was derived from the retroactive application of a model developed with the benefit of hindsight.  Hypothetical performance results are presented for illustrative purposes only.

 

Diversification does not eliminate the risk of experiencing investment loss.

 

Certain publications may have been written prior to the author being an employee of AQR.

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.

 

AQR Capital Management is a global investment management firm, which may or may not apply similar investment techniques or methods of analysis as described herein. The views expressed here are those of the authors and not necessarily those of AQR.