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.

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is intended exclusively for the use of the person to whom it has been delivered by AQR, and it is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

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. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. 

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.