Evening Brief – 03.14.24
Diversification
Institutional investors are seeking strategies to reduce their portfolios’ reliance on economic growth, increase diversification, and provide downside resilience, according to a recent analysis.
During the 13 years after the 2008 financial crisis, monetary policy was kept loose to support the U.S. economy and avoid a deflationary cycle. Access to low-cost lending fueled company expansion and triggered an exceptionally strong rally in the equity markets. Low interest rates prompted investors to make leveraged bets, and allocations to longer-term, illiquid investments like private equity and real estate increased.
This means that many institutional portfolios were exposed to low interest rates and economic growth risk. Technology companies, early-stage ventures, large-cap buyouts, and real estate investments with low cap rates are just a few examples of investments that have been vulnerable in today’s higher-rate environment, noted Man Group, a UK-based investment management firm, in its Views from the Floor. Diversification in many institutional portfolios may result in overexposure to this single low-rate element.
The long-term reduction in the number of publicly traded corporations is significant. In 1996, there were more than 8,000 companies traded on U.S. markets, compared to only 3,700 in 2023, highlighted Man Group, citing a recent CNN article.
Concerns about the breadth of opportunities in public equities have resurfaced in the last year given the dominance of the Magnificent Seven tech stocks, which many see as a deflationary bet that AI will spur economic growth and have driven more than half of the S&P 500 Index’s returns, making active management extremely difficult.
“This occurred after bonds failed to protect portfolios in 2022, falling alongside equities and challenging their traditional safe-haven, diversifier role. These developments have underscored a growing belief that the current allocations models need to be revisited and their assumptions on asset class diversification re-examined,” wrote the firm.
Institutional investors are increasingly looking for diversification throughout the liquidity spectrum rather than isolating long-only, hedge, and private market assets. “It recognizes that much market activity is now occurring in private markets, an area of significant growth and importance, even for public market investing.”
The shift toward private markets and diverse portfolios reflects the changing dynamics of the financial industry and is expected to continue. If higher interest rates remain in place for longer than currently anticipated, investors must reconsider their portfolio diversification strategies.