Alternatives Allocation: Market Volatility and the Denominator Effect
Investors that pause or scale back alternative investments during a downturn may find themselves under-allocated to the highest performing vintages, leading to longer-term underperformance.
Investors that continue on their pacing schedule despite “the denominator effect” may be rewarded with equal weight/higher exposure to higher performing vintages, leading to longer-term outperformance relative to peers.
Many investors with long-term horizons invest in longer-cycle asset classes such as private equity, infrastructure, real estate, and private credit. These private markets offer diversification and the potential for higher risk-adjusted returns, in exchange for illiquidity. An additional benefit is that private investments are often less volatile because valuations are performed less frequently (quarterly for the most part). As a result, private asset valuations are slower to react to market turmoil, including the turmoil that accompanied the COVID-19 crisis.
When pubic markets decline precipitously, institutional investors may experience “the denominator effect” – an increase in the private market portfolio as a percentage of the overall pool of assets – caused by a difference in valuation timing. See Figure 1.