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.
Co-Head of Real Estate
Head of Investment Strategy

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.

In response to market turmoil, an investor’s initial instinct may be to stop or scale back private market investments in an attempt to right-size the allocation. Investors may also be tempted to sell assets in secondary markets – this is generally not advisable for illiquid assets in times of market stress.

State Street Global Advisors has decades of experience managing through multiple crises on behalf of our clients. There are several methods we employ to steer our clients’ portfolios through times of volatility:

  • Manage the less liquid asset classes to absolute $, £, or € targets based on a longer-term glide path or journey plan. Rather than trying to hit a constantly moving target, managing to an absolute AUM1 target is a more practical and efficient way for an investment team to construct and manage a portfolio. Targets can be revisited or adjusted annually to ensure that illiquid asset classes stay on track with the broader asset allocation plan. 
  • Focus on manager selection. The dispersion of returns within alternative investments is wide, and past performance is not an indication of future returns. An experienced investment team to underwrite not only the investments, but also the resilience of the platform, vehicle, and strategy, is critical to long-term success.
  • Invest consistently to mitigate vintage risk. We posit that investors should maintain their original pacing schedule in a crisis, particularly if the allocation is relatively new and not yet fully invested. A market downturn presents opportunities for asset managers to buy re-valued and stressed/ distressed assets. Stopping or scaling back commitments to private market investments may lead to missing out on better buying opportunities, which in the past have helped to boost returns.2 Figure 2 uses historical private equity performance as an illustration of this point.

Figure 2 plots inception-to-date Internal Rates of Return (IRRs) for global buyout funds from 1980 to 2016 and overlays recessionary periods in the shaded bars. Funds from 2017 onward were excluded, as they are still in the investment period and the results to date are not indicative of overall returns. Generally, the fund vintages launched in recessionary periods fared better than fund vintages launched in the periods immediately prior and post. For example, the 1998-2000 vintage funds had pooled returns of approximately 8-17% while the 2001-2003 pooled returns ranged from approximately 22-27%. Similarly, the 2005-2007 vintage funds had pooled IRRs of 6-10%, while the 2008-2012 vintage funds posted a 10-15% pooled return.

Our research suggests, therefore, that a potential for outperformance does exist for those investors with capacity to commit additional capital during the COVID-19 recovery period.

Key Takeaways

In sum, there are three takeaways for private market investors from our analysis of prior market crises.

  • Do not overreact to market volatility by automatically scaling back private market commitments.
  • Review commitment pacing annually so long-term targets can be managed to in a controlled manner.
  • Take into account the broader plan’s liquidity needs and ability to fund future capital calls.