Ideas for allocation:

The nuts and bolts of introducing alternatives

Allocating with an eye on client objectives

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Gary Lin

Managing Director, Head of Global Portfolio Strategy and Solutions

Introduction

Current economic conditions remind us that volatility is an ever-present force in our lives. Macroeconomic uncertainty hangs over interest rates, inflation, and prospects for future growth. Geopolitical uncertainty around the world brings additional uncertainties concerning fuel prices and disruptions in global trade. Industrial policy disputes across the globe threaten large segments of the global supply chain.1

Investors looking to navigate these turbulent waters generally desire portfolios that seek to offer stable, resilient growth. Diversification remains a cornerstone to constructing portfolios designed for stability, but the traditional suite of public equity and debt products simply may not offer the same degree of diversification as they have in the past. Equity markets in particular have become increasingly concentrated, making diversification more difficult to achieve with public assets alone. A decade ago, the ten largest U.S. companies accounted for 14% of the S&P 500 stock index – today they account for 35.8%.2 Including investments from the private markets may offer an attractive way to provide diversification with the potential to improve returns. In this piece, we will explore the mechanics of incorporating alternatives into investor portfolios and how to approach asset allocation in ways that could align with their goals.

The Saver, The Spender, & The Grower: Defined

In my previous piece, I highlighted the similarities between large institutional investors and individual investors in terms of the investment goals and constraints they were trying to achieve. We talked about the saver, the spender, and the grower:

Coin bank icon within a blue circle

The Saver

Carefully saving to meet a tight budget.

Maybe this is a family with young kids and thus a lot of expenses, but they need to put money away for education, for retirement. They might skew towards safer investments, with less willingness to put capital at risk because meeting their investment goals means keeping a tight budget on a day-to-day basis. Capital preservation and income generation are top priorities here.

These investor types are likely holding different baseline portfolio allocations. For example, the saver could well be holding a portfolio that is heavily tilted towards debt, the spender could have a more traditional balance between equity and debt, and the grower could be predominately equity oriented. The question, then, becomes what is the best approach for building alternatives into portfolios based on a client’s objectives and their starting positions? In other words – how do we meet them where they are?

Introducing alternatives to the saver's portfolio 3

Suppose your saver client holds a portfolio that is 80% debt and 20% equity. This is perhaps extreme, but it captures the idea that the Saver is averse to volatility and places a premium on capital preservation. As the chart below illustrates, the average return of this strategy since 2005 would be nearly 4.8% per annum, with an annualized volatility of about 5.1%. The relatively low return means that $100,000 invested in January of 2005 would have grown to $257,878 by the end of 2023.

Incorporating alternatives into the Saver’s portfolio has the potential to boost yield and returns while lowering volatility. To see this, compare the performance of the portfolio below to that of a portfolio that maintains a 20% allocation to public equity, but splits the debt portion into 50% fixed income and 30% private credit.

As the figure illustrates, replacing some of the traditional fixed income allocation with an allocation to private credit could both lower the annualized volatility of the portfolio as well as raise its yield and portfolio return. As an example, $100,000 invested in this portfolio in January of 2005 would have grown to $371,149 – illustrating the potential for 43% more growth compared to the portfolio without alternatives.

If the primary consideration for the investor is lowering volatility, this can be further achieved by incorporating real estate into the alternatives portfolio. In the portfolio depicted below, the overall allocation to alternatives remains 30% of the total portfolio, but the portfolio below includes 10% private real estate and 20% private credit. Incorporating real estate into the portfolio can likely achieve better diversification, lower volatility, while potentially enhancing income over the base portfolio.

Figure 1

Illustrative saver portfolio

  • Public equity

  • Fixed income

4.78% Annualized Return

3.92% Portfolio Yield

5.16% Annualized Volatility 

Growth of $100k: $257,878

Figure 2

Adding private credit to the saver's portfolio

  • Public equity

  • Fixed income

  • Private credit

6.67% Annualized Return

6.15% Portfolio Yield

4.69% Annualized Volatility 

Growth of $100k: $371,149

Figure 3

Adding private credit & real estate to the saver's portfolio

  • Fixed income

  • Public equity

  • Private credit

  • Private real estate

6.44% Annualized Return

5.31% Portfolio Yield

4.40% Annualized Volatility 

Growth of $100k: $351,177

FOR ILLUSTRATIVE PURPOSES ONLY. All investments are subject to risk, including the loss of the principal amount invested. This information is being provided for Illustrative/informational purposes only, not indicative of actual client results. Assumptions are for modeling purposes only and alternative assumptions may result in significant or complete loss of capital. There can be no assurance that the strategy will achieve comparable results or that the strategy will be able to or will ultimately elect to implement the assumptive investment strategy and approach described in the model.

Adding alternatives to the spender's portfolio4

The spender is likely playing catch up. They need to generate income and grow their asset base in order to be prepared for retirement. Because they may already be holding a traditional 60/40 portfolio, alternatives can be meaningfully added to both the equity and the fixed income side of their portfolio to potentially boost returns and generate higher yield.

Consider two illustrative portfolio models for the spender that introduce alternatives to the traditional 60/40 mix. The first is formed by moving the 60% equity allocation to a 45% equity allocation and 15% private equity, leaving the 40% fixed income untouched.

The traditional 60/40 portfolio may achieve a 7.92% return over the 2005-2023 period with an annualized volatility of 10.14%. Both alternative portfolios, however, appear to offer higher return and lower volatility – $100,000 invested in a January 2005 portfolio that incorporated private equity would have grown to $507,174 compared to growing to only $415,895 in the traditional portfolio. Adding private credit into the mix furthers the potential to enhance returns and maintain lower volatility. As an example, a $100,000 investment over the same period would have grown to $544,931, around 31% more growth compared to the traditional portfolio.

The second model goes further, keeping the 15% private equity allocation on the equity side, but replacing the 40% fixed income with 10% private credit, 30% fixed income.

Figure 4

Illustrative spender portfolio

  • Public equity

  • Fixed income

7.92% Annualized Return

2.62% Portfolio Yield

10.14% Annualized Volatility 

Growth of $100k: $415,895

Figure 5

Adding private equity to the spender's portfolio

  • Public equity

  • Fixed income

  • Private equity

8.42% Annualized Return

2.47% Portfolio Yield

8.67% Annualized Volatility 

Growth of $100k: $507,174

Figure 6

Adding private equity & private credit to the spender's portfolio

  • Public equity

  • Fixed income

  • Private equity

  • Private credit

9.05% Annualized Return

3.22% Portfolio Yield

8.70% Annualized Volatility 

Growth of $100k: $544,931

FOR ILLUSTRATIVE PURPOSES ONLY. All investments are subject to risk, including the loss of the principal amount invested. This information is being provided for Illustrative/informational purposes only, not indicative of actual client results. Assumptions are for modeling purposes only and alternative assumptions may result in significant or complete loss of capital. There can be no assurance that the strategy will achieve comparable results or that the strategy will be able to or will ultimately elect to implement the assumptive investment strategy and approach described in the model.

Adding alternatives to the growers portfolio4

When your client is a grower, maximizing their risk-adjusted returns is their top priority. They may be holding a portfolio that is already heavily tilted towards equity. Our example grower below has a portfolio that is allocated 80% to equity and 20% to fixed income. That portfolio would have generated an annualized return of 9.49% with a volatility of 13.08% annually, and $100,000 invested in January of 2005 had the potential to be worth $494,903 at the end of 2023.

Let’s consider how this compares to two illustrative portfolios with alternatives in the mix. First, let’s consider a portfolio that replaces their 80% equity allocation with a mix of 50% equity and 30% private equity.

They sacrifice liquidity in the short term for higher historical returns and considerably lower volatility. In addition, $100k invested in January of 2005 would have grown to $677,462 by the end of 2023 in the portfolio incorporating alternatives, 36% more than the base “grower” portfolio, and with less volatility along the way.

Another approach to adding alternatives to the grower’s portfolio is to add a mix of private credit and private equity on the alternatives side, lowering the allocation of both fixed income and public equities compared to the traditional portfolio. This portfolio is depicted on the right.

This portfolio achieves a 35% allocation to alternatives by replacing the 20% traditional fixed income allocation with 15% traditional fixed income and 5% private credit. This could achieve a noticeably higher return and dollar growth than the traditional portfolio with the potential for lower volatility and sustained portfolio yield.

Both these examples illustrate how portfolio efficiency can be achieved by adjusting traditional portfolio allocations to include alternatives.

Figure 7

Illustrative grower portfolio

  • Public equity

  • Fixed income

9.49% Annualized Return

2.08% Portfolio Yield

13.08% Annualized Volatility 

Growth of $100k: $494,903

Figure 8

Adding private equity to the grower‘s portfolio

  • Public equity

  • Fixed income

  • Private equity

10.48% Annualized Return

1.64% Portfolio Yield

10.24% Annualized Volatility 

Growth of $100k: $677,462

Figure 9

Adding private equity and private credit to the grower‘s portfolio

  • Public equity

  • Private equity

  • Fixed income

  • Private credit

10.80% Annualized Return

2.01% Portfolio Yield

10.29% Annualized Volatility 

Growth of $100k: $696,340

FOR ILLUSTRATIVE PURPOSES ONLY. All investments are subject to risk, including the loss of the principal amount invested. This information is being provided for Illustrative/informational purposes only, not indicative of actual client results. Assumptions are for modeling purposes only and alternative assumptions may result in significant or complete loss of capital. There can be no assurance that the strategy will achieve comparable results or that the strategy will be able to or will ultimately elect to implement the assumptive investment strategy and approach described in the model.

Allocating with an eye on client objectives

Our three investor types – the saver, the spender, and the grower – likely vary in terms of their desired exposure to volatility, their need to generate income, and their desire to preserve capital. The grower may be willing to bear a substantial amount of risk to earn outsized returns over the long run, while our spender may not be able to afford to take as much risk because they have near-term cash needs. In addition, investors will undoubtedly vary according to personal real estate wealth and other components of their net worth.

All of these factors should be factored into determining an allocation to alternatives that is right for a specific client. Regardless of the client’s specific objectives and their starting portfolio, substituting components of the traditional portfolio for assets from the private markets could deliver higher risk-adjusted returns, better yield, or better capital preservation than the standard public equities and fixed income approach – qualities that may prove invaluable in seeking to build wealth for clients in today’s investment landscape.

FOR ILLUSTRATIVE PURPOSES ONLY. All investments are subject to risk, including the loss of the principal amount invested. This information is being provided for Illustrative/informational purposes only, not indicative of actual client results. Assumptions are for modeling purposes only and alternative assumptions may result in significant or complete loss of capital. There can be no assurance that the strategy will achieve comparable results or that the strategy will be able to or will ultimately elect to implement the assumptive investment strategy and approach described in the model.

Endnotes

  1. CNBC: “Is the U.S. stock market too ‘concentrated’? Here’s what to know”, published July 1, 2024.
  2. Sources: Bloomberg, Cambridge Associates, Cliffwater for the period 1/1/2005 to 12/31/2023. Public equity represented by the S&P 500, fixed income represented by the Bloomberg US Aggregate Bond Index, private credit represented by the Cliffwater Direct Lending Index, private real estate represented by the NCREIF NFI-ODCE Index.
  3. Sources: Bloomberg, Cambridge Associates, Cliffwater for the period 1/1/2005 to 12/31/2023. Public equity represented by the S&P 500, fixed income represented by the Bloomberg US Aggregate Bond Index, private equity represented by the Cambridge U.S. Private Equity Index, private credit represented by the Cliffwater Direct Lending Index.
  4. Sources: Bloomberg, Cambridge Associates, Cliffwater for the period 1/1/2005 to 12/31/2023. Public equity represented by the S&P 500, fixed income represented by the Bloomberg US Aggregate Bond Index, private equity represented by the Cambridge U.S. Private Equity Index, private credit represented by the Cliffwater Direct Lending Index.

Important information

Unless otherwise noted the Report Date referenced herein is as of August 2024.

Past performance is not a guarantee of future results.

The material presented is proprietary information regarding Blue Owl Capital Inc. (“Blue Owl”), its affiliates and investment program, funds sponsored by Blue Owl, including the Blue Owl Credit, GP Strategic Capital Funds and the Real Estate Funds (collectively the “Blue Owl Funds”) as well as investment held by the Blue Owl Funds.

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