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Tackling Key Asset-Allocation Controversies

11 December 2023

5 min read

Inigo Fraser Jenkins| Co-Head—Institutional Solutions

Alla Harmsworth| Co-Head—Institutional Solutions; Head—Alphalytics

As investors prepare to turn the calendar to 2024, we explore notable issues that run the gamut from private allocations to the prognosis for active equity management.

We’ve encountered many questions on allocation controversies during our meetings with clients during the past few months. Here we highlight a few: they underlie recent asset-flow trends, and evolving views on them will likely determine flows over the next few quarters, too.

Does the Allocation to Private Assets Still Need to Rise?

Earlier in 2023, public markets sold off while private markets largely did not, causing an apparent increase in allocations to illiquid assets. We think the real issues that ultimately shape private allocations are: 1) the likelihood that investors’ liquidity needs will remain elevated; 2) the case for sustained real returns from different private-asset categories in a regime with higher capital costs and higher inflation; and 3) the case that private assets offer diversification (not merely the faux diversification of not marking to market).

We’ve sensed a stabilizing appetite for private equity in 2023 (Display) given higher buyout multiples and the cost of credit, as well as the prospect of lower internal rates of return from new deal tranches. Yet we believe private equity still has a role in portfolios—especially as widely dispersed outcomes support a case for “alpha” from top fund selection. However, we expect average private equity returns to be lower than long-term history, with net-of-fee returns broadly in line with public equities. The reasons: the cost of debt is up sharply; there is very limited scope for multiple expansion; and economic growth is slower.

Allocations into Private Equity Appear to Be Stabilizing

Percentage of Respondents by Allocation Intention

Percentage of respondents by asset allocation intention

Historical analysis and current estimates do not guarantee future results.
As of June 20, 2023
Source: Preqin and AllianceBernstein (AB)

The private-debt outlook seems better, with strong structural support from the pullback of traditional credit providers. In fact, all net US credit growth over the past 30 years has come from nonbank sources, as capital requirements constrain banks from middle market lending. Most private lending is floating rate, which offers inflation protection, and with short-term rates up sharply over the past year, yields for middle market loans are historically attractive at over 11%. So, we think the marginal dollar allocated to private assets should go to private debt.

Is It Time to Increase Duration?

With 10-year US Treasury bond yields in the mid-4% range, we’re being asked more often whether it’s time to add duration, and we hear a related question on the role of government bonds in portfolios. Flows have been skewed toward shorter-duration assets for much of 2023 (Display), even if we exclude the roughly half of money-market flows that are replacing bank deposits. Flows into long-duration bond funds have picked up recently, though, so higher bond yields seem to be affecting investors’ preferences.

Fixed Income Flows by Duration

USD Billions

Money market, intermediate bond and long-term bond flows during 2023

Historical analysis does not guarantee future results.
Through October 25, 2023
Source: Emerging Portfolio Fund Research (EPFR) Global and AB

From a tactical viewpoint, the 10-year yield isn’t quite as high versus the fed funds rate as it typically is at a turn in the cycle, so yields could still rise. It’s a commonly held view that the odds are better that a larger-yield move will be down, increasing the potential benefit of adding duration relatively soon. However, the yield curve is still flat, so the “risk” of continued strong economic growth would make equities and short duration more attractive. And the dispersion of potential macro outcomes is unusually wide right now.

We think the tactical view could come down to the odds that growth slows. If this is the case, our tactical earnings indicator is consistent with a remarkably soft landing and US earnings growth of 9% one year forward. In other words, the bottom-up consensus could be right—but it depends on strong consumer data.

The strategic duration case is mixed. It presents a more attractive entry point than at any time in the past two years, but what about a longer horizon? The violent yield surge has spurred questions about whether “bond vigilantes” have returned, which really refers to the net supply/demand outlook for sovereign bonds. From an asset-allocation perspective—where the decision is about one asset class versus another rather than an asset class in absolute terms—it’s interesting how this balance stacks up versus equities.

We think buybacks exceeding issuance will be the main determinant of net equity supply/demand, so the net supply of public equity in the US should fall by about 3.4% in the next five years. Bonds face the opposite situation: demand from foreign investors could fall, as might strategic allocations from inflation-sensitive investors. A high and growing primary deficit will boost the supply of treasuries at a time when the Fed continues to shrink its balance sheet. As a result, we expect a net increase of about 17% in US bond supply over the next five years.

It's debatable how much the supply situation has driven the latest bond-market moves, and net supply/demand doesn’t directly affect bond or stock valuations, but we think it’s an important aspect for asset allocation over the next five years. Investors face structurally higher inflation and the potential that sovereign bonds will be less effective diversifiers. So, in absolute terms, the case for government bonds is stronger than it was a year ago, but their relative attractiveness in a portfolio that must beat inflation over a long horizon is moot.

2023 Has Been Bad for Active Equity So Far—What’s the Prognosis for 2024?

The past 12 months have been tough for actively managed stock funds, in part because of strong returns from US mega-cap tech firms. A right-hand skew to cross-sectional returns is not unusual and typically benefits skilled managers, but it becomes a problem if the very largest companies lead.

We won’t call a tactical turning point in the leadership of tech mega-caps, but the valuation of the 10 largest stocks versus the rest of the market is far beyond the bounds of previous experience and unlikely to last over strategic time frames. The average pairwise correlations of both global stocks and factors are low (Display), which is somewhat surprising given that correlations tend to be elevated when macro uncertainty is high.

Average Pairwise Factor and Stock Correlations Are Down

Pairwise correlations of factors and stocks since 2000

Historical analysis does not guarantee future results.
Stock correlations are the average pairwise correlations of daily stock returns for constituents of the MSCI All Country World Index over a rolling six-month window.
Through August 31, 2023
Source: FactSet, MSCI, Thomson Reuters I/B/E/S and AB

It can be demonstrated that low correlations are a good entry point for active. Grinold and Kahn’s so-called Fundamental Law of Active Management holds that low correlation increases the number of independent investment opportunities. Assuming constant skill, more independent investment opportunities implies a higher information ratio. In practice, our previous research has shown that active funds tend to fare better than normal when they start from low correlation levels.

What Do Recent Thematic Flows Tell Us?

Some investors have been reallocating to China, given its sizable underperformance and prior outflows; we can see this tactical behavior in the decoupling of China flows from lackluster emerging-market (EM) flows (Display). More strategically, we’re seeing a strong consensus that China allocations should be distinct from the rest of EM.

China Flows Decoupling from Lackluster Rest of Emerging Markets

Equity Flows (USD Billions)

Monthly equity flows into China and the rest of emerging markets

Historical analysis does not guarantee future results.
Through October 11, 2023
Source: EPFR Global and AB

This view reflects several factors. For one, China is large relative to the rest of EM countries. Also, arbitrary index inclusion factors lead to China’s benchmark weights in “passive” indices being somewhat artificial. There’s a recognition that the forces driving China’s market differ from those influencing other EM countries. And there is a risk that end clients or regulators may at some point limit investment in China.

We’ve made the point before that a different investment regime with higher equilibrium inflation could drive a sharper distinction among ESG investing approaches, whether the approach integrates issues that fall—under the aegis of ESG—into broader investment topics, uses ESG in engagement or translates ESG into omitting investments in certain sectors.

The most stark approach is excluding investments from a universe, which seems uncontroversial if investors request it, but harder to justify if they do not. In our view, ESG considerations can’t be divorced from the overall investment environment. For example, excluding sectors can alter portfolio duration and the ability to preserve purchasing power in higher-inflation environments—an issue low on the agenda in the first decade of ESG’s evolution. Engagement-led approaches may yield a very different performance profile. Since 2023 began, we have seen a divergence in ESG flows between the US and other regions.

Finally, sector and factor flows have diverged recently. Tech and communications stocks have seen the largest inflows, in stark contrast to energy and value-factor outflows. There may be fears about softer commodity demand in the face of risks to growth, but the energy sector’s cash-flow characteristics seem attractive for investors who seek income or are pro value, and the free-cash-flow-yield factor appears attractive in its own right.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Inigo Fraser Jenkins

Inigo Fraser Jenkins is Co-Head of Institutional Solutions at AB. He was previously head of Global Quantitative Strategy at Bernstein Research. Prior to joining Bernstein in 2015, Fraser Jenkins headed Nomura's Global Quantitative Strategy and European Equity Strategy teams after holding the position of European quantitative strategist at Lehman Brothers. He began his career at the Bank of England. Fraser Jenkins holds a BSc in physics from Imperial College London, an MSc in history and philosophy of science from the London School of Economics and Political Science, and an MSc in finance from Imperial College London. Location: London

Alla Harmsworth

Alla Harmsworth is Co-Head of Institutional Solutions and Head of Alphalytics at AB. She was previously head of European Quantitative Strategy at Bernstein Research. Prior to joining Bernstein in 2015, Harmsworth worked for two years on Nomura's Institutional Investor-ranked European Equity Strategy and Quantitative Strategy team. Her previous experience includes seven years at Fidelity as a quantitative analyst and portfolio manager, along with stints at Nikko Asset Management and ABN AMRO. Harmsworth holds a BA (Hons) and an MA in philosophy, politics and economics from University College Oxford and an MSc in economics from the London School of Economics and Political Science. Location: London

Tackling Key Asset-Allocation Controversies

Does the Allocation to Private Assets Still Need to Rise?

Is It Time to Increase Duration?

2023 Has Been Bad for Active Equity So Far—What’s the Prognosis for 2024?

What Do Recent Thematic Flows Tell Us?

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