Managing the Denominator Effect: A Portfolio Trading Perspective

The market downturn last year presented a vortex of formidable challenges to investors. Most significantly, the rapid decline in prices for publicly-traded securities bred the emergence of portfolio imbalances. This created an unexpected surge in relative allocations to private assets, a phenomenon now popularly known as the “denominator effect”. This forced institutional investors into a corner, compelling them to reconsider the optimal level of new commitments to private investments. With exposure limits being increasingly implemented based on asset classes, the necessity for this reconsideration became even more glaring.

When wrestling with this issue, investors find themselves faced with an array of options. Understanding the trade-offs inherent in each option is crucial to make a choice. Here, we dissect these trade-offs and frame the question in trading terms.

Demystifying the “Denominator Effect” and Understanding the Uniqueness of 2022

The denominator effect arises when a specific segment of a portfolio experiences a significant decrease, leading to a reduction in the overall value of the portfolio. Consequently, the portions of the portfolio that did not experience a decrease in value now constitute a larger proportion of the total. This issue primarily impacts investors with well-established private market portfolios, while those in the process of reaching a target allocation are less likely to encounter concerns related to overallocation.

The 2022 sell-off in public equities holds considerable magnitude, ranking just below the dot-com crisis and the global financial crisis (GFC) in terms of scale during the observed period. Such sell-off periods are typically accompanied by heightened volatility in public markets. The recent stock market downturn and rising interest rates have led to significant declines in the value of public market investments. In contrast, the private markets have shown relative resilience, with private asset markdowns typically lagging behind public market declines by two to three quarters. This disparity between public and private market performance has given rise to a situation where many allocators are now grappling with the denominator effect.

Source: Cambridge Associates, as of September 30, 2022; Bloomberg, as of December 31, 2022; Morgan Stanley (Note: BO+GE+VC is a Cambridge Associate benchmark for private markets that includes buyouts (BO), growth equity (GE) and venture capital (VC). BO+GE is a narrower index, excluding venture capital)

In comparison to previous corrections, the notable distinction in 2022 was the simultaneous underperformance of both fixed income and equity, resulting in a more pronounced denominator effect than what would be expected from a decline in equities alone. This correlation trend is clearly depicted in the chart below, illustrating the failure of fixed income to provide the negative correlation benefit which is typically associated with it, primarily due to the prevailing inflationary conditions, prompting central banks to adopt an aggressive tightening of monetary policy.

Source: Bloomberg, as of December 31, 2022; Morgan Stanley

Institutional investors follow an allocation framework to build their portfolios, setting target allocations based on strategies and goals. Liquidity needs vary among allocators, with some requiring immediate access to funds for emergencies (e.g. insurance companies), while others prioritize long-term holdings (e.g. foundations, sovereign wealth funds). However, when the denominator effect occurs, it disrupts the portfolio’s adherence to these allocations, impacting the overall risk-return profile.

Trading off the Portfolio Imbalances: Understanding the Implications

There is no “one recipe fits all” answer to this question, as each investor’s situation is unique in terms of their risk/return objectives, governance, asset-liability management constraints, etc. Consequently, the investor-specific circumstances will determine their tolerance towards skewed allocation targets. However, investors should be conscious of the subliminal trade-offs they take when assessing each path, essentially evaluating the relative value trade between private assets and public securities in terms of expected returns over a pre-defined time horizon of one asset class vs. the other.

Choosing Between “Do-Nothing” and “Rebalancing”

In situations where the portfolio faces an overallocation to relatively illiquid private assets, rebalancing the portfolio can pose challenges. The process of building or unwinding positions in the private markets is time-consuming and costly.

The “Do-Nothing” option: betting on mean-reversion

While some investors may choose to adopt a “wait-and-see” approach to give their public investments a chance to rebound and private assets a chance to catch up in markdowns, this can have significant consequences.

Firstly, the imbalance between public and private investments in uncertain, and as such, the distortion to the portfolio could last longer than expected. Secondly, they could run the risk of compromising vintage diversification of the private markets program, potentially lead to an under-allocation in the future that could prove difficult to correct, and/or missing out on valuable opportunities provided by vintages raised during recessionary years which have proven to produce the strongest returns historically as shown below:

Source: Pitchbook; as of June 30th, 2019

In trading terms, opting for the “Do-Nothing” approach implies taking a view that the public markets correction will revert back. This is essentially a bet on a mean-reversion of public vs. private market valuations which, in turn, is the equivalent of implicitly betting that the expected return of the former is going to be higher than that of latter over a certain period of time, all else equal. It also raises the need to address the question of opportunity costs associated with doing nothing.

The “Rebalancing” option: timing the market

Other investors may opt for swift action to rectify overallocation to private assets by divesting stakes in the secondary market. According to Jeffries, approximately 48% of institutional investors who pursued this course in 1H 2022 were first-time sellers. However, this decision carries significant potential consequences, akin to attempting to time the market, which is notoriously challenging. Firstly, strategic asset allocations lose their relevance as it becomes uncertain when over or under-allocations will change. Secondly, investors in private markets may need to slow down or halt their capital commitments to asset managers, which undermines the benefits of vintage diversification and complicates private investment programs. Lastly, selling stakes in the secondary market would entail realizing losses and accepting substantial discounts, ranging from 10% to 20% or more.

In portfolio trading terms, choosing to rebalance the portfolio means that investors must quantify the costs associated with rebalancing and weigh them against the expected gain from it. Additionally, determining a timeframe over which she expects to amortize these costs is crucial.

Focus on the big picture

While fixed allocation limits serve as valuable tools to keep portfolio risks in check, they can also obstruct smooth navigation through volatile and fast-moving market conditions if adhered to too strictly. This is especially relevant when increasing the rebalancing frequency.

Broadening the range of allocation limits and slowing trading frequency down can help mitigate this issue and better tolerate market noise. Re-assessing and relaxing portfolio guidelines can not only help investors with minimal overallocation avoid constantly playing “catch-up”, but it can also allow them more room to play offense and be opportunistic towards new commitments.

All in all, understanding the challenges and trade-offs, and having a broader perspective on portfolio allocation can equip investors to manage the denominator effect efficiently, ensuring the preservation of vintage diversification within the private markets program, and capitalizing on potentially attractive entry points offered by high-quality private-market GPs.