Diversification is widely accepted as a foundation for building asset allocations in investment portfolios. However, following a challenging year for many asset classes investors are revisiting their portfolios, wondering if their portfolio is sufficiently diversified. Indeed we expect an increasingly volatile and challenging environment ahead – detailed in PIMCO’s latest Cyclical Outlook “Prevailing Under Pressure” – making diversification especially critical.

In our view, it is particularly important in a late-cycle environment to understand the drivers of risk to ensure a portfolio is truly diversified. Here, we analyze a sample portfolio, typical of the asset allocation we see with family office and private wealth clients in APAC. We look through asset class labels to identify sources of risk and explore ways to optimize such a portfolio, thereby improving risk-adjusted return. We also look at how investors can construct better portfolios today, through approaches such as adding high quality bonds into an equity-heavy portfolio, complementing portfolios with uncorrelated relative value strategies, and seeking strategies that offer high quality income sources diversified across public and private markets.

Exposure to equity risk in private wealth portfolios may be higher than investors expect

While every family office or private investor has unique objectives that inform their asset allocations, we believe it’s important to periodically re-assess portfolios to ensure alignment with risk-return expectations.

We illustrate this risk-based approach using an example portfolio (shown in Figure 1). The example portfolio has a diversified allocation across a broad range of global and local asset classes in both equity and fixed income. It also has a meaningful allocation to alternative assets, such as hedge funds, private equity, real estate and private credit, which is typical for private investors in the region.

We mapped our sample portfolio into key risk factors and then combined the risk positioning with estimates of risk premia and factor volatility to generate forward-looking estimates for both risk and return. We also incorporated PIMCO’s forward-looking 5-year capital market assumptions since we believe that future asset returns could differ greatly from historical data.

When we ran this hypothetical portfolio through PIMCO’s proprietary risk analysis tool, we estimate the portfolio would have a return of 8.3% and volatility of 11.9%, with a beta to global equities of 0.77.

A closer look at the decomposition of the portfolio’s estimated risk reveals that while public equities comprise only 40% of the portfolio allocation, equity risk contributes 74% to overall portfolio volatility, making it the primary risk driver with a perhaps unexpectedly high concentration (see Figure 2). Interest rate risk such as duration comes mostly from the allocation to fixed income. While duration is a common concern for clients in the current rising rate environment, adding it to an equity-heavy portfolio should improve diversification and reduce overall volatility.

An asset inclusion test helps to determine portfolio-enhancing assets

While a risk diagnostic can provide interesting insights into the current portfolio, the results need to be translated into asset allocation changes that investors can act upon. Conducting an asset inclusion test can help. This provides an intuitive analytical framework to help identify asset classes that could enhance the risk-adjusted returns of the current portfolio.

An asset inclusion test evaluates two important characteristics of a single asset to determine whether a small additional allocation will enhance the risk-adjusted return of the portfolio. The first characteristic is the risk-adjusted return of the asset, as measured by the Sharpe ratio. Since the Sharpe ratio measures the expected return you receive per unit of volatility of an asset, generally, the higher the Sharpe ratio, the more attractive the asset is on a standalone basis. Increasing allocation to an asset with a higher risk-adjusted return is more likely to contribute positively to the portfolio’s overall risk-adjusted return. However, the other characteristic (often overlooked by investors) analyzed in the test is the correlation between the asset and the investor’s current portfolio.

For a single asset that has low correlation to the current portfolio, it can be additive even without a high Sharpe ratio. On the other hand, if the asset already has high correlation with the current portfolio, it would require a higher Sharpe ratio for investors to consider including it in the portfolio.

To illustrate this, we plotted the Sharpe ratio of each asset class against its correlation to the sample portfolio (see Figure 3). We then drew a line with a slope equal to the portfolio’s overall Sharpe ratio to determine which assets would be additive to the portfolio. Increasing allocation to assets sitting above the line could improve the overall Sharpe ratio, while increasing allocation to assets below the line could decrease the Sharpe ratio.

Our estimated Sharpe ratio for the sample portfolio is 0.45. To enhance the risk-adjusted return for the portfolio, the investor could:

• Increase allocations to investment grade credit, private corporate credit and private real estate, which appear well above the line,
• Decrease allocations to public equities, which appear well below the line.

Which asset classes could enhance APAC private wealth portfolios today?

Investors wanting to optimize their portfolio’s risk-adjusted returns may want to consider investments with either a high standalone Sharpe ratio or that have low correlation with existing portfolios. In Figure 4, we provide several examples of asset classes that screen well in an asset inclusion test.

High quality bonds, including global government bonds and investment grade credit, typically offer diversification benefits since duration is a risk factor that is often negatively correlated with other key factors such as equity risk. In today’s rapidly rising rate environment, many investors have been quick to dispose of any interest rate risk within their portfolios. However, it is important to remember that in a longer-term context, holding duration within the portfolio tends to decrease overall volatility, particularly in the event of a market shock. We also believe that over a longer horizon the expected return and Sharpe ratio for duration have increased given the repricing of rates we’ve seen this year.

Alternative investments are another way to enhance overall risk-adjusted returns. Especially worth considering are strategies that have reduced sensitivity to traditional market betas. Thus, they can target higher Sharpe ratios with lower correlations to existing assets. An example would be PIMCO’s Global Credit Relative Value & Macro Strategy (shown in Figure 4), which sits above most of the other asset classes, suggesting it would offer strong risk-adjusted returns with low correlation to global equity/bond markets. The strategy is able to achieve low correlations by minimizing beta risk and focusing on long-short, relative value alpha opportunities.

Income. Clients with an income objective should also consider broadening and diversifying income streams into both public and private credit, including not only corporate credit but also residential and commercial real estate and specialty finance to avoid over-allocation to single risk factors. PIMCO’s Tactical Multi-Sector Credit Strategy aims to capitalize on idiosyncratic opportunities while beta hedging the portfolio to increase the Sharpe ratio and maintain a modest correlation with a typical private wealth portfolio.

We believe that a truly diversified portfolio should look beyond asset class labels by first identifying the underlying risk drivers and then selecting a mix of asset classes that provide attractive Sharpe ratios, while considering their correlation to the portfolio. We work with many private wealth and family office clients to provide them with tailored risk factor analysis to help them meet their objectives while improving risk-adjusted returns.

For details on our outlook for the global economy and the implications for investors, read our latest Cyclical Outlook “Prevailing Under Pressure”.