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    All Insights Perspectives

    Investing in a High-Risk World

    INVESTING IN A HIGH-RISK WORLD

    April 20, 2023  |  7 Minute Read

    Maria Vassalou, PhD

    Co-Chief Investment Officer, Multi-Asset Solutions

    Maria Vassalou, PhD

    Key Takeaways

    • Profound changes in the underlying economic and market environment have increased the potential to generate alpha and require a new approach to portfolio construction that embraces public and private assets.
     
    • Markets today are more complete than in the past, with a wider range of strategies and securities that allow investors to expand their opportunity set and hedge against a wider variety of risks.
     
    • The evolving market environment calls for less leverage and more attention to liquidity and downside risk management. Dynamic asset allocation is increasingly important, as are active management and the search for uncorrelated alpha-driven strategies.

    Diversification is one of the core tenets of investing. For more than a decade after the 2008 Global Financial Crisis (GFC), however, the benefits of diversification were largely negated as a period of low inflation and general macroeconomic stability pushed asset prices higher across the investment spectrum. In this rising tide environment, simple beta exposure was enough to generate solid returns. Actively managed strategies in the years between the GFC and the pandemic generally struggled to keep up with traditional 60/40 portfolios composed of 60% stocks and 40% bonds, which benefitted as equities marched to new highs and interest rates hit record lows.

     

    That, of course, changed abruptly in 2022, as surging inflation and aggressive monetary tightening around the world sparked a simultaneous selloff in stocks and bonds. The 60/40 portfolio performed abysmally, and the commentariat read the strategy its last rites. But, we believe, one year of struggles and pointed critiques does not mean that pairing equities and bonds in a portfolio is a bad idea going forward. Eventually, interest rates will peak, monetary tightening will stabilize—and in the future may be loosened. Already this year, the correlation between stocks and bonds has been mostly negative and bonds were able to provide some protection against the episodes of equity selloffs so far.

     

    The problem, though, is that we live in a highly uncertain and dynamic world where volatility, correlations and risk premia can vary greatly over time. The 60/40 portfolio is a rudimentary form of portfolio diversification that was suitable for a world in which volatility was constant, correlation between equities and bonds mostly negative and markets calm. This is not the world we live in today, and we’re not likely to return to it soon. We believe investors need to go beyond the 60/40 and find additional ways beyond bonds to offset risk assets and protect against downside scenarios. Drawing on a wider set of assets in which to invest will require a portfolio construction approach that is rooted in active management.

     

     

    The 60/40 Portfolio has Historically Offered Balanced Returns, but Struggled in 2022 Amid Equity Market Volatility and Rising Interest Rates

     

    Source: Bloomberg and Goldman Sachs Asset Management. As of December 31, 2022. Past performance does not guarantee future results, which may vary.

     

     

    Towards a More Dynamic Way of Investing

     

    Economist and Nobel laureate Eugene Fama’s Efficient Market Hypothesis, detailed more than half a century ago, states that an individual investor shouldn’t be able to outperform in an efficient market in which all relevant information has been incorporated into asset prices. The hypothesis helped popularize passive index funds, which generally outperformed in the post-GFC era when the markets and macro environment were characterized by low inflation and mostly zero rates and quantitative easing, low volatility and largely stable correlations. This benign environment for passive strategies made it particularly challenging for active managers to deliver alpha, cementing the notion that the way forward is passive investing.

     

    The irony here, in our view, is that the overwhelming dominance of passive strategies over the last dozen years may have occasionally helped encourage larger deviations from fundamentals. When large amounts of money are being invested passively, without some degree of active risk-taking, it may at times take longer than otherwise for relevant information to be incorporated into prices. According to the Efficient Market Hypothesis, it is sufficient that the marginal investor invests actively for the markets to be efficient. However, it is not clear who the marginal investor is and whether they invest in sufficient size to make markets efficient at all times and avoid deviations from fundamentals. At the same time, the proliferation of retail trading and day trading have led to increased intra-day volatility on occasions, exacerbating deviations from fundamentals. External shocks and rapidly changing economic and market conditions have also fueled more volatility in recent years while the proliferation of algorithmic trading and natural language processing-based trade recommendations can either speed up the incorporation of new information into prices or create temporary large departures from fundamentals, especially during times of important data releases, speeches, or announcements.

     

    On the positive side, markets are more complete today than in decades past. In other words, they offer a wider range of securities and instruments that allow investors not only to access a broader investment opportunity set but also to hedge a wider set of risks. From private assets to tailor-made derivatives, securities and strategies, investors have the ability to incorporate into their portfolios return streams that provide lower correlations to traditional asset classes, enhancing their risk-adjusted returns and accessing potentially unique investment opportunities. At the same time, strategies that focus on the tails of the distributions of asset returns may be able to help protect against downside risk, whereas others may be tailored towards constructing asymmetric payoff structures that can positively contribute to overall performance. The inclusion of such securities and strategies in a portfolio is likely to improve its risk-return profile beyond more traditional approaches to portfolio construction. By the same token, dynamic asset allocation and active management are at the core of this evolved approach to investing, also necessitated by the changing macroeconomic and geopolitical backdrop, driven by long-term structural trends that we have referred to elsewhere as the 5 Ds—deglobalization, digitization, decarbonization, destabilization and demographics. This new investment environment is more conducive, in our view, to a holistic approach in portfolio construction that encompasses public and private assets in a way that maximizes expected risk-adjusted returns.

     

     

    Portfolio Construction: What Investors Should Consider

    We believe there are five important ideas that investors should incorporate into their portfolio construction decisions in today’s market environment.

     

    Focus on Risk Management: As volatilities, correlations and risk premia become increasingly dynamic, the need for further focus on risk management becomes very important. We believe downside risk, left-tail events and external shocks will be more common going forward than they were in the pre-pandemic world. Thoughts about the next potential external shock should never be far from an effective manager’s mind in today’s markets. Unexpected events are by nature difficult to prepare for. Constructing portfolios that can withstand adverse scenarios while providing asymmetric payoffs to the upside are more valuable now than ever.

     

    Revise Assumptions Often: The days of low volatility and stable correlations are over—and we don’t expect that to change for some time. Managers should be stress-testing their models and revisiting their assumptions and inputs more often to make sure they remain relevant for the changing market and macro environment.

     

    Reduce Leverage: In the current higher interest rate environment, there is less need for investors to use leverage to achieve target returns. This is a good thing. While leverage can amplify expected returns, it also amplifies risk, which can lead to catastrophic outcomes in a downside scenario. With interest rates hovering near multi-decade highs, cash is king once again and a valuable component of portfolios.

     

    Mind Your Liquidity: In uncertain times, liquidity is at a premium. With global monetary policy turning restrictive, the liquidity in the markets has been reduced and new information can lead to large reactions in asset prices. Maintaining lower leverage and sufficient liquidity in a portfolio go hand in hand in ensuring that portfolios can adequately absorb unexpected market shocks. The combination also helps to ensure investors have sufficient dry powder to seize opportunities when they do arise—usually after large external shocks and unexpected news that create significant market dislocations.

     

    Optimize Across Public and Private Assets Simultaneously: Since private and public assets are complementary to each other to a significant degree, optimizing their exposures simultaneously in a portfolio can lead to better expected risk-return outcomes—providing any overlap in the risk factors that both private and public assets are exposed to are taken into account. In addition, this holistic optimization and portfolio construction approach can provide a framework for managing liquidity at a portfolio level while maintaining its optimality at all times.

     

    With economic and market conditions rapidly changing, adapting our portfolio construction approach to the new realities is a must. The world economic order is in flux, political and economic alliances are changing, and uncertainty is high. There’s fragmentation in the goods markets. There’s destabilization in geopolitics. Trade patterns are changing, and that can alter existing alliances and help forge new ones. We believe staying dynamic and nimble is the way forward.

     

     

     

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    Glossary

    60/40 Portfolio refers to a portfolio of 60% invested in the S&P 500 and 40% invested in the Bloomberg US Aggregate Bond Index.

    Volatility refers to a financial instrument's price variation.

    Risk Considerations

    All investing involves risk, including loss of principal.

    Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

    Equity investments are subject to market risk, which means that the value of the securities in which it invests may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions. Different investment styles (e.g., “growth” and “value”) tend to shift in and out of favor, and, at times, the strategy may underperform other strategies that invest in similar asset classes. The market capitalization of a company may also involve greater risks (e.g. "small" or "mid" cap companies) than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements, in addition to lower liquidity.

    Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.

    Private equity investments are speculative, highly illiquid, involve a high degree of risk, have high fees and expenses that could reduce returns, and subject to the possibility of partial or total loss of fund capital; they are, therefore, intended for experienced and sophisticated long-term investors who can accept such risks.

    Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

    Alternative Strategies. Alternative strategies often engage in leverage and other investment practices that are speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the entire amount that is invested.

    Manager experience. Manager risk includes those that exist within a manager’s organization, investment process or supporting systems and infrastructure. There is also a potential for fund-level risks that arise from the way in which a manager constructs and manages the fund.

    Leverage. Leverage increases a fund’s sensitivity to market movements. Funds that use leverage can be expected to be more “volatile” than other funds that do not use leverage. This means if the investments a fund buys decrease in market value, the value of the fund’s shares will decrease by even more.

    Counter-party risk. Alternative strategies often make significant use of over- the- counter (OTC) derivatives and therefore are subject to the risk that counter-parties will not perform their obligations under such contracts.

    Liquidity risk. Alternatives strategies may make investments that are illiquid or that may become less liquid in response to market developments. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all.

    Valuation risk. There is risk that the values used by alternative strategies to price investments may be different from those used by other investors to price the same investments.

    Infrastructure investments are susceptible to various factors that may negatively impact their businesses or operations, including regulatory compliance, rising interest costs in connection with capital construction, governmental constraints that impact publicly funded projects, the effects of general economic conditions, increased competition, commodity costs, energy policies, unfavorable tax laws or accounting policies and high leverage.

    Alternative Investments - Hedge funds and other private investment funds (collectively, “Alternative Investments”) are subject to less regulation than other types of pooled investment vehicles such as mutual funds. Alternative Investments may impose significant fees, including incentive fees that are based upon a percentage of the realized and unrealized gains and an individual’s net returns may differ significantly from actual returns. Such fees may offset all or a significant portion of such Alternative Investment’s trading profits. Alternative Investments are not required to provide periodic pricing or valuation information. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of such Alternative Investments.

    Investments in real estate companies, including REITs or similar structures are subject to volatility and additional risk, including loss in value due to poor management, lowered credit ratings and other factors.

    Alternative investments are suitable only for sophisticated investors for whom such investments do not constitute a complete investment program and who fully understand and are willing to assume the risks involved in Alternative Investments. Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor’s capital.

    The above are not an exhaustive list of potential risks. There may be additional risks that are not currently foreseen or considered.

    Index Benchmarks Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.

    The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein.

    General Disclosures

    Diversification does not protect an investor from market risk and does not ensure a profit.

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