Tapping into Capital Efficiency
Adopting capital-efficient portfolio strategies will increase the power of portfolios to meet long term objectives without excessive market risk or illiquidity.
By Jared Gross, Head of Institutional Portfolio Strategy
- The current market environment will make it more difficult for investors to reach long-term return targets; traditional approaches to increasing return may not be able to close the gap.
- Allocations to broad market betas often come with an opportunity cost. These risk exposures can be acquired through more capital-efficient investment vehicles, freeing up a scarce resource for more productive use.
- A capital-efficient investment program embraces the prudent use of leverage to diversify risk, increase returns and improve long-term performance.
Capital efficiency in institutional portfolios
What can investors do to improve portfolio returns in a low return environment? Two traditional approaches readily come to mind. The first is increasing exposure to risk in traditional liquid markets, and the second is adding alternative investments. But risk-return trade-offs and liquidity constraints may limit what these approaches can achieve.
If these two dimensions of allocation flexibility alone can’t produce the required level of return with an acceptable level of volatility and liquidity, what else can be done? A third dimension is available: improving capital efficiency—that is, freeing capital trapped within certain investment vehicles and redeploying it in ways that can both enhance returns and improve diversification.
We explore this third approach and the different ways it can be implemented to address investors’ constraints and improve portfolio outcomes.
The limits of traditional approaches to enhancing returns
Reaching target returns using the traditional investment opportunity set typically requires strategic asset allocations that tilt toward high returning equity, with diversification provided by lower returning fixed income. But in a low return environment, it may be impossible to reach return targets with traditional public market assets—except with a highly risky, undiversified portfolio, and perhaps not even then. Investors might ultimately need to reduce their return expectations, but first, we suggest exploring all potential solutions.
Opening the investment opportunity set as widely as possible to include a broad range of private and alternative asset classes can potentially produce higher returns, income and diversification. While most investors have the capacity to take on a meaningful amount of illiquidity, there are limits to how much of a portfolio can be invested this way in an effort to generate higher returns.
The power of capital efficiency
Like adding cylinders to an engine, adopting a capital-efficient investment strategy increases the overall power of the assets to drive returns. This benefit arises from two distinct but complementary sources:
- The replacement of capital-inefficient traditional market beta exposures with capital-efficient index derivatives, freeing up resources to be used more productively. It is also possible to use new, capital-efficient alpha engines and risk management tools with a fully invested portfolio, further improving potential risk-adjusted performance.
- Deploying newly freed-up investment capital into strategies that cannot be easily replicated but can maximize the value of active management and offer exposure to alternative asset classes, with their many benefits.
When applied thoughtfully, capital-efficient solutions can materially improve investors’ risk and return trade-offs.
The untapped resource of inefficient beta
The best places to find efficiency gains will naturally be in the least efficient parts of a portfolio. But what does that mean, exactly? We are not looking at efficiency in terms of Sharpe ratios or other risk-return metrics. Rather, this question boils down to the mechanics of how an investor gains exposure to market risk: Can a given exposure be accurately replicated in a form that uses less capital? If it can, then it ought to be possible to gain an advantage from replacing it with a more efficient vehicle and redeploying capital elsewhere. If it can’t, then it will likely make sense to continue investing in a more traditional manner. The key takeaway: In a capital-efficient investment framework, there is a high opportunity cost to maintaining traditional passive strategies.
An example of inefficient capital for potential reallocation
EXHIBIT 1: ALLOCATIONS TO PASSIVE EQUITY AND TREASURIES OFFER THE BEST OPTIONS FOR BETA REPLACEMENT
Two examples make the point:
- Within fixed income, replacing physical Treasury bonds with liquid derivatives (Treasury futures or interest rate swaps) that use only a fraction of the capital can free up resources to invest in higher returning assets while maintaining the same overall level of interest rate exposure. In contrast, corporate bond or securitized benchmarks are far more difficult to replicate; it is more efficient to invest directly in these assets.
- Within equity, large passive allocations can be capital inefficient because investors can replace physical shares with index derivatives (equity futures or total return swaps) that provide identical market exposure and the same level of alpha (zero). Better to maintain the beta but free up capital to seek uncorrelated returns elsewhere. Actively managed portfolios or those focused on highly concentrated market sectors are more difficult to replicate and therefore should be invested in directly.
Exhibit 2 provides an illustration of how Treasury and passive equity exposure can be obtained synthetically, freeing capital to be used in expanding the exposure to actively managed stocks, bonds and alternatives.
Replacing capital-inefficient betas can free up capital and potentially improve portfolio risk-adjusted returns
EXHIBIT 2: AN EXAMPLE OF CAPITAL-EFFICIENT BETA REPLACEMENT
Given the widespread use of Treasury bonds and passive equity in institutional portfolios, along with the deep and liquid markets for these asset classes’ synthetic derivatives, these two sectors are probably the “most likely suspects” for targeting capital efficiency within the strategic asset allocation. But the scope of the opportunity is actually broader (Exhibit 3). Other market sectors—including credit default indices and inflation swaps—may also offer opportunities to replace traditional capital-intensive investments with more efficient approaches.
The opportunities to replace capital-intensive betas are quite broad
EXHIBIT 3: OVERVIEW OF LIQUID EQUITY AND FIXED INCOME DERIVATIVES MARKETS
Understanding the risks of beta replication
The use of index derivatives to replace more traditional capital-intensive vehicles, though efficiency-enhancing, is not riskless. While the intent of this paper is to explore the strategic implications of capital efficiency, it is worth a brief discussion of the operational aspects. In general, there are two main risks that must be addressed: basis risk and liquidity risk.
- Basis risk is the potential for the performance of a derivative to deviate from its target benchmark. In most liquid markets, the existence of arbitrage opportunities ensures that basis risk is minimal—investors can be confident that they will receive returns that are effectively identical to the cash market equivalent. A modest amount of basis risk may still be deemed acceptable, given the magnitude of the gains available from the application of capital-efficient investment.
- Liquidity risk rises when a pool of highly liquid “cash” collateral intended to provide for margin and collateral requirements is not adequate or efficiently managed and maintained. The efficiency gain can be maximized by limiting the amount of cash collateral held and ensuring that it is invested in a manner that offsets the financing cost of the derivatives. Some large investors handle this operational aspect in-house, but more commonly it is outsourced to a manager with expertise in derivatives operations.
While some derivatives still involve an element of counterparty risk, it is worth noting that many index derivatives are centrally cleared today, effectively eliminating this concern. Where counterparty risk remains, it is managed through a rigorous process of collateral posting that has proven effective over time. Understanding the risks of derivatives implementation, whether outsourced to managers or handled directly, is essential.
Adding value through capital redeployment
Returning to the broader strategic benefits of a capital-efficient approach, and having established the potential for unlocking the value trapped in inefficient vehicles, the question becomes: What should investors do with the efficiency gained? Broadly speaking, four paths can be taken:
- Beta leverage: Increasing market exposure outright through a combination of synthetic and traditional vehicles
- Shifting to capital-intensive sectors: Redeploying the capital into market exposures that cannot be replicated and that benefit from active management
- Seeking uncorrelated alpha: Increasing the alpha potential of market beta through portable alpha or long-short strategies
- Embracing alternatives: Allocating to alternative investments that potentially offer improved returns, income and diversification
Consider some real-world examples:
Beta leverage: Using synthetic betas—equity and fixed income—to achieve a levered market exposure with identical portfolio diversification. A good example would be a public pension plan that seeks to operate at 110% leverage while preserving the strategic allocation. Increasing beta through equity and fixed income derivatives allows existing active managers to stay fully invested.
Focusing on capital-intensive sectors: Moving capital from liquid market sectors that can be efficiently replaced to sectors that defy easy replacement. Consider the use of Treasury overlays in corporate pension liability hedging strategies: Substituting Treasury futures for Treasury bonds allows increased exposure to corporate credit or securitized assets while maintaining or increasing duration. This serves the valuable purpose of allowing a pension plan to hedge a larger percentage of its liability risk than a traditional fixed income allocation would allow.
Portable alpha: Adding an uncorrelated alpha engine to provide return above that of the passive beta, potentially complementing active managers elsewhere in the portfolio. The choice of alpha engine can range from relatively conservative fixed income strategies to more sophisticated hedge fund implementation. A portfolio of market-neutral hedge funds can provide a stable and uncorrelated source of alpha that can be “ported” to virtually any liquid beta.
Return diversification through alternatives: Deploying a portion of the capital into asset classes that offer higher returns and low correlation to traditional market betas. This could range from multi-sector credit at the low end of the risk spectrum to less liquid alternatives at the higher end. The common factor is the ability of these strategies to deploy capital in ways that diversify the sources of return within the portfolio. Many investors are beginning to focus on core realassets—real estate, infrastructure and transportation—as investment categories that offer attractive returns, high income and low correlations to equity markets.
Adding outsourced leverage via alternative investments
Investing in alternative asset classes is another means of adding leverage to a portfolio, even if that leverage is acquired indirectly through a manager. Hedge fund, private credit, private real estate and private equity managers all borrow against assets to increase returns (increasing risk in the process, of course). This combination of manager skill and leverage is compelling—it can produce return characteristics that significantly improve upon those available in public markets. But from the allocator’s perspective, the leverage is embedded in the strategy itself and is already reflected in the return and risk expectations. Beyond the initial decision to invest, there is little or no control over the level of leverage or how it is applied. These choices reside with the manager, who is assumed to have the skill and risk management resources to manage the exposure. In some instances, however, it may be possible to add leverage at the fund level to lower risk core assets – allowing for higher targeted returns from a traditionally lower risk sector of the alternatives market.
The primary constraint on expanding allocations in this direction is not the degree of leverage used but the illiquidity of the vehicle in which that leverage resides. Investors should be thoughtful in setting a level of exposure to illiquid assets; the objective is to preserve needed flexibility while putting the return generation and diversification potential of alternatives to maximum use.1
Capital-efficient strategies for managing specific portfolio risks
A final element concerns the ability to manage key portfolio risks directly through capital-efficient derivative solutions. In general, institutional investors rely on broad portfolio diversification for risk management and adjust asset allocations to deliver a specific level of overall risk and return. In certain instances, however, even a prudently diversified portfolio will retain risks of sufficient magnitude to justify a more direct approach to hedging. Three common concerns are: first, the equity tail risk2 that accompanies broad market exposure to stocks and other correlated risk assets; second, the risk of higher than expected inflation; and, finally, foreign currency exchange risk arising from global investments.
In each case, a capital-efficient solution is available to manage the potential downside while keeping assets fully invested:
- Tail risk hedging programs use portfolios of options to constrain exposure to a possible downturn in the equity market.
- Inflation swaps allow investors to avoid trapping capital in extremely low returning inflation-linked government bonds.
- Currency risk management programs can bridge the gap between an optimal global investment allocation and the desire to manage the largely uncompensated risk arising from currency volatility.
Giving investors the ability to reduce these risk exposures in a targeted manner, without reducing the amount of capital they have deployed to risk assets and global allocations, is an appealing prospect. The presence of the hedges can allow for an increased exposure to attractive but risky opportunities; this is often desirable as a means of letting the portfolio offset the hedge costs. Also, actively managing the hedges creates the opportunity to reduce the ongoing hedge cost and potentially add return to the overall allocation. Finally, for some regulated entities, the hedge can reduce capital charges and free up capital for other purposes.
The case for capital efficiency
Investors live with many constraints. Prudent risk management constrains exposure to high returning asset classes. High return targets constrain the use of the safest investments. The need to meet benefit payments or support other institutional distributions constrains the use of illiquid alternatives. Navigating these constraints requires discipline and creativity, as each choice within the allocation uses up precious capital and exposes trade-offs between risk and return.
The beauty of a capital-efficient investment framework is that it creates additional space within which the asset allocation process can do its job. Replacing inefficient portfolio segments frees up capital to find a more effective home.
1 See Jared Gross, “Optimize illiquidity,” J.P. Morgan Asset Management, January 2021. Available here.
2 Tail (tapering at the far ends of a distribution curve, representing least likely outcomes) risk is the low probability that an asset’s or portfolio’s value moves more than 3 standard deviations up or down.
Be the first to get the in-depth analyses for this series
Explore four themes that can lead to incremental benefits over the short-term and together can transform asset allocation over the long-term.