Portfolio Rebalancing, Part 2: The Private Markets Puzzle

Executive summary:

  • Portfolios with large allocations to alternatives can have many benefits. However, alternatives allocations can deviate meaningfully from policy, particularly during periods of equity-market turbulence.
  • One way to avoid this problem ahead of time is to be deliberate with assigning proxy asset classes.
  • An overlay program can help manage a portfolio with an overweight to alternatives while also reducing unintended risk.

Editor’s note: This is the second in a three-part series on the topic of portfolio rebalancing.

Portfolios with large allocations to alternatives can reap benefits in many ways, with improved returns and diversificationat the top of the list. However, some of those benefits are only possible due to their biggest drawback—illiquidity. The potential impact on the overall asset allocation from illiquidity can be meaningful, along with performance measurement distortions if not addressed.

At relatively small allocations of 5-10%, it’s difficult to stray too far from policy. But larger allocations of 30-50% can result in meaningful differences, particularly in volatile markets such as 2020 and 2022. This so-called denominator effect, resulting from the valuation lag on private assets, can quickly lead to a portfolio that’s 5-10% overweight to alternatives. We currently see this across a significant portion of our client base. In the absence of leverage, public assets will be meaningfully below targets—it’s just math. What are the best solutions in these cases?

Exhibit 1 shows one such example. This client began February 2020 with a 5% underweight to alternatives. By April of that year, the sharp drop in liquid markets put them almost on policy. Now, in late 2023, while total assets have largely recovered, alternatives are now +4% overweight.

Allocation to Alternatives