Aaron Costello, Head of Asia, and Vivian Gan, Investment Director, Capital Markets Research

Asian and global market volatility surged in early 2025 as US tariffs triggered global growth fears. Given the export-oriented nature of most Asian economies and their sensitivity to global growth and demand, the region may bear the brunt of US tariffs. As such, Asia market volatility is likely to persist in the near term, particularly since US trade policy can shift abruptly.

With the United States and China locked in a tariff standoff, at least for now, a key question is to what extent China and other Asian economies will increase fiscal and monetary stimulus to offset the economic impact from US tariffs. Aggressive stimulus, particularly from China, may help to support growth and sentiments in Asia more broadly.

Considering the current environment of higher uncertainty and volatility, as well as global equity market concentration in US large-cap technology stocks, we view portfolio diversification is key in managing downside risks. We favour strategies that are more attractively priced, are less correlated to the broader market, or are able to capitalise on any dislocations that may result from economic stress.

In this edition of Asia Insights, we highlight:

• Within Public Equities: We view Asia ex Japan value-oriented strategies could add a layer of downside protection, given less demanding starting valuations and a differentiated sector exposure that is less concentrated in technology.
• Across Hedge Funds: Asia event-driven strategies warrant a second look today, given an improved manager competitive landscape and a current macro environment that is supportive of alpha generation. Event-driven strategies also tend to be less correlated to broader equity markets, and therefore could serve as a diversifying strategy amid current market volatility.
• Within Private Investments: We remain constructive on Japanese buyouts, given strong underlying supply and demand fundamentals. Deal flow is likely to remain robust as Japan’s aging demographics and ongoing corporate governance reforms continue to drive corporate actions. It may be further accelerated by dislocations created by US tariffs. Meanwhile, attractive entry valuations today and the availability of cheaper leverage lend support to continued capital inflows.
• For Real Assets: We see increased opportunities in Asia-Pacific value-add and opportunistic infrastructure today, given the region’s maturing regulatory environment and longer-term demand for infrastructure spending. We are positive today on data centers and renewable energy infrastructure, which are backed by strong fundamental demands while also less sensitive to potential growth and trade shocks.

Public Equities: Seek Diversification Through Asia Value-Oriented Strategies

Wilson Chen, Managing Director, Public Equities, and Vivian Gan, Investment Director, Capital Markets Research

Global equities saw heightened volatility in early 2025 as US tariffs added uncertainty to the global growth and inflation outlook. Markets also saw a tentative rotation in leadership from US large-cap technology stocks towards non-US markets. In the current environment, we view that Asia ex Japan value-oriented strategies could add diversification to investor portfolios, given favourable valuations and underlying exposures.

Value-oriented strategies range from deep value to quality value, with managers seeking to identify undervalued segments of the market. Today, we would focus on value managers that invest with a quality lens, as companies that have stronger balance sheets can better withstand economic shocks. Value strategies that emphasise dividend returns may also be poised to benefit as global rates decline amid continued central bank easing.

While markets are in flux following the tariff announcements, active Asia value-oriented strategies tend to overweight China and Southeast Asia and underweight Taiwan and India as of end March. They also tend to underweight IT and communication services in favour of cyclical sectors (e.g., industrials) or more defensive segments of the market (e.g., consumer staples and utilities). While Asian equities as a whole face macro headwinds, the lower valuations for these markets and sectors may ultimately help to limit the downside. They may also see greater upside should Asian economies strike trade deals with the United States, and benefit from increased monetary and fiscal stimulus, particularly from China.

Overall, the market environment remains uncertain, but we still think Asia value-oriented strategies allow for a differentiated and less tech-concentrated exposure to Asia while offering a valuation cushion that could be more defensive in the current environment.

Hedge Funds: A Second Wind for Asia Event-Driven Strategies

Benjamin Low, Senior Investment Director, Hedge Funds, and Vivian Gan, Investment Director, Capital Markets Research

Asia event-driven strategies are starting to look more interesting today as a diversifying strategy amid current market volatility. Heading into 2025, the region had seen a tentative recovery in capital markets activities, with mergers & acquisitions (M&A) and initial public offerings (IPOs) on the rise. At the same time, the closure of a prominent Asia event-driven hedge fund in early 2024 has created a more level playing field for the remaining players and improved the manager competitive landscape.

Event-driven strategies seek to generate alpha from market inefficiencies around corporate events, such as mergers, spin-offs, stock buybacks, and IPOs. While these strategies are typically equity-oriented, managers may invest across the capital structure to add value. Event-driven strategies tend to be less correlated to broader equity markets, and therefore could play a role in investor portfolios as a diversifying strategy.

The opportunity set for Asia event-driven strategies had been improving amid a rebound in the region’s capital markets activities. Managers invest across both developed Asia (e.g., Japan and Australia) and emerging Asia (e.g., China, India, and Southeast Asia). While US tariffs are adding uncertainty to the near-term outlook, we continue to see the environment as favourable for event-driven strategies. Japan remains a key market of interest as ongoing efforts to improve corporate governance and shareholder returns have led to more robust levels of corporate actions, including M&As, take-privates, and spinouts. Managers also note similar opportunities may increase in South Korea following the introduction of its ‘Corporate Value-Up Program’. China and Hong Kong are also of focus. Weaker economic growth in recent years has led to increased deal opportunities from market consolidation and divestments by multinationals, and these trends may actually accelerate should US tariffs create economic and corporate dislocations in Asia.

Overall, we view Asia event-driven strategies warrant a second look today given the likely increase in corporate actions in the region and the added diversification such strategies can bring to portfolios.

Private Investments: Japan Buyouts Remain Attractive Despite Near-Term Macro Volatility

Sharad Todi, Senior Investment Director, Private Equity

Heading into 2025, buyout activity in Japan was on the rise, with the number of transactions reaching 162 in 2024, the highest level in a decade. Although the penetration level of private equity (PE) in Japan remains lower than in other developed markets, the country is emerging as a natural harbour for leveraged buyouts. We see reasons to remain positive on Japan buyouts now despite near-term macro volatility.

On the supply side, deal flow is likely to remain strong. First, several family-owned small- to medium-sized enterprises struggling to find natural successors are turning to PE firms to ensure business continuity. Second, large conglomerates in Japan are streamlining their operations by divesting non-core assets, creating opportunities for PE investors. Third, the Tokyo Stock Exchange’s demand for listed companies to justify their status by improving book value and capital efficiency ratios is also increasing take-private transactions. All these trends may be magnified by dislocations created by US tariffs.

On the demand side, investors are drawn to Japan for several reasons. Unlike most other Asian markets, control is the norm in Japan, allowing investors to shape the company’s journey more effectively. Valuations also remain attractive. According to Dealogic data, median EV/EBITDA multiples in Japan were 12.0x in 2024, compared to 14.4x for broader Asia, and Japan buyout managers can target even lower entry multiples of 10.0x or below. Plenty of low-cost debt is available, with most managers able to secure financing at 40% to 60% of enterprise value at an all-in cost below 4.0%. The terms of leverage are typically investor friendly, with banks being more relationship-focused and cooperative with borrowers dealing with struggling assets. Japan’s low economic growth rate drives corporates to pursue inorganic growth, making strategic buyers the preferred exit route for PE firms. Furthermore, Japan’s attractiveness as a private investment destination in Asia has increased as China’s appeal has waned, providing large pan-Asian funds a stable market to deploy capital. In addition, investors seeking currency diversification from the US dollar may benefit from a strengthening Japanese yen over the coming years.

All in all, we expect these broad macro trends should persist in the near term and lend support to buyout activity in Japan.

Asia Infrastructure: A Maturing Market with Growing Opportunities

Minesh Mashru, Global Head of Infrastructure Investments, and Derek Yam, Associate Investment Director, Real Assets

Asia-Pacific (APAC) is quietly gaining traction as an investment destination for infrastructure funds, supported by the region’s economic growth and demand for infrastructure spending. Historically, much of the region’s infrastructure capital had originated from global or emerging markets funds, while dedicated APAC infrastructure fundraising has been lumpy year to year. However, we view this should change going forward, given an improving regulatory environment and opportunity set, particularly in emerging Asia with increased deregulation and a relaxation of foreign control ownership rules.

APAC value-add and opportunistic infrastructure have the potential to deliver returns in the mid-teens and above, albeit requiring careful management and local knowledge. These strategies involve greenfield risks tied to development activities and operational complexities, as opposed to core infrastructure, which focuses on brownfield assets. The opportunities are broad based across developed Asia (i.e., Australia and Japan) and emerging Asia (i.e., India and Southeast Asia). However, given that Asian economies are more reliant on trade and, therefore, vulnerable to US tariffs, investors need to be discerning when investing in APAC infrastructure. Economically sensitive and trade-related segments, such as ports and logistics, may be especially impacted.

In the current environment, we favour sectors that are less exposed to trade while backed by strong fundamental demands. Data centers are one, given the region’s increased digitalisation and growing adoption of cloud computing. Current supply of data centers still lags the rapidly expanding demand by local enterprises, as well as hyperscalers seeking to expand their cloud service offerings across both traditional and secondary markets ¹ . Renewable energy infrastructure is also attractive, given low current penetration rates and a strong regulatory push towards decarbonisation. Opportunities range from regional solar assets across broader APAC to offshore wind farms in Taiwan, although an understanding of local regulations and onshoring requirements is key. The expansion of cross-border power trading in markets such as Southeast Asia has also bolstered the region’s renewable energy development.

In sum, despite the economic headwinds from US tariffs, we view there remains growing opportunities for APAC infrastructure, given the region’s maturing regulatory environment and structural tailwinds for infrastructure demand.

David Kautter also contributed to this publication.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.

The post Asia Insights: Managing Risk Through Diversification appeared first on Cambridge Associates.

In today’s dynamic environment, strategic thinking and flexibility are essential. This edition of VantagePoint revisits the core principles of best-in-class investment strategies, exploring how investors can allow wealth to compound by remaining disciplined, diversified, and focused on long-term opportunities while adapting to change. We explore the fundamentals of investment policy development, including conducting an enterprise review to understand investment goals and objectives, setting a flexible policy framework, and revising policies as needed. Additionally, we highlight best practices in portfolio construction and examine how investors can adapt their strategies to navigate today’s challenges and seize emerging opportunities.

Good Investment Policy Starts with Understanding Objectives and Constraints

Successful investors share a key trait: the discipline to adhere to a long-term strategy through both favorable and challenging times. However, there is no universal strategy that fits all. Each investor’s approach must be tailored to their unique return objectives, risk tolerance, financial constraints, investment expertise, time horizon, and resources.

The foundation of any investment plan begins with an enterprise review—a comprehensive evaluation of financial circumstances, risk attitudes, and governance considerations. This process clarifies objectives, constraints, and potential vulnerabilities, helping to mitigate surprises during crises. For institutions, this might involve assessing how asset pools support operating budgets or reliance on endowments. For families, it could mean prioritizing wealth building for future generations, current consumption, or philanthropic goals.

These priorities must also account for evolving portfolio requirements, particularly under stress. For example, institutions facing reduced government financial support may require more support from endowments, while higher interest rates may prompt pension sponsors to accelerate liability hedging as funding ratios improve.

Key considerations include operating liquidity, balance sheet flexibility, liabilities, debt structure, external liquidity access, cost structure, and income or revenue streams. Qualitative factors, such as stakeholder risk tolerance, are equally critical. Balancing short-term portfolio volatility with long-term purchasing power, addressing illiquidity constraints, and aligning with spending, debt management, and other priorities are essential to effective investment planning.

The Primacy of Policy

After completing the enterprise review, the next step is to develop an investment policy, including the formulation of a strategic asset allocation (SAA). An investment policy serves as a ten-year business plan, providing guiding principles and direction, while remaining flexible to adapt to evolving market conditions, assumptions, and execution. SAAs are not fixed anchors but dynamic frameworks that should be reviewed and refined periodically to account for long-term trends.

Historically, SAAs have regularly adapted to changing conditions as reflected in the median target policy allocations below. The most notable shifts have been large increases in target allocations to private equity and venture capital (PE/VC) that provide significant value-added return potential, funded primarily by reductions in public equities. By increasing these allocations, investors have been able to maintain high return expectations even as falling interest rates lowered return expectations for bonds.

Similarly, actual allocations across endowments and foundations in our database reflect sensible shifts. For example, as bond return expectations fell, investors reduced bond allocations and reallocated hedge fund exposures toward absolute return strategies less correlated with equity risk, while trimming equity long/short strategies.

In addition to adapting to capital market circumstances, changes in investment policy often reflect evolving circumstances, such as tax considerations, significant endowment gifts, or shifts in financial strength. Flexibility in portfolio targets and allocations is critical to improving the likelihood of meeting performance objectives as conditions change.

Investment policies should align with the investor’s philosophy and governance structure. Greater latitude for portfolio implementers (e.g., investment staff, outsourced CIOs, or advisors) and longer evaluation horizons typically require less detailed asset allocation policies, allowing for more flexibility in execution.

We begin building investment policy with a foundational framework, such as a 60% equities/40% bonds or 80%/20% volatility-equivalent profile. From this base, we seek opportunities to enhance returns, while maintaining or lowering risk. Some investors may define SAA simply as a stock/bond policy, while others incorporate more detailed categories based on asset classes, objectives (e.g., growth, diversifiers, liquidity reserve), or a hybrid mix. For example, growth assets may be divided into public and private investments. This level of detail fosters alignment among stakeholders, ensuring a shared understanding of objectives, risk parameters, and strategy. Strong governance and clear expectations help keep portfolios on track and aligned with the investment committee’s intent.

Best Practice Portfolio Construction Features

Successful investment strategies begin with a well-designed policy tailored to investor needs and flexible enough to adapt to changing market conditions. Whether through adjustments to SAA, implementation decisions led by portfolio management, or through external asset managers, the following best practices guide our approach to compounding wealth over time:

• Maintain a long-term horizon to capitalize on illiquid asset classes with more potential for value-added returns.
• Use external best-in-class managers and foster lasting partnerships.
• Diversify to enhance long-term risk/return characteristics beyond a simple stock/bond portfolio.
• Adopt contrarian positions with asymmetric return potential by investing in undervalued assets and dislocated markets.
• Define and manage key risks aligned with constraints and objectives identified in the enterprise review.

Playing the Long Game

Maintaining a long-term investment horizon is one of the most challenging yet essential aspects of successful investing. Understanding the historical behavior of markets helps investors set realistic expectations for portfolios and resist the impulse to sell assets or managers based on short-term underperformance. For example, a diversified portfolio with a nominal expected return of 10% and a standard deviation of 13% would see annual returns ranging from -3% to 23% two-thirds of the time. While short-term volatility is inevitable, the range of expected returns narrows over longer horizons.

A long-term perspective enables investors to access illiquid asset classes—such as
PE/VC—which offer greater value-added return potential compared to liquid, efficient public markets. As demonstrated below, the best-performing investors over the long term have consistently maintained higher allocations to these private investments.

Additionally, a long horizon also allows investors to capitalize on undervalued investments. Doing so requires a strong stomach; sharp market dislocations can be quick to reverse, but absent those, valuation disparities are often slow to revert to fair value. Thus, careful judgment is required to avoid value traps. In general, absent other criteria that may serve as catalysts, a seven- to ten-year horizon is advisable. Momentum is also a powerful force and can be a helpful supplement to identify turning points.

Sourcing Best-in-Class Managers

Even the best managers experienced a difficult period relative to passive benchmarks, especially in the large-cap US equity market, given the concentration of performance in the Magnificent Seven heavyweights in recent years. Greater dispersion of returns across stocks globally should increase the ability of skilled managers to outperform. We believe active management can outperform passive benchmarks, particularly in less efficient markets, if investors: 1) employ a rigorous manager research process, 2) exercise patience, and 3) build well-diversified portfolios to reduce unintended risks. Building outperforming portfolios using active managers is hard work but worth the effort.

Engaging in deep research to identify firms with a repeatable competitive edge and strong organization that can stand the test of time is far more relevant than analyzing short-term performance. As the technology and regulatory environments have leveled the playing field for accessing corporate information, managers must work harder to gain an edge. Technology acumen can provide an advantage, but managers must continually invest to maintain their lead. Experience and judgment also go a long way to set managers apart. From an organizational perspective, we advise partnering with firms that have good governance, thoughtful alignment, a strong culture, and a well-diversified customer base of a high caliber. Securing fee structures that enable investors to retain most of the value-added returns also increases the odds of earning excess returns over the long term.

Patience in active management is key, as even the best managers experience periods of underperformance. Behavioral mistakes, such as firing managers after short-term losses, can erode returns. Staying the course through cycles is essential for long-term success.

Dispersion of long-term returns varies by asset class, with more inefficient asset classes exhibiting greater dispersion across managers. The following exhibit shows the importance of manager selection, especially for private investments where manager return spreads are materially wider than for liquid, more efficient asset classes. ²

Sticking with Diversification

No one can argue with the fact that putting 100% of risk capital in US equities over the 15 years ended 2024 would have been a brilliant strategy. The MSCI US Index returned 13.9%, outperforming the MSCI All Country World Index by 4.1 percentage points (ppts) per year, in US dollar terms. However, such concentrated positioning is risky and subject to sharp reversals amid any change of fortune. Indeed, year-to-date through April 8, lofty valuations combined with prospects for implementation of the highest effective US tariff rates in more than 100 years have seen US equities underperform global ex US equities by roughly 12 ppts, in US dollar terms.

Diversification is a long-term strategy. While a simple portfolio may outperform periodically, a diversified portfolio is expected to generate higher returns over time at a given level of risk—the proverbial free lunch. To better understand the value-added potential of diversified portfolios, we compare the return profile of a simple portfolio of 70% global equities and 30% US government bonds to a highly diversified portfolio constructed to have roughly the same level of volatility as the 70%/30% portfolio. The highly diversified portfolio is expected to outperform the simple portfolio by 100 basis points (bps) over the long term, but could underperform by as much as 100 bps to 200 bps per year over shorter periods. Based on a conservative estimate using indexes to represent asset class returns, over periods of five years or longer ended in 2024, a representative diversified portfolio has outperformed the simple portfolio despite underperforming over the last three years.

The higher expected return for the diversified portfolio reflects the ability to earn incremental returns from various sources, including private investments and pursuit of more diverse market risks. Even after spending more over time, ³ highly diversified portfolios are expected to create more wealth through the benefits of compounding. This effect is particularly pronounced over longer horizons.

Tilting Tactical

Another lever that can be used to build returns is tactical asset allocation. This typically involves shorter-term horizon positions that require in-depth analysis, a disciplined process, and risk controls. To develop an investment thesis and exit strategy, it’s important to carefully analyze the historical relationship between the overweight and underweight positions and the environments in which the positioning tends to outperform. Positioning should be sized thoughtfully, scaled by the degree of risk inherent in the position. Ideal positions have higher upside than downside, which is usually derived by relatively attractive pricing for the overweight position. Market dislocations often provide opportune times for initiating tactical positions, so studying asset class relationships and being prepared to take opportunities when they arise is beneficial.

Measuring and Managing Risks

The fundamental purpose of risk management is to provide a clear path for risk assets to compound and build wealth over time. Understanding the portfolio requirements to meet associated spending and liabilities is critical to successful portfolio management. Effective portfolio construction requires identifying and managing risks—such as illiquidity, equity beta, total portfolio standard deviation, drawdown risk, and pension funding shortfall risk—directly, rather than relying on heuristics. For instance, not all public equity portfolios are equally liquid, with emerging markets small-cap and frontier markets equities among the least liquid and US large caps, among the most liquid. Key risks should be identified during the enterprise review and incorporated into investment policy. Management of these risks should focus on taking the right amount, not just limiting risk. Failure to take enough risk could result in underperformance.

Stress testing portfolios to evaluate their resilience under a range of challenging scenarios is a critical component of policy setting and ongoing risk management. The ability to navigate bear markets depends on several factors, including portfolio liquidity, diversification, liquidity needs during periods of stress, and access to external liquidity sources. Such assessments should be repeated regularly over time as conditions change. For example, investors have increased their equity exposure and portfolio illiquidity over the last decade. Understanding how these changes relate to any changes in liquidity requirements especially during times of stress is a core component of portfolio management.

For instance, as demonstrated below using a stylized portfolio reflecting index returns, a $500 million long-term investment pool entering a 2008-like bear market would have meaningfully less portfolio liquidity available to meet cash needs if it had a 50% allocation to illiquid assets compared to a 25% allocation, despite outperforming by about 5 ppts during the drawdown. A high allocation to illiquid assets may be desirable, particularly if the institution can construct a high-performing private investment portfolio. Sustaining such a high allocation requires careful attention to liquidity sources and uses.

The example below shows asset allocation changes before any assets are sold to support cash needs. The ratio of liquid assets including stocks and high-quality bonds to annual cash needs would be 3x, compared to 5x for the less illiquid portfolio. The relatively high allocation to high-quality bonds would have provided a lifeline for the more illiquid portfolio, covering nearly two years of cash needs. Higher cash needs would constrain the ability to maintain a high allocation to illiquid assets, while lower cash needs facilitate such positioning. As a general guideline, bear markets tend not to last longer than three years without recovery, so 3x coverage of cash uses with cash sources (inside and outside the portfolio) following a bear market decline is a reasonable target. Under conditions of limited liquidity, the ability to capitalize on market dislocations would largely depend on existing managers, a factor that should be carefully considered during portfolio construction.

Risk management also extends to implementation. Using external managers to add value requires understanding how individual managers interact and align with benchmarks. Unintended risks—such as geographic, currency, economic sectors, and factor exposures (e.g., value, momentum)—can undermine returns if not carefully managed.

Adapting to Change

Portfolios have historically evolved in response to long-term trends, such as US equity and dollar outperformance since 2010, falling interest rates since 1982, and declining geopolitical risk since the 1990s. These shifts have led to increased allocations to large-cap US equities, greater US dollar exposure, reduced fixed income, and fewer hedge funds. As we move through 2025, diversification is showing signs of renewed value, and investors must assess how their portfolios would fare in the event of a reversal of these trends. We review changing economic and market conditions on an ongoing basis, regularly sharing our views on investment implications. All of these long-term trends have potential to shift the investment landscape in unforeseen ways as they evolve and interact with each other. Indeed, the evolution of global trade conditions will influence fiscal and monetary policy, the ability of countries to finance their debt, and the cost and access to materials and technology to fuel AI developments. We focus here on key implications of the end of ZIRP, challenges and opportunities in private investments, and the role of AI. Other increasingly significant factors that can influence markets and investment outcomes include shifting global trade dynamics, geopolitical risks, and climate change. Investors should remain diversified and vigilant, and incorporate these considerations into their strategic planning.

The end of ZIRP has significant portfolio implications. Higher rates suggest improved fixed income returns, but investors must carefully evaluate credit risk. Weaker credits that borrowed short term with an expectation that rates would remain low indefinitely may find their balance sheets stressed. Indeed, the market sell-off has started to pressure credit spreads in some segments of the market. We would seek to take advantage of such opportunities once spreads reach more distressed levels, including through credit opportunity funds or distressed managers that have requisite experience through investing over prior distressed cycles. Strategies like asset backed lending and insurance-linked securities can help diversify away from corporate credit risk and offer attractive spreads.

We regard high-quality sovereign bonds, particularly US Treasury bonds, as the primary part of a deflation hedge or liquidity reserve allocation. However, we acknowledge that such bonds could come under pressure due to rising interest expenses and fiscal imbalances absent successful efforts to improve debt dynamics. Treasuries served their role well this year until this week, providing much needed ballast to portfolios. However, this week saw significant Treasury volatility for technical reasons, amid an unwinding of leveraged positions. The US dollar has been reasonably stable after initially softening this year. However, US dollar weakness may resume for several reasons including concerns over US growth prospects and the tarnishing of the US exceptionalism consensus that has poured capital into US capital markets over recent years. With prospects for more fiscal and monetary stimulus in the EU and China and heightened policy uncertainty in the US, diversified global equity allocations are more compelling. US Treasury bonds remain a core defensive asset, yet diversifying with other defensive assets like inflation-linked bonds and trend-following strategies can provide similar returns with stronger downside protection.

Higher rates also enhance the appeal of hedge funds. In the early 2010s, endowments and foundations allocated nearly 25% of portfolios to hedge funds, a figure which has since dropped to 16%–17%. Equity long/short hedge funds (ELS) saw the largest decline, but we anticipate a brighter future for these strategies. Higher rates improve returns on collateral, short rebates, and equity dispersion, creating opportunities for skilled stock selection. Disruptive trends—such as shifting global trade relationships, advancements in AI, and the energy transition—are likely to sustain this dispersion, benefiting active managers with strong shorting capabilities. While the HFR Equity Hedge Index still underperformed long-only global equities in higher rate periods, equity dispersion provides the opportunity for strong manager selection to close the gap. Indeed, what matters is achieving equity-like returns over the investment cycle, not matching equity returns in any one period.

And of course, higher rates pose challenges for leveraged strategies like buyouts, requiring general partners to focus on improving operating margins and revenue growth to offset higher capital costs. While valuations remain elevated, they have moderated from ZIRP-era highs.

More broadly, we expect private investment performance to improve as the impact from funds’ rapid deployment of capital into overvalued assets in 2021–22 recedes. Current conditions will likely see some improvement in relative performance as market corrections have a lagged and muted impact on private investments relative to public markets. Yet, the widely expected improvement in IPO and merger & acquisition prospects may need to wait as the current environment is not conducive to improvement in the exit environment. These conditions are ripe for bringing attractive buying opportunities in the secondary market.

Disciplined investors should not be deterred by the recent underperformance of PE/VC relative to public markets. Private markets continue to offer compelling opportunities, particularly for managers with strong operational expertise. The advantages of operating outside the public market’s quarterly reporting pressures remain intact. However, investors should be mindful of the growing retail interest in private investments, which could lead to crowding at the larger end of the market. Further, investors must be exceptionally discriminating if considering investing in supersized funds, given the significant revenue to these managers through management fees relative to carry and the greater difficulty in delivering top quartile returns with very high assets under management. In private investments, effective implementation is critical to generating value-added returns that justify the illiquid, long-term exposures and the significant resources required for success.

Technological advances in AI have potential to create significant value across all sectors over time. To date, much of AI’s impact has been concentrated in public companies—namely chipmakers (e.g., Nvidia, Taiwan Semiconductor) and hyperscalers (e.g., Amazon, Alphabet)—and venture capital. Over time, opportunities will expand as AI integrates into broader industries. Private equity strategies can leverage AI to unlock value in low-margin businesses, while public companies across sectors—such as security, data analytics, and software—will increasingly adopt AI tools. Hype around generative AI’s capabilities has lifted valuations in the near term, but longer term, the transformative potential of AI underscores the importance of staying attuned to technological developments.

Conclusion

In the face of uncertainty, the investment planning process should embrace humility and avoid the pitfalls of overconfidence. For high total return–oriented investors, our approach combines the stability of a predominant allocation to equities and equity-like investments with a diversified and flexible approach. While the aggregate allocation to these growth-oriented assets should remain relatively constant, their composition should be diversified and adaptable, evolving in response to attractively valued opportunities and focusing on identifying best-in-class managers. Without adequate diversification, portfolios risk becoming overly concentrated and excessively volatile. Similarly, diversifying assets should encompass a range of strategies, with allocations shifting toward the most compelling opportunities as they arise.

For taxable investors, the cost of adjusting asset allocations can be significant, shaped by factors such as trust structures, tax status, and the availability of losses to offset realized gains. As a result, any shifts in asset allocation should be carefully evaluated, ensuring that the expected benefits outweigh the associated costs.

In a world defined by shifting economic regimes, technological disruption, and evolving market dynamics, investors must embrace a strategic, flexible, and forward-looking approach to portfolio construction. By adhering to core principles—such as maintaining discipline, embracing diversification, and managing risks thoughtfully—investors can navigate uncertainty and capitalize on emerging opportunities. Adapting to change is not just a necessity but a competitive advantage, enabling investors to build resilient portfolios that align with their long-term objectives. As the investment landscape continues to evolve, those who remain vigilant, innovative, and committed to their strategy will be best positioned to succeed.

Celia Dallas, Chief Investment Strategist
Grayson Kirk and Graham Landrith also contributed to this publication.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
3. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.

The post VantagePoint: Strategic Portfolio Construction in a Changing World appeared first on Cambridge Associates.

We believe the future looks brighter for ELS strategies due to several factors that should enhance returns. First, cash yields are near their highest levels in nearly two decades, creating a more favorable environment for short sellers. While most key central banks have cut their policy rates in recent quarters, we—and the market—expect rates will remain well above the zero-interest rate policy (ZIRP) levels of the 2010s. Second, increased equity dispersion presents opportunities for managers to distinguish themselves. Lastly, ELS strategies have complemented traditional stock/bond portfolios, indicating that hedge funds continue to provide diversification benefits to broader portfolios, even in recent times. With diligent manager selection, we believe investors can see even more meaningful benefits from these allocations.

Institutional Hedge Fund Trends: A Decade of Change

A little over a decade ago, endowments & foundations (E&F) allocated one-quarter of their total portfolios to hedge funds. Since then, these allocations have decreased, with the average hedge fund allocation dropping to approximately 17% by 2024 (Figure 1). This decline was mainly due to the reduction in ELS manager allocations, which have been nearly halved since 2008, alongside the rise of private investment allocations. In contrast, allocations to absolute return strategies—which we define, for simplicity, as a broad category that includes any hedge fund strategy that is not ELS or distressed—have held more stable.

There are several reasons for this reduction. The first involves performance, which has been inconsistent for many managers. The ZIRP environment reduced carry trade opportunities and returns on cash holdings, while muted equity market volatility meant fewer market dislocations for ELS managers to capitalize on. Additionally, exceptional public equity returns increased benchmark pressure and investor expectations, all of which have challenged ELS managers. However, during periods of market turmoil, managers have tended to capitalize on market dislocations, highlighting the role of market conditions in a manager’s ability to add value (Figure 2).

As the level of value add decreased, information ratios (IRs) also declined, indicating less efficiency in generating excess returns relative to their benchmarks. Despite the drop in IRs since 2009, it’s important to remember that many managers have still added significant value. In the past three years to December 31, one-third of managers achieved IRs of 0.30 or higher versus the HFRI Equity Hedge Index, a level targeted by many investors based on industry standards and performance benchmarks (Figure 3).

The second key reason for the decline in institutional hedge fund allocations is the maturation of the private investment landscape. Over the past decade, private equity and venture capital have experienced significant growth and delivered strong returns. This has led many investors to allocate more to the space, which in turn has meant smaller allocations to other asset classes, including hedge funds. Indeed, the mean E&F allocation to private equity and venture capital strategies has exceeded that of hedge funds in each of the last four years.

A More Appealing Interest Rate Environment

Low interest rates were a headwind for long/short hedge funds for many years. This was because funds earned paltry interest on the collateral held for short sales, i.e., the “short rebate.” In fact, during the ZIRP years, even the interest charged by brokers for lending securities was higher than the minimal short-term interest rates that stock borrowers earned on their collateral. Hedge funds are also obligated to pay securities lenders dividends received on borrowed stock. Taken together, hedge funds were starting at a disadvantage, given the cost of carrying positions in the short book.

Recent market developments have removed this hurdle. The short rebate now looks much more attractive to ELS managers, particularly those that run low net or market neutral portfolios (Figure 4). Increased cash yields from short sales provide additional income, which can enhance the overall returns of these portfolios. Low net portfolios—which typically have a balanced mix of long and short positions—can particularly benefit from the higher short rebate, as it offsets some of the costs associated with short selling. Cash yields have increased substantially in the past few years and are likely to remain relatively sticky, even as the Federal Reserve has embarked on a cautious path of policy rate reductions. In late 2024, the short rebate exceeded dividend yields by nearly the widest margin since 2001.

Historically, environments where the short rebate has exceeded the dividend yield have been beneficial for ELS funds. Since 1990, the median monthly ELS return has been nearly 50 basis points higher when the short rebate exceeded the dividend yield compared to periods when it did not. Indeed, higher cash yields mean the starting point for hedge fund managers is better, given that they achieve a positive return simply by opening short positions due to the short rebate. But a rising tide lifts all boats, and higher cash yields suggest that other asset classes could also perform better. As has historically been the case, long/short funds must differentiate themselves primarily through manager skill.

The shift to an environment with higher borrowing costs could lead to greater equity market dispersion and lower equity market correlations, offering more opportunities for ELS managers to achieve differentiated returns. S&P 500 equity dispersion is elevated compared to the dispersion observed in the post-GFC ZIRP period. In fact, a key measure indicates that recent dispersion levels were in the top quintile of observations since 2010. On the flipside, correlations among S&P 500 stocks rank in the bottom quintile of observations during the same time horizon. The combination of higher dispersion and lower correlation can create a more fertile ground for top long/short managers. However, equity dispersion is still well below the peaks seen during recessionary periods in February 2000, April 2009, and March 2020, when it reached up to twice the current levels. These three periods proved to be attractive starting points for ELS fund managers. Manager dispersion—which tends to follow equity dispersion—has also risen during volatile market periods, so the need for adept manager selection is even more pronounced in these environments.

The Strategic Appeal of ELS

ELS funds are not designed to match the performance of equity markets, and their returns may not always be positive. Historically, these funds capture a smaller portion of market downside and lag on the upside (Figure 5). This lag can be difficult for some investors, particularly when public equities enjoy such strong bull market returns as have been observed recently. Indeed, global equities have climbed 64% since reaching lows in late 2022. But after such a rapid ascent, it remains crucial for investors to ensure that their asset allocation can withstand the ups and downs of market cycles. Equity valuations are elevated today, suggesting that higher expectations are priced in, which could limit equity returns going forward. For instance, developed markets equities’ normalized price-to-earnings ratios are currently trading higher than 99% of the historical observations dating back to 1979.

Historical data underscore the resilience and potential of ELS strategies during market downturns. For instance, during the GFC, the MSCI All Country World Index (ACWI) declined by 55% from its peak in late 2007 to its trough in early 2009. In contrast, the HFRI Equity Hedge Index fell by 31%, representing an outperformance of 24 percentage points. The shallower downturn in ELS allowed investors to recoup their losses within two years of reaching the nadir, whereas the broader MSCI ACWI took nearly five years to recover. ELS strategies also held up better than broader equities during the bear market drawdowns of 2020, and in 2022. These observations highlight the ability of ELS strategies to provide downside protection and mitigate losses during periods of market stress. Conversely, they offer the potential for capital appreciation and active management benefits that safe-haven assets, such as cash or treasury bonds, may not provide. ELS managers can actively exploit market inefficiencies and position for recovery, potentially enhancing long-term returns beyond mere capital preservation.

It is crucial to consider how a specific manager may perform in different environments by reviewing their performance during times of stress. This includes assessing how their equity or credit beta moves in such environments if their track record allows such a review. Understanding a manager’s tendencies during market drawdowns can provide valuable insights into their ability to protect capital and deliver consistent returns.

Positioning for Success

Despite challenges faced by ELS managers, hedge funds have enhanced the performance of simple stock/bond portfolios in both the short and long term. For example, since 2000, a portfolio consisting of 70% stocks and 30% bonds has underperformed compared to a similar portfolio adjusted to include a 20% allocation to ELS. Additionally, the portfolio with ELS exhibited lower volatility compared to the one without it. ⁴ This trend has persisted over the past three years, particularly as bonds faltered and hedge funds demonstrated resilience during the equity market downturn in 2022. While these results are encouraging, selecting top-tier managers could further improve outcomes. The heterogeneity among ELS managers offers investors opportunities to benefit from careful manager selection, as the performance dispersion among hedge fund managers tends to be broader than that among public equity managers, who typically follow more standardized investment strategies.

A successful hedge fund allocation will depend on good manager selection and thoughtful risk management. ELS managers tend to have higher tracking error relative to other asset classes. For instance, the median ELS manager in our database had a tracking error of 11% in the three years ended December 31, 2024—double that of global equity managers in the same period. This means investors may need to size ELS positions more modestly relative to other managers in the broader portfolio. Investors should also assess the stability of a manager’s tracking error over time, as this can provide valuable insights for managing risk through position sizing.

Investors should also consider fee structure alignment. A higher risk-free rate environment should boost the expected absolute returns of long/short hedge funds, but managers should not be rewarded simply for collecting that cash yield. If funds are charging performance fees on total returns, which include the impact of the higher short rebate, then the structure of those fees could create a drag that offsets any supposed benefit from yields on the short book. Fee alignment will vary and will be driven by numerous factors, but investors should be attuned to the benefit of more investor-friendly fee structures, such as those that incorporate a cash-based hurdle.

Conclusion

Fundamental ELS strategies have faced challenges since the GFC, but the tide may be turning. The recent increase in cash yields and higher equity dispersion create a more favorable environment for the short book and will offer opportunities for managers to distinguish themselves. Moreover, with equity markets having experienced a massive rally over the last decade and trading at elevated valuations, it is prudent for investors to consider adding more defensive strategies like ELS to their portfolios. Success in hedge fund portfolios will depend largely on manager selection, sizing, and strategy mix. Thoughtful implementation of these portfolios will enable investors to capitalize on the new attractive dynamics emerging in the ELS landscape.

Sean Duffin, Senior Investment Director, Capital Markets Research

Ilona Vdovina also contributed to this publication.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
3. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
4. In this example, we assume the ELS allocation has a 0.3 equity beta for the entire period. Given that assumption, we fund the 20% ELS allocation from 30% equities and 70% bonds. This results in a portfolio with an allocation of 64% equities, 16% bonds, and 20% hedge funds, which we compare to a 70% equities and 30% bond portfolio. We use the following indexes as proxies: MSCI World, Bloomberg Global Aggregate, and HFRI Equity Hedge, and calculate based on monthly rebalancing.

The post A More Appealing Environment for Equity Long/Short Strategies appeared first on Cambridge Associates.

Developed Markets Value Equities Should Outperform in 2025

Sean Duffin, Senior Investment Director, Capital Markets Research

There are several key reasons that value looks set to outperform growth in 2025. First, the euphoria surrounding the AI boom has moderated, alleviating a key tailwind that benefited growth stocks in recent years. Second, value stocks trade at attractive discounts relative to their growth counterparts. Third, central banks have recently begun cutting rates, and value stocks have often benefitted from these rate cycles.

Large-cap growth stocks have surged due to rising AI stock prices in the last few years, but much of that enthusiasm appears priced in. The “Magnificent 7” stocks, central to the AI theme, now make up more than 40% of the MSCI World Growth Index. Heading into 2025, we believe that investors may recalibrate expectations for growth stocks, given concerns about sustainability and uncertain timeline for realizing returns on AI investments.

By almost any valuation metric, value stock indexes are trading at historic discounts to their growth counterparts. For example, value stocks currently trade at a 63% discount to growth stocks on a normalized price-earnings ratio basis, well above the typical 43% discount that they have averaged in the last 40 years. From these levels, value offers a margin of safety in an environment where the range of economic outcomes is wide. If the relative earnings growth advantage of growth stocks shrinks, value stocks could see considerable relative upside from valuation re-rating.

Central banks have started cutting interest rates, as inflation has moderated and economic data has softened. With policy rates starting from their highest levels in several decades, central banks have more leeway to reduce borrowing costs and keep economic growth stable. This should be supportive to cyclical sectors where value stocks are concentrated. Indeed, value stocks have historically edged growth stocks in the 12 months after the initial Fed rate cut when a recession is avoided. On the flipside, any upside risk to inflation and yields as a result of Trump’s new policy proposals could also be a boon to value stocks, which outperformed growth under such circumstances in 2022 when unexpected inflation surged and the Fed was forced to hike rates.

US Equity Returns Should Be Lower in 2025

Sehr Dsani, Senior Investment Director, Capital Markets Research

The US market’s return in 2024 reflects its profitability growth. That growth was mostly driven by its roughly 30% exposure to the information technology (IT)sector, which made great strides in AI-related innovation. However, valuations and growth forecasts imply that the market is pricing in high expectations. We think this, combined with the fact that returns have rarely exceeded their solid performance in 2024, suggests US equity returns in 2025 should be more typical.

Returns for US equities in 2023 (26%) and so far in 2024 (28%) were great, ranking in the top quartile of returns since 1995. While it is rare for returns to be that high for two consecutive years, it is even more rare for it to occur three years in a row. More often, years of strong performance have been followed by middling returns.

Nonetheless, solid economic and earnings fundamentals make it reasonable to expect returns to be typical next year. Although US GDP growth (2.1%) is forecast to slow, it is still relatively attractive versus other developed markets. Additionally, expected 2025 earnings growth of 14% exceeds the rest of the world by 7 ppts. Relative profitability has notably improved since the pandemic, in part because of the US overweight to IT. This sector’s high barriers to entry and highly specialized products means it benefits from higher margins than other more competitive industries.

However, valuations adequately reflect this leadership. The normalized price-to–cash earnings multiple in the United States is close to peak levels, and while neither DM ex US (76th percentile) nor emerging markets (58th percentile) are trading at inexpensive levels, they are cheaper than the United States. It is hard to argue that multiples will expand further when considering that projected earnings growth rates for the largest US sector (IT) are within the top quartile of its historical range, after an already robust 2024. Overall, it would take dramatically higher earnings and valuations in 2025 to achieve higher returns than 2024. We think that is unlikely because the market is already pricing in elevated levels.

Relative Performance of European Equities Should Improve in 2025

Thomas O’Mahony, Senior Investment Director, Capital Markets Research

European equities have underperformed global equities by more than 16 ppts so far in 2024. This is perhaps unsurprising in light of the strong performance of tech stocks and Europe’s underweight to those sectors. However, underperformance has extended beyond mere differences in exposures, as Europe underperformed across all 11 GICS sectors. Macroeconomic divergence has also been a factor behind this performance gap. On a trailing one-year basis, GDP in the euro area and United Kingdom has grown by 0.9% and 1.0%, respectively, in comparison to 2.7% in the United States.

Going into 2025, expectations for European equities are relatively depressed from a bottom-up perspective, leaving some scope for upside surprises. Analysts expect European earnings growth to lag that of global equities by 4.6 ppts in 2025, according to the consensus estimate. This is lower than 86% of relative year-ahead earnings per share (EPS) growth forecasts going back to 1987 and 3.7 ppts below the average forecast over that history. What’s more, it is slightly worse than the amount by which earnings growth in Europe has trailed that of global equities so far this year. This is despite the fact that consensus expects GDP growth differentials to narrow in 2025. Currently, GDP is expected to grow by 1.2% and 1.4% in the euro area and United Kingdom, respectively, and 2.1% in the United States.

Valuations also paint a picture of negative sentiment toward European equities. Once adjusted for sectoral differences, the forward price-earnings (P/E) ratio for both Europe ex UK and the United Kingdom relative to global equities is close to 0.8. Nonetheless, despite some valuation cushion and relatively depressed EPS expectations, we refrain from taking an active overweight to the region. A primary concern is the continuing challenges faced by Germany, the largest economy in the region. Activity and sentiment indicators are deteriorating and indicating contraction, loan growth has flatlined, and fiscal policy will likely be a detractor. Adding to these cyclical headwinds is the more secular issue of increasing competition from China. Similarly, the threat of tariffs on exports to the US remains a source of uncertainty and a potential headwind, even if partially priced in. In addition, while we do not foresee a global recession in 2025, risks are more tilted toward the downside, whereupon the cyclicality of European equities may be a headwind.

Japanese Equity Performance Should Be Similar to that of Developed Markets in 2025

Thomas O’Mahony, Senior Investment Director, Capital Markets Research

Japanese equities should benefit from some supportive factors as we head into 2025. These include a corporate reform agenda, continued inflows from individuals and less stretched valuations. However, we also expect the yen to strengthen, which would be an earnings headwind. What’s more, we remain sensitive to the risks of a broader economic slowdown, during which Japanese equities tend to underperform. All told, we ultimately expect their performance to be broadly in line with that of developed markets.

Central bank divergence should drive a recovery for the yen in the coming quarters. The BOJ has started to raise rates, and with inflation consistently above target and positive real wage growth we expect further hikes. Meanwhile, the Fed will likely cut rates further, even if the impact of the incoming administration means cuts will be more gradual. The yen’s real effective exchange rate is more than 30% below its median, suggesting potential for further strengthening. This could negatively impact Japanese equities in the short term due to the earnings headwind a stronger yen represents.

Japanese equities are vulnerable to global economic slowdowns due to their cyclical exposure, particularly in industrials and consumer discretionary. We expect global growth to be close to trend but remain sensitive to downside risks, given weak activity data in China and Germany, signs of a cooling US labor market and the potential impact of tariffs. Japanese valuations, while somewhat attractive, do not sufficiently compensate for these risks. Our cyclically adjusted price-to–cash earnings (CAPCE) valuation measure shows Japanese equities trading at the 76th percentile of their own history and the 14th percentile versus global peers.

A potential ongoing tailwind for Japanese equities comes from the continued adoption of the Tokyo Stock Exchange (TSE) corporate reform agenda. This is aimed at increasing shareholder value by encouraging improvements in corporate governance and transparency, and promoting financial efficiency. An expanded tax-free Nippon Investments Savings Account scheme for Japanese individuals should also be a source of continuing inflows into domestic equities. However, these factors are not enough to warrant an overweight position. Small-cap Japanese equities may exhibit greater resilience due to lower foreign revenue exposure and potentially greater benefits from TSE reforms.

Developed Markets Small-Cap Equities Should Outperform in 2025

Stuart Brown, Investment Director, Capital Markets Research

DM small-cap equities have struggled to keep pace with their larger-cap brethren. 2024 was no exception, with small caps on track to underperform for a fifth time in the past six years. This has left them trading at historically discounted levels vis-à-vis mid/large caps. However, we think 2025 may mark a turning point, and recommend that investors modestly overweight broader DM small caps.

Markets are likely to favor cyclical equity market sectors as central banks continue easing policy. Small caps are among the key beneficiaries of rate cuts, being relatively overweight the industrials, real estate, materials, and consumer discretionary sectors. Indeed, some of these were the top-performing segments in the second half of 2024. This dynamic looks set to continue, particularly as we expect near trend economic growth with limited risk of recession. Such an environment should support risk appetite, boosting small caps.

Recent underperformance has created a valuation opportunity. Both US and DM ex US small caps trade at historically wide discounts to their mid-/large-cap peers. Highly valued US tech stocks are partly to blame, as high expectations from the impact of AI have left global equity indexes increasingly concentrated. Further, small-cap earnings growth is expected to exceed that of mid-/large-caps. Taken together, we think investors are well compensated for leaning into small caps at these valuation levels.

The US and DM ex US segments enjoy distinct tailwinds. In the United States, small caps stand to benefit from a potential policy shift, given Trump’s preference for tax cuts and a lighter regulatory touch. Ongoing investment in manufacturing capacity favors industrials, while potential for a steeper yield curve supports financials via several channels, namely net interest margins. US small caps are overweight these two sectors. DM ex US small caps are relatively overweight Japan, where improving economic fundamentals should allow for further monetary policy normalization and support the yen. In addition, DM ex US economic growth is expected to pick up modestly after slowing in 2024.

Emerging Markets Equity Performance Should Be Similar to Developed Markets Equity in 2025

Stuart Brown, Investment Director, Capital Markets Research

EM equities are on track to trail DM peers for a fourth straight year in 2024. However, the underperformance margin is among the narrowest over that span. We see this as a fair analog for 2025, where we expect EM equity performance to broadly match that of developed markets. Indeed, many of the factors benefiting EM performance in 2025 should help DM performance as well.

The economic outlook should support EM equities. We expect the Fed to continue cutting interest rates as the US economy expands in-line with recent trends. This setup bodes well for EM equities, which have historically delivered strong results during non-recessionary Fed rate-cutting cycles. Further, economists expect GDP growth differentials versus the United States to shift in favor of non-US countries and regions. The US election result may contribute to near-term US dollar strength, but we ultimately think the economic backdrop will induce modest weakening in 2025, providing a tailwind for EM stocks.

Broader policy easing has bolstered the earnings outlook. With the hurdle of Fed rate cuts cleared, we think EM central banks will continue their own rate-cutting cycles. Monetary easing in China and across broader emerging markets has often been a tailwind for EM corporate profits, where consensus expectations for EPS growth of around 15% appear well supported. Chinese stimulus has also lifted prospects for EM trade. Earnings among smaller Asian economies and Latin America, where China represents a significant proportion of export demand, stand to benefit the most.

Valuations may ultimately limit EM performance. Although emerging markets trades at a nearly 40% discount to developed markets, absolute valuations have climbed to among their highest levels in the past decade. These elevated levels are largely concentrated in India and Taiwan, which have been the primary drivers of EM performance in recent years. Given these two countries account for nearly 40% of EM market capitalization, the risks of underwhelming expectations are elevated. Against this backdrop, we are wary of leaning into EM equities, and suggest investors hold this allocation in line with the weight in their policy portfolio.

Chinese Equity Prices Should Not Collapse in 2025

Aaron Costello, Head of Asia, and Vivian Gan, Associate Investment Director, Capital Markets Research

We expect the Chinese equity rally to stall but not necessarily collapse in 2025, given markets have already front run the benefits of increased fiscal and monetary stimulus. With Chinese equity valuations back to fair value, a further re-rating of the market will require China’s economic data and corporate fundamentals to improve, which will take time absent further policy support.

Chinese equities rallied 35% from their September lows to their October peak ⁵ as investors frontloaded expectations of more aggressive fiscal stimulus from China. However, the rally subsequently stalled as the fiscal measures announced disappointed and the re-election of Trump raised concerns about more hawkish US policies on China.

With the recent rally, Chinese equity valuations have risen, with our preferred valuation metric for China at the 41st percentile relative to its own history. For the Chinese equity rally to resume, this will require a meaningful acceleration in China’s economic growth, easing deflationary pressures, and a rebound in corporate earnings growth. Although certain Chinese economic data are starting to improve, key indicators such as housing market data and inflation data remain weak and will take time to recover. Nevertheless, downside risks to China seem contained as monetary easing and actions taken to control local government debt risks should help to prevent further stress.

Overall, given investors have priced in current policy stimulus, and Chinese equity valuations are fair, a further re-rating of the market may require China to ramp up stimulus in 2025. This may occur either in response to weaker-than-expected economic growth or further US policy actions (e.g., increased tariffs) on China. While additional stimulus is needed for a renewed rally, a market collapse is unlikely given current policies should help to stabilize the economy. Thus, we believe investors should hold China allocations in line with the weight in their policy portfolio.

Indian Equity Performance Should Moderate in 2025

Stuart Brown, Investment Director, Capital Markets Research

Indian equities have been on a tear. The market gained a staggering 13.5% annualized over the past five years, topping nearly all other countries. Still, amid a backdrop of high valuations and expectations, we expect Indian performance will moderate in 2025. Investors should hold the country in line with its weight in global equity benchmarks.

Indian equities are richly priced, reflecting high growth expectations. A composite of Indian equity valuations trade nearly 40% above their 20-year median, the highest level among large EM countries. India’s forward P/E ratio of 22.8 sits near an all-time high, with small caps even more expensive. Although the 2025 earnings outlook (18%) was upgraded during 2024 and profitability recently hit a ten-year high, the 20-year average EPS growth rate was just 10%. Further, India’s PEG ratio—which relates valuations to growth expectations—of 1.44 is near a ten-year high. Taken together, Indian stocks are priced for perfection and face elevated risks from even a modest earnings disappointment.

The economic outlook, which has contributed to equity market exuberance, appears stable. Growth is expected to slow modestly to 6.8%, supported by lower inflation, investment in infrastructure and industrial capacity, and a broadening of consumer strength to rural populations. A favorable monsoon season in 2024 should support 2025 consumption, while also limiting upward pressure on food prices. This should enable the Reserve Bank of India to lower rates, as food makes up a meaningful share of India’s inflation basket.

India should remain resilient to external shocks. Despite potential for Chinese equities to garner increased foreign investment flows, we do not think this will come at India’s expense. Domestic investors have superseded the impact of foreign flows, and Indian households in aggregate remain underinvested. Downside risks to global growth would likely be mitigated as India’s economy is domestically oriented, with exports making up a relatively small share of the economy. Further, India has shored up its foreign exchange reserves, providing yet another buffer to adverse shocks, such as higher oil prices.

Long/Short Equity Should Deliver Above-Average Results in 2025

Stephen Mancini, Senior Investment Director, Hedge Funds

We expect most long/short equity strategies will perform better than typical, driven by a favorable macroeconomic backdrop and the potential for strong alpha generation on both the long and short sides of the portfolio.

Contributing to the attractiveness of long/short equity are the ongoing challenges faced by companies reliant on capital markets for funding. Despite central banks’ recent easing decisions, rates remain elevated relative to the past 15 years. This environment has created a relative scarcity of capital, making it marginally more difficult for financially challenged companies to secure the funding they need to sustain operations and growth. As a result, these companies face headwinds, providing fertile ground for attractive short opportunities. The continued tailwind from the positive short rebate many long/short funds are receiving further enhances the potential for alpha generation on the short side, as managers can capitalize on the struggles of overleveraged and underperforming firms while earning a positive carry on their collateral.

On the long side, the market presents numerous opportunities for managers to add value by identifying companies with real earnings and strong free cash flow growth that are trading at relatively attractive valuations. While certain segments of the market may exhibit frothiness, many fundamentally sound companies remain undervalued, offering significant upside potential. Furthermore, global ex US valuations remain favorable; coupled with idiosyncratic fundamental catalysts, the global opportunity set on the long side remains robust. The ability to discern between overhyped stocks and those with genuine growth prospects is a key advantage for skilled long/short equity managers.

The combination of strong alpha potential on both the long and short sides should enable long/short funds to generate attractive long/short spreads. By maintaining a balanced and diversified portfolio, managers can mitigate market risk while capitalizing on individual security selection. This approach not only enhances the potential for outperformance but also provides a robust framework for navigating various market conditions.

Figure Notes

Value Trades at a Steep Discount to Growth Across Various Metrics
The cyclically adjusted price-to–cash earnings (CAPCE) ratio is calculated by dividing the inflation-adjusted index price by trailing ten-year average inflation-adjusted cash earnings. Cash earnings are defined as net income from continuing operations plus depreciation and amortization expense. MSCI does not publish cash earnings for banks and insurance companies and therefore excludes these two industry groups from index-level cash earnings.

Consecutive Years of Top Quartile Returns Are Rare
Returns are based on the MSCI US Index, net of dividend withholding tax. Return data for 2024 are through November 30.

Consensus Expects European EPS Growth to Lag, Even When Sectorally Adjusted
Japan FY EPS data represents earnings growth from March through the next 12-month period. Regions are represented by the following indexes: MSCI ACWI (Global), S&P 500 (US), MSCI Europe (Europe), MSCI Japan (Japan), and MSCI China (China).

Japanese Equities Have Tended to Underperform During Global Slowdowns
Japanese equities are represented by the MSCI Japan Index, US Equities are represented by the MSCI US Index, EM equities are represented by the MSCI Emerging Markets Index (data begin in 1988), Europe ex UK equities are represented by the MSCI Europe ex UK Index, UK equities are represented by the MSCI UK Index, and Global equities are represented by the MSCI World Index prior to 1988 and the MSCI ACWI Index thereafter. Data for 2024 are through October.

Small Caps Appear Unduly Discounted Vis-à-vis Mid/Large Caps as we Expect Catalysts for Outperformance Will Emerge in 2025
CAPCE ratio based on trailing five-year average real cash EPS.

Non-Recessionary Fed Rate Cut Cycles Have Supported Equities
EM returns are represented by the MSCI Emerging Markets Index, US returns are represented by the MSCI US Index, and DM ex US returns are represented by the MSCI World ex US Index. Recessions are defined by NBER cycle peak-to-trough dates. EM data begin December 1987 and exclude the first non-recessionary rate cut cycle in 1984. For the non-recessionary rate cut cycle in 1987, the EM return calculated is for nine months due to limited data availability. Total return data are gross of dividend withholding taxes.

Chinese Equity Valuations Have Recovered
Valuation percentile reflects the average of three valuation metrics: ROE-adjusted P/E, five-year CAPCE, and P/FE. Global Equities are represented by the MSCI All Country World Index (ACWI).

Indian Equities Are Priced for Perfection
PEG ratio calculated as the forward 12-month P/E ratio divided by the consensus long-term (five-year) average earnings growth expectation.

Dispersion Is Trending Higher
Dispersion is calculated as the weighted cross-sectional standard deviation of the performance of stocks within the index during one month.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
3. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
4. In this example, we assume the ELS allocation has a 0.3 equity beta for the entire period. Given that assumption, we fund the 20% ELS allocation from 30% equities and 70% bonds. This results in a portfolio with an allocation of 64% equities, 16% bonds, and 20% hedge funds, which we compare to a 70% equities and 30% bond portfolio. We use the following indexes as proxies: MSCI World, Bloomberg Global Aggregate, and HFRI Equity Hedge, and calculate based on monthly rebalancing.
5. Data reflect net total returns of the MSCI China All Shares Index from September 11, 2024, to October 7, 2024

The post 2025 Outlook: Public Equities appeared first on Cambridge Associates.

This paper looks at the asset class in the context of current market conditions, specifically higher interest rates and the potential for increased volatility, combined with improved access to hedge fund strategies more generally. These factors could create a prime opportunity for liability investors—such as pensions, nuclear decommissioning trusts, and insurance companies—to explore their use. It also discusses the primary risks associated with hedge funds and presents four actionable guidelines for investors aiming to effectively incorporate these strategies into their portfolios. These include defining a clear role for hedge funds, ensuring thorough due diligence, maintaining diversification, and adopting a strategic approach.

Why Consider Hedge Funds Today?

While institutional hedge fund allocations have been reduced in recent years (Figure 1), current market conditions may help to bolster the asset class moving forward.

Higher Interest Rates

Although a “higher-for-longer” interest rate environment can have both positive and negative implications for investors, it tends to be a tailwind for hedge funds. Heightened interest rates and persistent inflation have pushed the short rebate ⁶ into meaningfully positive territory for the first time since the GFC (Figure 2), a dynamic that directly benefits hedge fund managers that undertake short selling. While alpha generation remains paramount, the short rebate can function as a stabilizer against volatility for managers with high short exposure, such as long/short equity managers. Higher interest rates also mean increased returns on cash. This is an advantage for managers that have significant amounts of free capital, whether they are operating global macro strategies, relative value strategies, or other approaches involving derivatives.

Increased Volatility Potential

Although volatility has remained relatively low through the first half of 2024, the rapid emergence of generative artificial intelligence is likely to continue to impact volatility in various market sectors over the near term. Moreover, geopolitical uncertainty—including the war between Russia and Ukraine, ongoing conflicts in the Middle East, and US-China tensions—also has the potential to create elevated market turbulence.

What’s notable here is that hedge funds have traditionally thrived amid heightened volatility. This is because greater volatility results in greater dispersion of returns among individual securities and asset classes more broadly, often with projected highs soaring higher than expected and projected lows drawing lower.

As the market identifies winners and losers and companies compete for capital, more alpha opportunities become available to diligent hedge fund managers. Nimble asset managers can also look to capitalize as disparities between a company’s business fundamentals and security price become more defined, creating additional trading opportunities. It is also important to note that hedge fund allocations have the potential to offer portfolios protection from unexpected market headwinds, particularly those designed to be less correlated to traditional sources of return.

Improved Access

Investors allocating to hedge funds today have access to opportunities that they could only dream of a decade ago, partly due to increased openness and innovation within the industry. What’s more, regulatory changes have helped to improve hedge fund transparency. Lastly, technological advancements have helped make it easier to retrieve and analyze information about hedge funds in the pursuit of strategies that are best suited to specific portfolio needs.

Implementation: Four Actionable Guidelines

Even amid more favorable market conditions for hedge funds, investing success depends on effective portfolio implementation. Four important action steps will help institutional investors determine which strategies can complement their broader investment goals.

1. Clearly Define the Role of Hedge Funds in the Portfolio—and Adapt as Needed

Given the wide array of hedge fund strategies available, it is critical to first set clear goals and expectations around the role they will play in a portfolio and seek out managers that match this profile (see Case Study: Enhancing Pension Health with Hedge Funds). Traditionally, hedge funds have been positioned to generate returns between those of bonds and equities, with the expectation of sub-equity volatility.

However, allocations should be carefully customized to an investor’s specific needs and risk tolerance (Figure 3). Where some investors may be willing to take on more risk for more return potential, others many want a highly diversifying hedge fund portfolio that seeks to generate returns with low-to-no equity beta. By setting clear goals, investors can access managers that better align with their risk and return objectives. Regularly reviewing and adjusting hedge fund allocations can help ensure they continue to meet these goals.

2. Rigorously Evaluate Managers to Uncover Top-tier Partners

The hedge fund landscape presents substantial divergence in performance outcomes across managers. Working with top-tier managers is essential, as seemingly negligible differences among managers’ expertise and investment approaches can lead to materially different returns (Figure 4).

Historically, the hedge fund industry has been categorized by notable manager turnover due to the risks associated with the use of intricate financial products and balance sheet leverage. Navigating this universe and underwriting new funds demands a due diligence process that requires considerable time and resources. However, this effort is vital and will help investors uncover managers with high-quality investment processes, fund administration, and risk management.

To ensure thorough due diligence, investors should establish clear criteria for manager selection, including track record, investment strategy, risk management practices, and alignment of interests. A comprehensive quantitative analysis of historical performance, including metrics such as Sharpe ratio, alpha generation, and drawdown analysis, is crucial. Tools such as Monte Carlo simulations can be invaluable for stress-testing performance under various market conditions. Additionally, in-depth qualitative assessments through interviews and on-site visits can provide insights into the manager’s investment philosophy, team structure, and operational infrastructure. Engaging third-party service providers for background checks, legal reviews, and operational due diligence helps uncover hidden risks. Comparing potential managers against a peer group using industry benchmarks and databases offers a well-rounded view of their relative strengths and weaknesses.

Many leading hedge funds today are large and complex organizations whose proper evaluation requires significant industry experience. Investors must undertake comprehensive risk assessment to avoid blowups. With the rise of new trading platforms and the increasing commoditization of fundamental research, it becomes even more valuable for allocators to possess deep expertise and substantial global resources. This is necessary not only to proficiently underwrite funds, but to discern the sustainability of a manager’s competitive edge and identify top emerging talent. Understanding the nuances of the manager’s strategy, including their edge in the market, sources of alpha, and competitive advantages, is crucial. Assessing the robustness of the manager’s operational infrastructure, including compliance, reporting, and fund administration, is also essential. Collaborating with industry experts can provide valuable insights and validate findings.

Among the more than 8,000 hedge funds operating worldwide, Cambridge Associates believes that fewer than 2% merit investment consideration. Accessing these “high conviction” funds can be challenging but can improve as investors build relationships with fund managers. Most managers value their client relationships and are often willing to negotiate capacity. This underscores the importance of a proactive, informed approach that emphasizes strategic partnerships. We believe by actively networking within the industry, investors can build relationships with top managers and unlock exclusive opportunities. Being well prepared when negotiating terms and capacity can secure more favorable investment conditions. Additionally, demonstrating a long-term commitment fosters collaboration that can lead to superior investment prospects.

3. Use Hedge Funds to Optimize Diversification

In today’s investment environment, a thoughtfully diversified portfolio requires iterating beyond the traditional 60/40 split between equities and bonds. Investors should consider increasing allocations to alternative investments to provide valuable and differentiated sources of return, downside protection, and liquidity during times of market stress (see Case Study: Navigating Yield Uncertainty, Insurance Firm Turns to Hedge Funds).

While private equity and venture capital deserve consideration, they are highly illiquid, and cannot be used for regular rebalancing or ongoing cash needs. Hedge funds, however, offer a middle ground. They provide more liquidity than private asset classes and, given the wide array of available strategies, can offer the potential for robust returns in various market environments.

Executed effectively, hedge funds have the ability to play an all-weather role in a portfolio. For instance, in 2022, as equities and bonds suffered material losses, many hedge fund managers generated positive returns for the calendar year. Pensions with hedge fund allocations have tended to show more resiliency amid such market drawdowns (Figure 5).

Investors looking for greater consistency in down markets can consider absolute return-oriented funds, which aim to provide positive absolute returns regardless of backdrop. Those expecting inflated default rates following higher-for-longer interest rate conditions can consider credit-oriented funds that excel in identifying and profiting on struggling businesses and/or dislocated securities. Over the past 20-year period, hedge funds have provided moderate returns with lower volatility than equities, helping to balance risk and deliver diversification benefits in an ever-changing investment landscape (Figure 6).

4. Use a Strategic Mindset to Overcome Valid—But Not Insurmountable—Hedge Fund Challenges

Investors are right to be concerned about hedge fund fees, transparency, and liquidity, but a well-informed, strategic approach can help unlock their potential.

While the hedge fund industry is known for its “2 and 20” fees—2% management fee and 20% performance fee—investor costs and terms are often negotiable, particularly with scale. It is critical to ensure fees are reasonable relative to expected alpha and to only invest with managers offering compelling return potential net of all fees.

Similarly, investors should only invest with hedge funds that offer appropriate transparency. Transparency is central to assessing the strategies employed by the fund. Investors should demand clear, comprehensive reporting on holdings, risk metrics, and performance attribution so that they can make informed allocation decisions. Greater transparency not only aids in understanding a fund’s approach and alignment but fosters trust between investors and fund managers.

In terms of illiquidity, adopting strategies that reduce an investor’s readily available capital may be justified in some cases, as long as the overall portfolio maintains adequate liquidity levels. Investors should complement less-liquid strategies with those that provide quarterly, monthly, or more frequent liquidity options to ensure a capital reserve during stressful periods. For those with greater liquidity needs, building well-diversified hedge fund allocations offering full quarterly liquidity is advisable.

Conclusion

Economic conditions and financial markets are unpredictable. Despite 2023’s equity bull run and its continuation in early 2024, investor circumstances can always change. For pensions, insurance firms, and other liability-focused investors, being positioned to withstand volatility is a critical component of successful portfolio management. Despite the skeptics, hedge funds can offer an attractive option for enhancing portfolio diversification and returns, especially in an environment of interest rate uncertainty and elevated volatility.

However, understanding risk is the essence of informed decision making. Action items for investors include: clearly defining the role of hedge funds within the portfolio; seeking out the highest quality managers; maintaining diversification; and adopting a strategic mindset to navigate inherent challenges. By carefully pursuing these actions, liability investors can successfully leverage hedge funds to help achieve their investment objectives, ensuring a balanced approach to risk and return in an ever-changing investment landscape.

Melanie Mandonas, Managing Director, Pension Practice

Index Disclosures

Bloomberg Aggregate Bond Index
The Bloomberg Aggregate Bond Index is a broad-based fixed income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.

HFRI Fund of Funds Composite Index
Fund of Funds invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The investor has the advantage of diversification among managers and styles with significantly less capital than investing with separate managers. PLEASE NOTE: The HFRI Fund of Funds Index is not included in the HFRI Fund Weighted Composite Index.

MSCI All Country World Index
The MSCI ACWI captures large- and mid-cap representation across 23 developed markets and 24 emerging markets countries. With 2,760 constituents, the index covers approximately 85% of the global investable equity opportunity set.

S&P 500 Index
The S&P 500 is a market capitalization–weighted stock market index that tracks the stock performance of about 500 of some of the largest US public companies.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
3. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
4. In this example, we assume the ELS allocation has a 0.3 equity beta for the entire period. Given that assumption, we fund the 20% ELS allocation from 30% equities and 70% bonds. This results in a portfolio with an allocation of 64% equities, 16% bonds, and 20% hedge funds, which we compare to a 70% equities and 30% bond portfolio. We use the following indexes as proxies: MSCI World, Bloomberg Global Aggregate, and HFRI Equity Hedge, and calculate based on monthly rebalancing.
5. Data reflect net total returns of the MSCI China All Shares Index from September 11, 2024, to October 7, 2024
6. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.

The post A Liability Investors’ Guide to Reassessing Hedge Funds appeared first on Cambridge Associates.

New Dynamics, Old Strategies?

Plan sponsors today are operating in the aftermath of one of the fastest rate hikes in history and a prolonged yield curve inversion. Discount rate increases, along with strong equity performance since the March 2020 COVID-19 bottom, have powered significant improvements in funded status (Figure 1). These factors have proven especially beneficial to plan sponsors with underfunded and underhedged plans, helping them catch up with those that have spent the past decade contributing to their plans and increasing their liability-hedging targets.

Most DB plans today also have much improved risk profiles. Funding relief regulations such as MAP21 ⁷ and ARPA ⁸ have stabilized the interest rates used for determining plan contributions and lengthened the time periods available to plans for addressing funding shortfalls (Figure 2). These measures have helped to make funding more predictable over the long term by using a moving average yield to determine funding requirements. As a result, pension plans have much lower contribution risk as compared to two decades ago. Even with the steep rise in discount rates devaluing some of the cost savings from these regulations, it is still important for plan sponsors to recognize that these changed dynamics are likely here to stay. What’s more, they may need to reconsider how they manage their plan to remain on track for long-term success.

Shifting Gears

Plan sponsors have four key levers to manage their pensions—asset returns, liability hedges, contribution policy, and benefit management (Figure 3). While these levers do not change over time, how they are operated should, as plan sponsors look to remain on track with plan goals and objectives. Whether a plan is recently closed, frozen, or open, the observations we share below are broadly applicable to ensuring its optimized management.

Growth Assets: Meeting New Goals Amid New Risks

Although many plans today are well funded and well hedged, growth assets remain a critical component of overall plan health, helping to offset administrative expenses, unfavorable demographic trends, actuarial assumption changes, and other unhedgeable aspects of liabilities. As later discussed in the benefits management section of this paper, a properly executed growth strategy can also increase a plan’s overall value to an enterprise by reducing the cost of retirement and other employee benefits and by funding other organizational priorities.

Even though many plans have been focused recently on investing in a higher interest rate environment, these allocations alone may not provide adequate diversification in the event of market volatility. This volatility could be driven by multiple variables, including additional interest rate changes, an economic recession, increased pressure in the banking sector, heightened geopolitical tensions, or any black swan event.

Private credit, high-yield fixed income, hedge funds, and real assets are all strategies with the potential to help enhance diversification, provide downside protection, and achieve superior returns. Of these strategies, private credit can be particularly advantageous. Higher yields, coupled with a floating rate structure, may prove beneficial in a rising rate environment, with some strategies providing risk mitigation due to senior standing in companies’ capital structure. As with any private asset class, however, conducting robust due diligence will help achieve superior returns and avoid strategies that appear favorable on the outside but may contain hidden risks on the inside, such as subpar lending standards, poor execution, and unfavorable deal flow.

As plan sponsors evaluate their growth-oriented options, they should validate their true liquidity needs. Doing so may enable them to unlock their portfolio’s full growth potential by using excess liquidity to take advantage of opportunities in higher return, generating private equity investments (Figure 4). A liquidity coverage ratio of 2x to 3x can help ensure a portfolio is positioned to tolerate periods of market stress.

The liquidity risk of private investments in a pension portfolio varies depending on its net cash flow. As net distributions increase, the optimal allocation to private investments decreases (Figure 5). Partnering with experts in the private investment space is crucial to understanding the implications of these cash flow dynamics. The days of investors shooting in the dark to build out private investment allocations are over, as data and technology improvements make it easier to analyze liquidity requirements in an asset/liability context.

Liability Hedging: Less May Be More

Many plan sponsors have been highly focused on increasing long-duration liability-hedging assets in recent years. However, it may be time to reconsider how to manage liability risk going forward, including the appropriate amount of capital committed to these strategies and the optimal mix of credit duration. As always, a plan’s liability-hedging strategy is informed by its funded status. It follows that improvements in funded status should inspire a revised approach to liability hedging. As plan sponsors consider their options in today’s investment landscape, they now have a better set of tools at their disposal.

For example, because the accounting discount rate for single-employer pension liabilities is based on the Aa yield curve, a portfolio of duration-matched bonds can provide a good hedge against interest rate volatility. The earlier use of a completion manager may also help to keep higher hedging ratios, while also freeing up capital to implement more effective credit risk management and achieve additional exposure to growth assets.

It’s important for plan sponsors to recognize that the old paradigm of devoting the vast majority of plan assets to liability hedging should evolve into a more balanced approach. In fact, with liability durations decreasing relative to many fixed income assets today, more hedging can be achieved with fewer dollars. Less commonly used investment strategies, such as intermediate credit, also can play a role here. They can offer multiple potential benefits, including increased yields, liability carry offset, and better credit curve exposure, which in turn can result in lower volatility and higher returns.

Plan sponsors should also evaluate the overall fit and relative importance of liability hedging for their plans. There is now diminishing marginal utility in hedging the “last-mile risk” in pension portfolios with more capital. In some cases, an excessive hedging effort may result in a lower returning liability-driven investment (LDI) program, which decreases the efficiency of not only the liability-hedging assets, but the entire portfolio. Instead, plans may pick up incremental yield by adding non-traditional instruments for hedging, such as private investment-grade credit, commercial mortgage loans, and securitized assets. This may help the liability-hedging portfolio keep pace with the higher interest cost on liabilities, while still reducing interest rate risk through completion or other Treasury strategies. Figure 6 depicts how allocating only 30% of the liability-hedging portfolio to more diverse hedging assets can result in 50 basis points of extra annual yield.

For plan sponsors whose main objective is controlling or minimizing contribution requirements, hedging liabilities may introduce additional risk. In this scenario, plans should consider blending total return investment approaches with specialized liability-hedging programs to achieve the optimal outcome. The recent rise in discount rates has also presented a new option—adjusting contribution requirements to be based on mark-to-market liabilities. This option allows a liability-hedging program to not only reduce accounting funded status risk, but also contribution risk.

Contributions: A New Paradigm

Even if plans should experience negative asset returns in the near term, they can afford to be less concerned about contribution volatility due to the favorable impact of regulatory changes on funding target ⁹ calculations. The significant funding relief options passed in the last decade have resulted in the adoption of higher interest rates for minimum required contribution calculations. For example, plans are allowed to discount liabilities using 25-year moving average rates, which are then bound by interest rate corridors. When higher discount rates are used, liabilities are lower, which leads to higher funded status and lower contribution requirements.

In addition, due to new shortfall smoothing rules, a decline in funded status will no longer result in exceedingly high mandatory contributions. This changed regulatory backdrop, coupled with revamped asset and liability management options, effectively lightens the load for plan sponsors, potentially freeing up corporate assets for other purposes, including critical enterprise goals.

Contribution risk should generally be considered separately from funded status risk, since the duration for liabilities used to determine contribution requirements is essentially zero. While the use of long-duration fixed income strategies is beneficial to hedge long-duration accounting liabilities, it has a countereffect for liabilities with zero duration. While this wasn’t much of an issue when interest rates were low, the disparity is presenting a bigger opportunity in today’s higher interest rate environment. Well-hedged plans can consider aligning accounting and funding target methodologies through the Full Yield Curve approach, which may not only reduce expected contribution requirements, but eliminate much of the contribution volatility risk.

Underhedged plans should be more cognizant of the difference and focus on controlling the risk that is most important for them—balance sheet or contribution volatility. Even under the stabilized interest rate approach, certain aspects of pension management, such as Pension Benefit Guaranty Corporation (PBGC) premiums, are sensitive to interest rate changes. The most risk-efficient plan portfolios often blend traditional investments with LDI strategies in accordance with plan sponsor objectives and circumstances.

Benefits Management: Reassessment Required

Multiple benefits management approaches are always available to plan sponsors. These include plan termination, hibernation, partial risk transfer, future benefit modification, maintaining an open plan, or even re-opening one. Each of these approaches carries direct and indirect costs and risks. A close consideration of the plan sponsor’s specific needs and goals will help determine the right way forward.

Many plan sponsors can evolve their DB plans from feeling like a burden to feeling like an asset, one that supports corporate goals and financial health. Thanks to effective benefit management—combined with more supportive plan regulations and tools for generating asset growth and managing liabilities and contributions—plan sponsors are able to extend the life of their DB plans. Well- and over-funded pensions can become a point of differentiation for these enterprises and a valuable tool in attracting and retaining talent for the organization. Surplus plan assets also can be used in other ways that are long-term value additive to an organization, including mergers & acquisitions activity and retiree medical benefits. As plan sponsors consider a DB plan restart, expansion, or extension, they are likely to find that DB plans come at a marginal cost compared to defined-contribution plans. In fact, the National Institute on Retirement Security estimated that a DB plan costs 27% less than an “ideal” defined-contribution plan—one with fees below the industry average delivering strong performance. ¹⁰

Those sponsors closer to the termination side of the spectrum should consider how they can approach de-risking economically. For instance, many lean toward offering a lump sum payment option to plan participants; in this scenario, participants who receive a payment are no longer due a benefit from the plan. While this seems routine enough, it is important that payments be apportioned strategically so they result in less assets transferred than the liability. Generally, cost savings occur during declining interest rate environments that generate a lower lump sum payment relative to the market-to-market liability. However, this strategy can backfire in a rising rate environment and result in many plan sponsors having to contribute capital in order to terminate as lump sums become more expensive than buying annuities. Similar issues can occur for plans opting for pension risk transfers (PRTs) via lump sum windows.

Partial PRTs are commonly used with the idea of reducing plan size for purposes of PBGC premium savings. However, for most underfunded plans, this kind of transaction may actually negatively impact funded status and increase plan costs and PBGC premiums over the long term—even if the amount of assets transferred is less than the liability (or a gain to the plan). All sponsors should fully understand the implications of PRTs in terms of funded status, risk reduction, and future costs for their plan. For many plans, managing risk through asset allocation decisions is more effective.

Achieving a surplus position is never easy or risk free—and may be prohibited by many glidepath designs, especially those that aim to lock in funded status at a point just above 100% funded. For this reason, plan sponsors should reconsider the end stage of their glidepath, given the utility of a surplus and the potentially higher funded status needed to terminate without cost if a previous PRT has already been performed. Plan sponsors wishing to use surplus assets may find that increasing allocation to growth strategies could be advantageous as the plan moves higher in funded status, with the notion that the further away the plan is from becoming underfunded, the more risk a plan can take in pursuit of higher surplus.

Adaptability Is Key

Although pension plans today are experiencing much improved funded status relative to years past, the extent to which they take advantage of the opportunities made available by favorable improvements in funding and regulations will be a key determinant of their future health.

In all market conditions, the four levers that plan sponsors control as they seek to accomplish their objectives remain the same. However, an informed, adaptive approach to the operation of each will help ensure continued plan success over the near and long term. Plan sponsors are strategizing for growth and managing risk in in a significantly different investment environment. To accomplish their goals, it is imperative that these changes be taken into consideration. By taking a fresh look at their investment strategies and plan management, organizations have an opportunity to adapt, evolve, and reap significant benefits.

Serge Agres, Managing Director, Pension Practice

Cathy Xu, Investment Director, Pension Practice

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
3. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
4. In this example, we assume the ELS allocation has a 0.3 equity beta for the entire period. Given that assumption, we fund the 20% ELS allocation from 30% equities and 70% bonds. This results in a portfolio with an allocation of 64% equities, 16% bonds, and 20% hedge funds, which we compare to a 70% equities and 30% bond portfolio. We use the following indexes as proxies: MSCI World, Bloomberg Global Aggregate, and HFRI Equity Hedge, and calculate based on monthly rebalancing.
5. Data reflect net total returns of the MSCI China All Shares Index from September 11, 2024, to October 7, 2024
6. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
7. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
8. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
9. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
10. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post A Changed Investment Landscape Is Providing Greater Opportunity for US Corporate Pensions appeared first on Cambridge Associates.

Bitcoin ETFs are unlikely to impact sophisticated investors in the near term because few are interested in exposure and those that are interested in the space may already have exposure to bitcoin-only or broader crypto asset closed-end funds, which have existed for years. Still, retail flows to these bitcoin ETFs will likely be substantial. These flows will improve the market’s depth, increase options and futures activity, and attract more hedge funds to the space. As a result, sophisticated investors may acquire modest exposures to the space over time via existing hedge fund exposures.

The approval of bitcoin ETFs does not signal a shift in the SEC’s skeptical attitude toward crypto assets, and the broader regulatory environment in the United States remains cloudy. The United States lagged some countries in spot bitcoin ETF trading, but it is ahead of other jurisdictions. On broader crypto regulations, the United States is behind the EU, and some countries in the Middle East and Asia. We do not expect any changes in the US regulatory situation until after the 2024 election, if at all.

Investors targeting bitcoin exposure will have to decide whether to hold the asset directly or via an ETF, much like the dilemma gold investors face. Those investors that prefer to hold gold bullion will likely also prefer to hold bitcoin directly. But, as with gold, investors will need to decide if a speculative bitcoin investment makes sense in their portfolios.

Joe Marenda
Head of Hedge Fund Research and Digital Assets Investing

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
3. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
4. In this example, we assume the ELS allocation has a 0.3 equity beta for the entire period. Given that assumption, we fund the 20% ELS allocation from 30% equities and 70% bonds. This results in a portfolio with an allocation of 64% equities, 16% bonds, and 20% hedge funds, which we compare to a 70% equities and 30% bond portfolio. We use the following indexes as proxies: MSCI World, Bloomberg Global Aggregate, and HFRI Equity Hedge, and calculate based on monthly rebalancing.
5. Data reflect net total returns of the MSCI China All Shares Index from September 11, 2024, to October 7, 2024
6. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
7. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
8. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
9. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
10. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

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Equity Long/Short Performance Should Be Above Average in 2024

Joe Marenda, Head of Hedge Fund Research and Digital Assets Investing

We expect equity long/short (ELS) hedge funds should perform above the industry’s long-term average in 2024, due to the considerable rise in short rebates and economic conditions within major geographic regions. We believe this will support US ELS generalist strategies and sector specialists, as well as regionally focused ELS funds in Europe and Asia.

Higher short-term interest rates have increased the short rebate to levels unseen since the GFC. In fact, a fund’s short book now generates yields greater than benchmark equity dividend yields for the first time since 2008. A higher short rebate improves potential future performance, as it lowers the cost of carrying short positions and increases the opportunity set for single-name shorts.

The weak economic backdrop we expect in 2024 should lead to a greater focus among investors on earnings and free cash flow. This positions ELS funds well, as companies that have been cheap on a fundamental basis may perform better and companies that are expensive may be strong candidates for shorting.

In Europe, dispersion is above median among listed companies, which suggests that active stock pickers have an above-average field of candidates for longs and shorts. Economically transformative dynamics—reshoring of supply chains and a wall of low interest rate loan maturities, the latter of which will peak in Europe in 2026—will lead to clear winners and losers among European companies.

In Asia, where long-biased strategies did particularly well over the last decade, we expect less directionally biased ELS funds should outperform in 2024. Market leadership and underperformance are likely to shift more rapidly among companies and countries in Asia in 2024 than over the past decade, which will give more nimble portfolios greater alpha opportunities.

In the United States, the same dynamics facing Asian managers and the broader European economy will set up US ELS and sector specialist funds for a wide dispersion of outcomes. Historically popular long-biased sector strategies are likely to face pressure from peers with lower net exposures and greater skill at selecting alpha generating shorts. In 2024, long out-of-favor US value ELS funds should perform particularly well.

Footnotes

1. Traditional markets include Tokyo, Sydney, Seoul, Hong Kong, and Singapore. Secondary markets include Mumbai, Johor, Jakarta, Kuala Lumpur, Bangkok, Ho Chin Minh, and Manila.
2. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
3. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
4. In this example, we assume the ELS allocation has a 0.3 equity beta for the entire period. Given that assumption, we fund the 20% ELS allocation from 30% equities and 70% bonds. This results in a portfolio with an allocation of 64% equities, 16% bonds, and 20% hedge funds, which we compare to a 70% equities and 30% bond portfolio. We use the following indexes as proxies: MSCI World, Bloomberg Global Aggregate, and HFRI Equity Hedge, and calculate based on monthly rebalancing.
5. Data reflect net total returns of the MSCI China All Shares Index from September 11, 2024, to October 7, 2024
6. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
7. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
8. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
9. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
10. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

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