KKR proposes 30% increase in private equity

Highlights Aug.29,2022 07:41

Since the outbreak of the new crown epidemic, especially in 2022, the geopolitical situation has heated up, and the uncertainty of the global capital market has further increased. In a persistently volatile financial environment, investors tend to turn to an allocation model that traditionally consists of 60% stocks and 40% bonds in order to avoid risk and ensure the safety of their portfolios.

Historical data suggests that such a combination has indeed delivered decent returns over the past 10 years, but this has been largely driven by idiosyncratic financial conditions, including low interest rates, low inflation and a low correlation between stocks and bonds .

A recent study by U.S. private equity firm KKR found that the financial environment that has fueled the outperformance of the “60/40” equity and debt portfolio is undergoing a fundamental shift. In the new investment environment, the best way to improve the potential returns of a portfolio will be to increase private equity, including real estate, infrastructure and private credit. From the perspective of risk-return, the investment portfolios with increased private assets outperformed the traditional stock-bond portfolios in different financial environments.

KKR concluded that a portfolio consisting of 40% equities, 30% bonds and 30% private equity, in a low-inflation environment, reduced volatility by 2.5% while reducing returns by only 50 basis points, resulting in a significant reduction in volatility. Increased expected Sharpe ratio. What's more, in a high inflation environment, the "40/30/30" portfolio was 3.7% less volatile and 2.8% more volatile, resulting in a Sharpe ratio of nearly 0.4x.

"60/40" Equity and Debt Portfolio Gold 10 Years Are Over"

According to KKR's analysis of monthly returns on the S&P 500 U.S. Equity Index and the Bloomberg Barclays U.S. Bond Aggregate Index, the "60/40" equity-bond portfolio not only delivered solid returns, but also had a significant Sharpe ratio. higher than single stock and bond assets. As of December 31, 2021, the 3-year and 10-year annualized returns of the "60/40" equity-bond portfolio were 17.5% and 11.1%, respectively, and the Sharpe ratio reached 1.67 times and 1.41 times, respectively.

In this mix, equities are designed to achieve capital appreciation in tandem with overall economic growth, while bonds are designed to provide steady income and act as a stabilizer or shock absorber in times of market volatility or heightened downward pressure on the economy.

For the "60/40" model, 2010-2020 was the "Golden Decade". Especially after the 2008 financial crisis, U.S. stocks rose, interest rates fell, and bond prices rose, making this model very strong. However, in the next 10 years, the macro environment will undergo great changes, which will be manifested in the slowdown in the growth of the real economy and the rise in inflation, accompanied by the rise in interest rates and the intensification of geopolitical risks.

These all mean that the investment environment is undergoing a fundamental change. In such an environment, the relationship between stocks and bonds, and the roles each plays in the mix, will also change. On the one hand, stock yields will fall, and on the other hand, bonds will not be effective as shock absorbers and risk diversifiers.

Therefore, KKR pointed out that investors need to build a portfolio that can adapt to the new investment environment in order to better protect their "purchasing power". Specifically, KKR proposes to increase private equity investment and appropriately reduce the ratio of equity to debt, adjusting the allocation of various assets from 60% stocks and 40% bonds to 40% stocks, 30% bonds and 30% of private equity, including real estate, infrastructure and private credit. Among them, real estate and infrastructure are mainly used to make up for the weakened role of stocks in capital appreciation, and private credit is mainly used to make up for the weakened role of bonds in stabilizing returns and diversifying risks.

KKR's research found that since 1928, both nominal and real average returns on U.S. stocks have been significantly better in all non-inflationary periods (13.9% and 11.5%) than in inflationary periods (4.2% and -1.7%). (Note: A period of inflation is defined as a year in which inflation is above the median level of 2.7%, with annual inflation growth exceeding 1%).

As a result, KKR believes that adding asset classes that can appreciate in an inflationary environment will help compensate for future declines in equity returns. Specifically, reducing the weighting of equities to 40%, while increasing the weighting of real estate and infrastructure investment by 10% each.

Improve portfolio diversification to prevent "equity and debt double kill"

In the traditional "60/40" stock-bond portfolio, an important premise for bonds to play the role of income "stabilizers" is that the correlation between stocks and bonds is negative (that is, when the stock price falls, the bond price rises). But in fact, the correlation between the two is highly unstable and closely related to the macro environment.

KKR's research found that the equity-bond correlation has been slightly less than zero (-0.1) since 2000, but was significantly positive (0.4) between 1980 and 2000. When inflation rises, the stock-bond correlation increases further. Trends in recent months reflect this.

Therefore, increasing portfolio diversification will help hedge against the loss of returns from rising equity-bond correlations. Especially in a stagflationary environment where inflation is rising and economic growth is slowing, stock and bond prices will fall at the same time, while real estate and infrastructure can act as a "safe haven".