Morgan Stanley IM: Deconstructing the Denominator Effect

Portfolio Solutions Group

Our Portfolio Solutions Group analyzes the key factors that impacted the "denominator effect" in 2022's market downturn

20.03.2023 | 08:19 Uhr

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The downturn in markets last year ushered in a host of challenges for investors. Chief among them have been portfolio imbalances resulting from the falling prices for publicly-traded securities and the increase in relative exposures to private assets, the so called “denominator effect.”

At this juncture, investors are mulling over a few key questions. For instance, what’s really driving today’s denominator effect? Are imbalances simply illusory, the product of a transitory market? Or is now the time to act? Should investors shed exposure to private market assets and forgo new commitments?

While many asset owners are already taking corrective action, the rush to rebalance is not without risk. Remediation measures warrant a cautious and calculated approach, in our view, that’s based on an in-depth appraisal of the underlying drivers.

Five Factor Analysis

To this end, we analyzed the impact of five key factors on the denominator effect in 2022, with a specific focus on Private Equity (PE) allocations by U.S. pension funds (for an in-depth look at our analysis see our latest whitepaper, Deconstructing the Denominator Effect).

The five factors include:

  1. Public market downside stress and volatility: The magnitude of the stress to public markets and the associated volatility can impact the denominator.
  2. Lagged effect of PE valuations: The lag and smoothing effect in the performance of private markets can affect the numerator.
  3. Relative performance: In relative terms, outperformance of private over public markets can impact the numerator.
  4. Net capital flows: Distributions and capital calls to PE play an important role in the value of the numerator.
  5. Allocations relative to target: The starting point and the gap in investors’ allocation to target can compound the denominator effect.

Not surprisingly, we found that all five factors influenced the 2022 denominator effect, but impact varied. PE outperformance in the run up to the correction was the top contributor, followed by lagged PE performance and investors’ precorrection overallocation.

Notably, three factors have already materialized (public markets drawdown, relative outperformance and investors’ starting point), while two have yet to fully be realized or recorded (lagged performance and net PE flows). On balance, we estimate that the potential impact of these two factors could be mutually offsetting, with the lagged effect causing exposure to edge downward while net PE flows are modestly additive.

As a result, we do not expect the total overallocation to private markets to increase significantly in 2023 – in fact, balances will likely remain in line with 2022.

Risks in Rebalancing

If fluctuating balances prove to be more illusory than real, then moving to rebalance now may, in fact, introduce portfolio risk. Investors might have an asymmetric risk profile in trying to reduce this overallocation, as reducing or stopping new commitments, or more drastic measures like secondary sales, can be likely more damaging than a continued overallocation. This can potentially lead to costly sacrifices in vintage diversification, missed opportunities in post-crisis strong vintages, risks of underweighting (if markets bounce back) and possibly crystallizing losses if investors resort to secondary divestments.

As such, investors may be better served by temporarily relaxing target allocation guidelines and becoming slightly more opportunistic on new commitments.

Investor Implications

Overall, we believe that the consequences of a forced portfolio re-weighting to neutral and/or the consequences of becoming underweight by stopping new commitments outweigh the risks of allowing an overweight in the short to medium term.

We will re-assess portfolio conditions at the end of Q1/beginning of Q2 2023 when the final 2022 PE marks are released, and a better picture of the PE flows is available. Until then, any measure to correct the overallocation could be premature and adversely impact the portfolio and performance.

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The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively the Firm”), and may not be reflected in all the strategies and products that the Firm offers.

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For the complete content and important disclosures, refer to the PDF download of “Deconstructing the Denominator Effect”

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