Bottom Line Up Front
- The Denominator Effect (TDE) can impact any portfolio, not just institutional or pension funds with private assets.
- TDE occurs when the value of the fund decreases, causing the percentage of the fund's assets invested in a particular asset class to appear larger than it actually is.
- Wealth managers can mitigate the impact of TDE by discussing liquidity needs, exploring product options, and reviewing portfolio rebalancing frequency.
Most consumers and retail investors have never heard of the Denominator Effect (TDE), let alone how it could impact their portfolio. While most wealth managers are familiar with the concept, they’ve never had to consider its impact on client portfolios. The Denominator Effect historically affected massive institutional and pension funds, private equity, venture capital, and similarly sized portfolios.
We’ve talked a lot about volatility and what to expect as we navigate this unpredictable market. But that volatility means we must account for the Denominator Effect as we help manage your asset allocations to fit the goals and risk profiles we agreed upon, so you might hear the Denominator Effect come up in future portfolio updates and conversations as we act to manage and mitigate it.
So, what is the Denominator Effect?
A Quick Math Refresher
If you remember most of your math lessons, skip ahead – but if you dozed off hearing your algebra teacher list off formulas from an overhead projector (like most of us), this quick refresher is for you.
For a good reason, hearing the Denominator Effect might give you flashbacks to elementary-school math and fractions worksheets. Remember that a fraction is made of a numerator on top and a denominator on the bottom. When considering portfolios and funds, the numerator is an asset in a portfolio, and the denominator is the total portfolio value:
Adding in the dollar amount of each gives you the percentage of that asset in the overall portfolio:
The Denominator Effect describes what happens when Stock A and the portfolio get out of whack with one another.
Defining the Denominator Effect
It’s easiest to describe the Denominator Effect (TDE from here on out, for simplicity’s sake) in terms of practical examples. Let’s first look at it from an institutional or pension fund standpoint since the term comes blended with both private and public assets.
Portfolios like these have real estate, private company investments, direct lending, and similar non-public assets alongside standard stocks, bonds, structured notes, and ETFs in your retirement portfolio.
When public markets fall, the value of stocks and similar public assets in the fund drops. But private investments may not decline at the same rate; for example, real estate holdings don’t typically crater, and, if they do drop in value, it’s slow and by a matter of degrees rather than dramatically.
Let’s look at a comparison between those public equities in a portfolio and theoretical real estate values over the past few years:
- The massive dip in red, representing the percentage change in the S&P 500, is the beginning of the pandemic when massive fear and uncertainty brought the index down nearly 20% in a single go.
Let’s assume our hypothetical fund billed itself to investors as 80% SPY (S&P 500 ETF) and 20% residential real estate to diversify risk. At the beginning of 2020, we’d see:
- 2,484,472M shares at $322 per share.
- 522 homes at $383,000 each, based on a US Census Bureau report.
At the beginning of Q2 2020, SPY was around $250 per share, but those home prices only fell about 2%, leaving us with a fund allocation of:
- 76% SPY
- 24% real estate
Not terribly skewed from the 80/20 goal allocation, but those homes are less liquid than stocks. So, as the fund tries to rebalance, they may be unable to offload those homes and remain permanently misallocated – a severe issue since investors pick funds and set allocations based on risk profile, and managers are obliged to maintain the promised proportions.
Why Does Any of This Matter?
“OK,” you’re thinking, “that’s a fun lesson, but so what? I don’t have any real estate or private equity in my retirement account.”
Volatility as we’re seeing changes everything, and not all assets trade equally. Even in a basic retirement portfolio. Many wealth managers, us included, use structured notes as an alternative to bonds to fit fixed-income investment needs. Without fully explaining their mechanisms, most structured notes are certificates of deposit (CDs) built from a package of traditional bonds combined with various derivatives based on the note’s profile.
We love structured notes because they provide greater returns than bonds and, in some cases, specifically protect against downside risk in an index like the S&P 500. But they may not be liquid and thus exposed to the Denominator Effect.
Here’s some specifics from the prospectus of a structured note typical of what you see in a retirement portfolio:
No matter the performance of the underlying index (the S&P 500, in this case), you’ll get your initial deposit amount back in seven years when the CD note matures.
- You can’t cash out early unless you die or are deemed incompetent.
- Since the CDs aren’t securities, they aren’t listed on any exchange to trade easily.
- The issuing bank says they may operate a secondary market to sell before maturity but notes that “proceeds from a sale of CDs prior to maturity may be less than the principal amount initially invested.”
So, in this case, you have a basket of fixed-income, stable investment products worth $1,000 but as illiquid as real estate or private equity. A growth-centric retirement portfolio could be 80% stocks and 20% structures notes. If you had $1M in cash on January 1st, 2022 and allocated 80/20 into SPY and these notes, you’d have:
- 1688 shares at $474 per share.
- 200 notes at $1,000 par value.
In September that year?
- Your portfolio (denominator) is worth $790,000, of which:
- 75% is SPY at ~$350.
- 25% are structured notes at $1,000.
You’re stuck on the sidelines, misallocated, and unable to push those notes onto a secondary market to reallocate into an 80/20 split.
Today, SPY is up around 15% from that low (about $400 per share). The unbalanced portfolio is worth $875,000. But if you had rebalanced, your portfolio would be worth $1.1M.
And that’s in just a few short months! Imagine the compounding effects as the market truly rebounds. Since the 80/20 allocation befits a younger investor with time until retirement, that missed opportunity caused by the Denominator Effect represents millions in lost potential gains.
Managing the Denominator Effect
We made a lot of assumptions to simplify our examples. We don’t constantly tweak and rebalance to maintain constant allocations. That isn’t practical, and trying to time the market like that is a fool’s game.
But our example shows the risk the Denominator Effect represents for even standard retirement portfolios, especially for younger investors trying to capitalize on potential gains with an aggressive risk profile.
So how can we mitigate the effect?
Talk to us. Now that you understand the effect let’s discuss the impact TDE might have and your liquidity profile. You might want to take advantage of the downturn to dollar-cost average on the way down and back up, so fixed-income assets might not suit you. You might want more frequent updates or to review how often we’re rebalancing your portfolio to meet your goals.
As wealth managers, we also have access to tools and derivative securities you might not. Talk to us and explore ways to buffer the effects of lost liquidity – our job is to protect your capital and help it grow, so we’ll explore as many product options as possible to meet your needs and keep you comfortable.