Six Ways to Boost Returns and Efficiency in Australian Institutional Portfolios

1. Valuations favour bonds and credit over equities

While timing the relative performance of stocks versus bonds over short periods is difficult, starting valuations are strong predictors of returns over three to five years. This is especially true for core bonds, where starting yields correlate over 90% with subsequent five-year returns. Based on simple but powerful metrics^Footnote2 such as bond yields and equity cyclically adjusted earning yields (CAEY), valuations currently favour credit over equities. Bonds are yielding more than stocks in the U.S., despite their seniority in the capital structure (see Figure 2).

In Australia, the default-adjusted yield on BBB credit is 4.7%, close to the 5.1% CAEY for equities. Not as compelling as the U.S. equity vs. credit proposition, but still attractive given that bonds rated BBB exhibit less than a third of the volatility of equities.^Footnote3

Valuation-based return expectations suggest a tilt towards bonds relative to longer-term strategic asset allocation targets. Bonds also offer crucial defensive qualities. Our research shows that the correlation between stocks and bonds depends on the origin of market shocks: Equity shocks tend to produce negative correlations, while bond market shocks (e.g. an inflationary shock) tend to induce positive correlations.

Additionally, valuation matters: When the equity risk premium is far from its long-run average, valuation can dominate any transitory shocks to bond or earnings yields. With inflation stabilising near central bank targets and equity valuations elevated, we expect a lower stock-bond correlation than seen over the last three years (see Figure 7 in the appendix).^Footnote4

In a recent analysis for a strategic partner, we optimised interest rate duration exposure across the curve and geographies to maximise diversification against equity risk. Over the long term, we found that non-U.S. rates have outperformed U.S. rates in 68% of global equity drawdowns since the late 1940s. The correlation between U.S. and non-U.S. rates has not always been as strong as in the past 25 years. While U.S. Treasuries continue to play an important role, it is prudent to diversify across multiple rates markets, particularly as the underlying economies diverge, which should be a key consideration as investors reassess U.S. exceptionalism.

2. Targeting low equity beta in liquid alternatives

Liquid defensive alternatives are gaining traction under TPA. Blending diverse equity-defensive strategies – such as equity-market neutral and macro hedge funds, defensive alternative risk premia strategies, trend-following, defensive currency exposure, and put option-based tail risk hedging – can enhance risk-adjusted returns and improve diversification during equity drawdowns, as there is less reliance on a particular strategy to shine.

We have partnered with large asset owners globally to tailor defensive alternatives solutions that seek to maximise unconditional expected returns while limiting conditional equity beta. From January 2020 to June 2025, an equally weighted blend of PIMCO defensive alternatives strategies achieved a net Sharpe ratio of 0.5 while hedging crisis risk, with an equity beta of -0.7.^Footnote5 Depending on the total portfolio setup, defensive liquid alternatives programs tend to have a better impact on total portfolio Sharpe ratios than uncorrelated or procyclical hedge fund programs, which may have Sharpe ratios more than twice as high.

3. Uncovering true alpha in private markets

The quest for lower beta extends into illiquid strategies. Private markets may offer compelling alpha but often carry significant smoothed beta exposure. Understanding what is alpha and what is beta is crucial for effective portfolio construction. Our research, shown in Figure 3, suggests that global private debt has tended to deliver higher and more stable alpha than private equity.

Diversifying private market exposure beyond corporate risk is another trend. Although private equity and direct lending often concentrate similar economic risks, Australian investors have historically allocated to infrastructure and real estate, which generally carry lower, but still meaningful, equity beta. Within private credit, we expect the highest risk-adjusted returns with lower equity beta are likely to be in the asset-based finance and commercial real estate debt markets. In contrast, the spread premium of direct lending over bank loans has compressed significantly, indicating reduced liquidity and complexity premia in private corporate debt going forward (see Figure 8 in the appendix). We have assisted clients in tracking these premia across private markets to inform the allocation of marginal capital.

4. Capital efficiency and portable alpha

As Australian portfolios shift towards illiquid assets, managing liquidity at the total portfolio level becomes increasingly important. We have helped clients plan for liquidity needs during equity sell‑offs, when liquid assets decline in value but capital calls from private market commitments and margin calls from currency hedges rise. Fully funded, capital-efficient equity and bond allocations, capable of providing 30%–50% of short-term liquidity, can optimise portfolio-level (stress) liquidity. For example, active core bond strategies can replicate full discretion active exposures via derivatives, while keeping 60% of assets in cash-like instruments (e.g., short term Australian Commonwealth government bonds or U.S. T-Bills), serving as a liquidity buffer or generating additional yield through collateral upgrade trades (repo).

Portable alpha, a derivatives-based beta replication combined with preferred alpha sources, is a popular capital-efficiency tool. Demand for portable alpha solutions for equity betas is rising due to low replication costs, low tracking error, and the low (average) alpha from active equity management. The key benefit of portable alpha strategies in a total portfolio approach is the ability to separate the alpha and beta decisions.

Historically, institutional investors with equity-heavy portfolios have limited their alpha strategies to a single source – stock selection. Allowing beta choices and regulatory benchmarks to dictate alpha sources inherently restricts the opportunity set. Designs vary by client objectives, from enhancing yield in fixed income collateral pools to accessing hedge fund alpha without divesting from equity portfolios or increasing tracking error relative to YFYS benchmarks.

While these techniques increase notional exposures, portfolio risk may remain stable or even decline if the alpha strategy is negatively correlated with the starting portfolio (see Figure 4). Investors should monitor the alpha-beta correlation, maintain sufficient liquidity,^Footnote6 particularly for periods of market stress, and ensure the risk management and portfolio management teams oversee both the alpha and beta components.

Portable alpha solutions have the potential to materially enhance risk-adjusted returns while maintaining the equity beta footprint. Liquid diversifiers, such as discretionary and systematic macro strategies, have the highest potential alpha and can boost absolute returns while maintaining low beta correlations. Blending liquid alternatives and bond alpha in the collateral pool may materially boost returns while maintaining a low tracking error to the beta, a particular focus for YFYS-aware investors.

5. Tactical asset allocation overlays can enhance returns

The popularity of TPA and the desire to be more dynamic are fuelling adoption of dynamic tactical asset allocation (TAA) programs. Success hinges on solid systematic frameworks, total portfolio diversification, and capital-efficient implementation.

TAA overlays serve as effective risk management tools, broadening diversification beyond traditional asset classes and potentially uncovering new sources of return. The growing depth of capital markets enables sophisticated, liquid, cost-efficient, and capital-efficient TAA strategies.

Implementing TAA is not as daunting as many presume. Its effectiveness depends on three critical factors: risk-adjusted returns, capital efficiency, and expected correlation with the existing portfolio. Our analysis shows that a 2% standalone volatility TAA program^Footnote7 could boost total portfolio risk-adjusted returns by 10% to 40%, assuming TAA Sharpe ratios between 0.25 and 0.5 and a low correlation to the reference portfolio (see Figure 9 in the appendix).

Partnership models vary, but hybrid approaches that combine the internal resources of institutional investors with the scale of a large investment manager offer advantages. Investment managers may assist in strategy design and signal generation, quantitative research, and access to co‑investments, analytics, and risk management expertise. Experienced buy-side traders with best‑execution incentives and market-leading access typically offer materially lower transaction costs than what is typically available to Australian asset owners.

6. Integrating currency hedging into portfolio strategy

The optimal degree of currency hedging remains a perennial debate. Many institutional investors have allowed their currency exposure to be dictated by the nature of their foreign currency assets, such as the MSCI All Country World Index (ACWI) equity index, which creates a bias towards U.S. dollar (USD) exposures. For unconstrained investors, optimised currency overlays may offer a better approach than simply deciding whether to hedge individual assets. This involves constructing a basket of foreign currencies that diversifies the total portfolio while aiming to maximise expected currency returns.

Although effective, this strategy requires a deep understanding of portfolio risk factors and relies on assumptions about currency returns, risks, and correlations. Given the U.S. dollar’s perceived overvaluation and recently weakening safe-haven characteristics, we have helped clients optimise exposures to Japanese yen, euros, Swiss francs, and select emerging market currencies.

A recent key question is the valuation of the Australian dollar (AUD) and its impact on foreign currency returns, as well as the AUD’s historically robust positive equity beta. Our currency model, which accounts for distance to fundamental fair value and expected real carry differentials, forecasts the AUD appreciating about 1.6% annually against the USD over the next five years, suggesting reduced foreign currency exposure. The valuation impact reaches beyond expected returns, as we have documented that undervaluation of the AUD is empirically linked to a drop in future equity beta.^Footnote8 While USD exposure is still expected to be defensive, our research suggests its equity-hedging characteristics are likely to weaken by 25–35% over the coming five years, relative to long-term averages. These changes have meaningful implications for AUD-based portfolio construction.

Holistic portfolio optimisation: Bringing it all together

PIMCO takes a consistent risk factor-based approach across public and private assets to compute optimal portfolios under multiple linear and nonlinear constraints. Figure 5 illustrates the impact of these six asset allocation tweaks for the average MySuper Balanced portfolio.

In our first optimisation, the “Stock-bond mix”, we allowed the public-bond-versus-equity allocation to shift by up to 10 percentage points. This improved the portfolio’s risk-adjusted return by up to 13% annually by tilting towards fixed income, with increasing allocations to credit relative to core bonds as risk appetite increased.

In our second optimisation (the “Alternatives reallocation”), we allowed the algorithm to shift weights between alternative assets. We limited the overall increase in private and liquid alternatives to 5 percentage points above the starting portfolio, allowing up to 3 percentage points each in two lower-beta private market assets (asset-based finance and commercial real estate (CRE) debt). Additionally, we permitted an allocation up to 5 percentage points for a blend of discretionary and defensive systematic global macro hedge fund strategies. Combined with the stock-bond shift, this improved the total portfolio Sharpe ratio by up to 35%.

The third optimisation (“Capital efficiency”) incorporates the option to replace up to one-third of the equities in the MySuper portfolio with capital-efficient equities that source portable alpha from the fixed income universe. We also allowed up to 1% volatility exposure in a TAA overlay and conducted a currency-by-currency optimisation, allowing the overall currency hedge ratio to vary by +/-10%. These three overlay-based enhancements boosted the risk-adjusted returns of the representative MySuper portfolio by 55% while maintaining peer-comparable risk factor exposures (defined as estimated tracking error below 2%). Additionally, adding a peer-aware constraint will impose limits on the ability to shift the portfolio materially higher or lower in risk. We believe that these allocation refinements could materially enhance returns relative to regulatory benchmarks and the peer group.

Balancing innovation and prudence can lead to better portfolio outcomes

Ultimately, the future of Australian institutional investing lies in a careful balance between innovation and prudence. By making modest but deliberate shifts – whether through adjusting allocations between equities and bonds, adopting more capital-efficient strategies, or reassessing the role of alternatives – investors can improve outcome potential without unnecessary risk both from a market and YFYS perspective. A total portfolio approach that integrates these techniques offers a practical way forward. It’s not about material changes from the status quo but about building portfolios that are better equipped to meet the varied needs and challenges facing Australian investors in an increasingly uncertain world.

Appendix

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