Stress Testing

Allocator relevance: Reveals tail risk and liquidity failure modes—especially important when private marks lag and correlations jump in stress.

Expanded Definition

Stress testing focuses on “bad states of the world”: liquidity freezes, rapid drawdowns, credit spread blowouts, rising defaults, or regime changes (rates, inflation). Unlike scenario analysis (which can be broad), stress tests tend to be more severe and are used to validate whether the portfolio can survive and remain fundable (capital calls, spending needs, redemptions) under pressure.

In allocator portfolios, stress testing must incorporate second-order effects: distributions slow, capital calls accelerate, and redemption features gate.

How It Works in Practice

Teams apply shocks to exposures (equities down, spreads widen, rates spike), then estimate portfolio losses, liquidity needs, and constraint breaches. They also test “stacked” stress: multiple shocks at once, which is where portfolios typically break.

Decision Authority and Governance

Governance defines required stress tests, frequency, and action triggers (e.g., pause commitments, increase liquidity sleeve). Strong governance treats a failed stress test as a decision input—not as a model artifact to ignore.

Common Misconceptions

• Stress tests predict what will happen.
• Private assets don’t need stress tests because marks are stable.
• One stress test is enough.

Key Takeaways

• Stress tests measure survivability, not forecast.
• Tail risk is often about liquidity, not just return.
• Use results to enforce pacing and limits.