How much should you invest in private equity, private debt, hedge funds?

SOPHISTICATED money and family offices are moving to less liquid, higher-cost asset classes. Are you missing out on something?

From 1985 to 2021, Yale’s endowment achieved an annualised return of 13.7 per cent, growing from US$1 billion to over US$40 billion after making withdrawals for the endowment’s liabilities.

To give a sense of this 36-year achievement and the power of compounding, a good annualised return of 8 per cent – global public equities’ historical return over longer time frames – would have compounded your money by 16 times.

Yale’s 13.7 per cent annual return would have compounded your money by 100 times.

The Yale portfolio was famously deployed not only into professionally managed public equities and fixed-income funds, but also into multiple asset classes, including hedge funds, private credit, private equity, real estate and other alternatives. The main source of incremental returns came from a combination of alpha, manager selection, the illiquidity premium, longer duration assets, and leverage through investments in various private market funds and hedge funds.

Careful, diversified asset allocation was no doubt key in increasing returns. But what is often misunderstood is why and how to apply these same principles to achieve one’s own life goals.

We cannot just copy and paste Yale’s asset allocation for ourselves. An individual’s asset allocation is dependent on the time horizon, expected return and liquidity tolerance of that individual’s specific and unique wealth goals. This asset allocation will no doubt change as your life circumstances and goals evolve, much like it did for Yale.

More asset classes, more sources of return

Private markets give you access to companies that are not listed in the public markets. Moreover, unlike public markets, information on private companies is not readily available to all investors. A private equity or private credit manager who does his homework and has a relationship with the private company is likely to have a significant information advantage that enables the fund to generate alpha.

Private capital is also likely to demand better terms for funding from the private company, given the longer-term nature of its capital. This forms the basis of the illiquidity premium, or higher incremental returns from private-market assets than public markets.

Hedge funds that largely invest in public-market instruments benefit less from the alpha and the illiquidity premium associated with private markets. However, certain hedge funds have developed a systematic edge over their peers – typically through trading and risk-management systems, and calculated use of leverage to generate alpha within public markets. Their goal is to generate absolute returns without taking much directional market risk or beta.

There are many types of hedge funds out there, so it is important to be specific. One approach that has been successful for many decades is the multi-strategy hedge funds. These asset-management firms hire talented traders and give them an attractive performance-based formula on their compensation, but with ruthlessly tight risk limits on both drawdowns and the amount of market risk they can take.

Any breach of limits can instantly cost them their jobs. This risk-management system has enabled the funds to use leverage on the alpha generated by the managers and collectively produce returns comparable to public equities after fees, but with significantly lower volatility and correlation to markets.

What’s the catch?

It is worth being sceptical about the marketing material of private credit, private equity and hedge funds. Claims of higher returns and lower volatility must have a catch, and this is found in the funds’ lower liquidity with possibility of gates and lock-ups; their higher fees, increased complexity and use of leverage lead to tail risk, as well.

Beware of high costs and ensure you know why such funds are being pushed to you. Does the bank or platform earn subscription fees and recurring trailer commissions from the funds? Such remuneration may drive them to sell you certain funds, rather than advise you on whether they are best-in-class and suitable for your goals. Fewer high-quality funds may be willing to pay for distribution, causing a negative selection bias.

When assessing whether a fund is good, always consider the manager’s proven implementation, net returns after fees, strategy repeatability and vintage diversification, particularly for private-market funds.

Even more importantly, when assessing if a fund might be suitable for your portfolio, consider whether your specific investment goals can sustain the liquidity terms, as well as the lower transparency and less-timely market pricing than that of public securities.

Do you need private market and/or hedge funds?

Yale’s endowment is managed towards the institution’s future demands or liabilities, including renovation of buildings, provision of scholarships and funding for research programmes, among others.

David Swensen,Yale’s chief investment officer from 1985 until his passing in 2021, once said: “By relying on the decisions of others to drive portfolio choices, investors fail to take responsibility for the most fundamental fiduciary responsibility – designing a portfolio to meet institution-specific goals.”

Your approach is no different when you set your wealth goals with an eye towards your life goals, which may include saving for a rainy day, a down payment, for children, parents or retirement needs.

Your allocation to private markets and hedge funds could form a majority of your portfolio, or nothing at all. When deciding how much to allocate to less-liquid asset classes, or any asset class for that matter, you must first consider your specific goals. These goals guide your overall asset allocation – not the other way around.

This is the backbone of a personalised and success-oriented asset allocation.

Gregory Van is chief executive officer and Hugh Chung is chief investment advisory officer of Endowus, an independent wealth platform advising over S$5 billion in individual and family office client assets.