The new diversification: a public-private play

WHEN I started in the investment business more than 38 years ago, the common wisdom was simple: If you wanted to get ahead, you just had to remain invested in publicly traded stocks and bonds for the long run – and that was enough.

But as markets have evolved, we have seen a fundamental shift. Public markets, despite their accessibility, do not always offer the kind of diversification, risk management or returns that today’s investors seek.

Moreover, in the midst of widespread uncertainty, the foundational trust in the traditional 60/40 portfolio allocation (60 per cent equities, 40 per cent bonds) is being challenged at its core. For decades, investors have depended on the negative correlation between stocks and bonds to create diversified portfolios, with bonds acting as a buffer during periods of stockmarket downturns.

However, this correlation has recently reversed, undermining the downside protection bonds once offered in downturns. The old ways of investing might no longer be the best ways. This is where private markets come into play.

In recent decades, private markets have increasingly become central to financing mature companies and fostering growth. Various private market asset classes have played a key part in this expansion. The growing significance of private equity in the broader economy is evident in its evolving connection with public markets.

Notably, the number of initial public offerings has dwindled globally, as more companies opt to remain private for extended periods. At the same time, the rise in take-private transactions and carve-outs from publicly listed companies highlights a notable shift – once-public entities are increasingly being brought back under private ownership.

Compared to a conventional 60/40 client portfolio, a portfolio that includes private market assets can provide enhanced diversification and the potential for better returns. Alternative asset classes, particularly those in the private markets, have arisen as worthy candidates for portfolio diversification.

Private assets have retained uncorrelated performance against publicly listed assets for most parts after the global financial crisis, most recently registering a negative correlation of 0.65 against stocks – justifying their presence in a traditional portfolio of stocks and bonds.

Moreover, private market managers typically focus on long-term growth, aiming for sustained performance over extended holding periods. This approach can lead to greater portfolio stability, especially during market downturns and inflationary spells.

Illiquidity premia

Unlike stocks and bonds, alternative assets are often illiquid. Private assets, in particular, are sought for their significant long-term growth potential. These investments are structured with extended holding periods, restricting exits before maturity.

In return, investors are promised higher returns as compensation for illiquidity. The approach of committing capital for longer periods in exchange for greater gains has proven effective for institutional investors such as pension funds and endowments, who enjoy long-term investment horizons and stable funding.

They can weather market fluctuations in public investments while awaiting returns from private assets backed by “patient” capital. These investors focus on long-term growth over short-term liquidity, explaining why pension funds and endowments allocate a substantial portion – often more than 50 per cent – of their portfolios to alternative assets.

The endowment model, developed by the late David Swensen (Yale’s endowment fund manager) and popularised by university endowments, exemplifies the preference for performance over liquidity. This strategy emphasises large allocations to illiquid private assets, such as private equity and venture capital, as a complement to liquid assets to manage capital calls on the private investment sleeves.

Larger endowments, with greater exposure to private assets, often outperform smaller ones, demonstrating the impact of private assets on hybrid portfolio performance.

Beyond the velvet rope

We believe some of these institutional best practices can be mimicked in part to improve the performance of the individual investor. However, private markets have historically been a tough nut to crack for individuals. The lack of liquidity, high minimum investments and complex fee structures have made them the domain of ultra-wealthy and institutional investors.

Today, private markets are no longer an exclusive club. KKR and Capital Group are seeking approval from the US Securities and Exchange Commission to sell public-private debt funds to retail investors, while Apollo and State Street are looking to launch an exchange-traded fund that combines both public and private credit.

These strategic moves demonstrate how the industry is evolving, as traditional money managers come together with private asset firms to democratise private market products to a broader pool of investors.

Ever-greener pastures

Alongside allocations to liquid diversifiers, semi-liquid funds – also known as “evergreen” funds – have gained popularity as effective structures for liquidity management. Semi-liquid funds maintain a liquidity sleeve of cash and money market instruments. This sleeve allows funds to meet operational needs without tapping into upfront capital commitments, enabling capital to be fully and immediately deployed to target assets.

As a result, these funds can achieve faster compounding, more consistent and earlier distributions, as well as a more palatable quantum of capital commitment. In the absence of redemption requests, the capital base pools from continual re-investments, circumventing the need for frequent fundraising rounds. The structure scales very rapidly in a cost-efficient manner, allowing fund managers to focus on value creation.

For all the potential that private markets hold, there is an inherent risk in navigating these uncharted waters. The complexity of semi-liquid funds, the relatively high fees associated with alternative investments and the long holding periods might not suit the appetite of some investors.

Then there are the operational risks. Consider semi-liquid structures, where investors could face withdrawal limits (3 to 5 per cent of net asset value) and quarterly processing, capping annual redemptions at about 20 per cent. Investors ultimately need to decide if such risks are within tolerable levels for their own appetites.

Legendary investor Howard Marks once said: “If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different. And being different is absolutely essential if you want a chance at being superior.”

At the end of the day, the real question is not whether private markets are good or bad, but rather, whether we as investors are willing to do something different for a shot at superior performance. It is a delicate balance, but for those who can stomach the ride, the rewards – both in terms of returns and diversification – could be well worth the journey.

The writer is chief investment officer, DBS Bank