Ever wonder how the most sophisticated consultants and highest-rated portfolio managers allocate investments for their large, institutional clients?
Although it might not surprise you to learn that they do things a little differently than your average retail investor, you might not know that it's possible for many individual investors to assemble similar portfolio allocations and essentially ride along with some of the same top-quartile funds found in those multibillion-dollar institutional portfolios.
The biggest difference is a sizable allocation to private market investments, or alternative investments, in institutional portfolios. For example, according to a trio of 2022 reports — Preqin Global Private Equity Report, Hodes Weill & Associates: Institutional Real Estate Allocations Monitor and UBS' Global Family Office Report — sovereign wealth funds, on average, allocate 28% to private markets, public pension funds allocate 31%, foundations 34%, college endowments 37%, and family offices 38%.
Many retail investors allocate little if anything to private market investments, though admittedly non-accredited investors generally can't due to eligibility requirements.
But that's changing, along with access to more investor-friendly fund structures enabling accredited investors to purchase heretofore inaccessible private funds with modest investment minimums, no capital calls, 1099 tax reporting, monthly (or even daily) pricing, and quarterly liquidity.
These new alternative investment funds aren't suited for, or available to, every individual investor in the same way a mutual fund, or exchange-traded fund, generally is. But many accredited investors can purchase these private market investments, affording them many of the same benefits accruing to large institutional investors.
What are those benefits? In short, higher returns along with lower volatility and drawdown risk. Historically, many institutions found that blending private market, alternative investments into a traditional portfolio consisting of publicly traded stocks and bonds reduces risk through the addition of uncorrelated asset classes, extending and improving diversification, yet these alternatives also consistently offer higher returns.
In an annual CAIA Association performance study, for example, private equity allocations by state pension funds outperformed public stocks by 4.1% annually, on average, over a 21-year period. In its March 2023 Insights publication "Regime Change: The role of private equity in the 'traditional' portfolio," KKR Global Institute found the following: "Over three decades, Private Equity has — on average — empirically delivered excess returns of about 4.3% on a net annualized basis. This relationship also holds true across regions and cycles over the long term."
Apollo Global Management, in a May 2023 paper titled "Beyond Beta: How to Use Alternatives to Replace Public Equity," illustrated that, over a 14-year period ending in September 2022, private equity provided 3.2% annual outperformance as compared to the S&P 500 index, with 8.7% lower volatility and 17.3% lower drawdown. Morningstar found that over a 36-year period, private equity outperformed public stocks by 4.7% annually, with 6.5% lower volatility.
If investing in private markets seems scary or reckless, consider that private markets are roughly 10 times larger than the public market. As of April 2022, Capital IQ reported, 92% of all companies with annual revenues greater than $100M were private, with the other 8% being the more commonly known publicly listed and traded companies. In 2018, the Kaiser Family Foundation published "Number of Private Sector Firms, by Size," estimating that there were 7 million private companies in the United States.
But private firms are certainly less well known by the public, and the private investment market is definitely more opaque, requiring investors or their advisors to carefully review fund-specific data and information. Manager dispersion of investment returns is much greater among private market funds and managers, compelling many accredited investors to hire specialty advisory firms well versed in the private markets, with access to the top funds and managers.
Due diligence is a must before considering any investment in a private market fund, whether private equity, venture capital, private credit, private real estate or private infrastructure.
