We recommend diversifying by investing in a range of managers with different styles and approaches to markets – ranging from market neutral, relative value, macro, and merger arbitrage. By taking this approach, investors should reduce their dependence on a single driver of return. If we consider a range of measures such as maximum drawdown, illiquidity, performance, volatility, and the Sharpe Ratio, a diversified portfolio of styles is superior overall to any individual strategy.
We expect high risk-adjusted returns from private markets
The “private markets” asset class includes private equity, private debt, and real assets. Investors who don’t need regular access to their money can benefit from investing in private markets, accessing opportunities with a wide range of return drivers, providing portfolio diversification, long-term capital appreciation, and, depending on the investment, potentially regular income and an inflation hedge too.
We think private markets can offer strong returns in the years ahead. First, private market investments offer access to opportunities that are not yet widely tapped, where mispricings may be more common.
Second, depending on the strategy, the active involvement of experienced private market fund managers can create significant value for investors.
Third, the illiquidity of the investment gives investors a return premium to compensate for the long-term capital commitment that enables fund managers to add value.
Finally, illiquidity is an advantage from a behavioral finance point of view. Biases can cause investors to trade out of investments at times of high volatility. The illiquidity of private markets means that quick exits aren’t possible, so investors are forced to take a long-run approach.
Illiquidity must be tolerated
While we believe that a private markets allocation is essential for long-term-oriented investors who can tolerate illiquidity, investors need to carefully consider their need to access capital, particularly in times of market stress. Should an investor need to sell large parts of the liquid part of a portfolio to meet expenses, it could leave the asset allocation unbalanced, and forced liquidation increases the risk of selling at unfavorable prices.
Investors also need to consider the current market environment when making these illiquid commitments. Dynamics like lower valuations and less competitive capital, which can represent natural tailwinds for private fund managers earlier in the business cycle, are no longer available at this point in the cycle. Manager and strategy selection are increasingly important in such an environment, and investors should seek out funds pursuing differentiated strategies and focusing on complexity and execution given these dynamics.