John Richman, Investment Manager
Diversification is often described as the only free lunch in investing. It is used in the construction of portfolios in an effort to help protect investors from an array of different risks including market risk, liquidity risk, geographical risk or the now very relevant interest rate risk. Not only does it mean investing in a range of different companies or funds to spread risk, diversification is also particularly applicable across different assets classes where a blend of investments, which have a low or negative correlation, can help to smooth portfolio returns over time.
Historically, fixed income investments have been used to diversify portfolios, often performing well when equity markets have suffered. However, this year the rapid increase in interest rate expectations has caused both equities and fixed income to fall simultaneously. This has been a particularly rare phenomenon. Looking back over the last 90 or so years, there have only been four calendar years where the US ten-year treasury bond and the S&P 500 Index have delivered negative returns (1931, 1941, 1969 and 2018, Source: NYU). The selloff in the fixed income market has caused yields to increase, making fixed income a relatively more attractive investment now. That said, it is important to consider other asset classes that can offer diversification to our clients’ overall investment portfolios.
Is private equity an option?
For investors with a high ability and willingness to take risk, paired with a long investment time horizon, private equity can be a potential diversifier in addition to a core liquid discretionary portfolio.
Private equity refers to the ownership of companies with shares that are not listed on a public exchange. Private equity investments provide funding to companies when it is either not possible or desirable for them to access the public markets, typically due to their size. Owning a stake in these companies provides investors with exposure to often relatively early-stage companies and can help investors gain access to new and upcoming industries, and in some cases, provide exposure to industries or sectors that do not currently include any publicly traded companies.
Typically, on behalf of our clients, we look to invest in a range of funds that in turn invest in private businesses, actively manage them over five to ten years, then exit to achieve capital gains. These funds incorporate various strategies including buyout, debt, secondary, venture and special situations. The higher risk and illiquid nature of these investments means that the best approach is a portfolio diversified by strategy and “vintage”- the year when a private equity firm first begins making investments from its fund.
When looking at private equity investments as a diversifier to public equities, we place an emphasis on targeting specialists and sector-focused managers with thematic funds. When looking at the asset class of private equity overall, correlation to public equities is relatively high, which is why it is so important to be focused on manager and fund selection to gain the diversification benefits.
One of the key benefits of private equity historically has been the outperformance verses public equities on a net basis. A report by Blackrock shows private equity funds produced an annual time-weighted return of 11.5% over the 20-years ending 31 December 2020. Over the same period the MSCI World averaged 7.5%, and S&P 500 returned 8.7%. (Source: Blackrock – Private Equity Partners July 2021).
Factors to consider
However, there are some downsides to private equity as an asset class which need to be understood by any potential investor.
Firstly, there is the lack of liquidity. Commitments are generally called over the first five years and paid back over the following five years, meaning clients must have a long-term time horizon when looking to invest in the asset class. During the investment time period there is often no secondary market, thus no opportunity to sell or back out of the committed investment. Private equity can also be expensive with higher fees and earnouts.
Minimum investment amounts are often high within the asset class which can be a barrier to entry. However, by pooling client commitments we are typically able to keep the investment minimums relatively low at £100,000 per client per fund.
Due to the illiquid nature of private equity, it is not an asset class used within our main discretionary portfolios; we prioritise the liquidity that public markets provide to allow investors to sell their investments at short notice if required. However, private equity can be an attractive option for the right client to invest in alongside their main portfolios. The potentially favourable returns, compared with other assets classes over the long term and the ability to access a different part of the equity market can make the asset class a useful diversifier to listed equities.
