Improving Portfolios with Private Markets

The 60/40 portfolio dates back to 1952, when Harry Markowitz and William Sharpe created Modern Portfolio Theory. Modern Portfolio Theory is a practical method of selecting investments to maximize returns within an acceptable level of risk which paved the way for the classic blend of 60% public stocks and 40% public bonds. While it has, undoubtedly, helped millions of investors diversify and grow their wealth, this allocation may not be as suitable in the today’s markets.

Why? Because the 60/40 portfolio excludes assets from the private markets that may help investors as they pursue their goals.

Private markets represent a large and growing opportunity – nearly 9 in 10 companies in the United States that generate revenues in excess of $100 million are privately held.¹ These companies have historically been difficult or impossible for individual investors to invest in as they do not trade on public exchanges. Supplementing the traditional approach with these assets does not abandon the principles set forth by 60/40 — they may even enhance them. Backed by decades of outperformance, private market assets can serve as powerful tools to diversify return streams, providing ballast to portfolios.

Private equity: Investing for growth

In a traditionally diversified portfolio, equity serves a distinct purpose: growth. By allocating to individual public equities or equity funds, investors hope to capture the potential upside of businesses or industry sectors. For decades, this has been the standard.

However, historical data points to a more effective avenue for growth: private equity has consistently outperformed its public counterpart. The delta between private and public equity returns can be substantial, driven by several factors: expanded investment opportunities, hands-on ownership, longer investment horizons, and the premium associated with less liquid assets, to name a few.

While public equities will always remain a staple, the modern portfolio demands a more strategic approach. Broadening a core growth allocation to include private equity may unlock a number of potential benefits: powerful diversification, historically greater returns, and reduced volatility. edu4-1-vf

The Sharpe ratio is one of the most widely used methods for measuring risk-adjusted relative returns. When comparing two investments, the one with a higher Sharpe ratio appears to provide better returns for the same risk.

Private credit: Bolstering portfolio income

In traditional 60/40 portfolio construction, fixed income has an explicit role: generating income and preserving capital. This dual role has made fixed income an indispensable component for investor portfolios. Theoretically, bonds and treasuries provide stability during downturns in equity markets, as predictable income streams can help offset the inherent volatility of equity markets.

However, shifting market dynamics have driven a growing correlation between public equities and bonds — a concerning trend. The fundamental purpose of diversification is to build a portfolio with assets that behave differently under varying market conditions. If equities and bonds move in unison, the conventional benefits of holding bonds are diminished, leaving portfolios more exposed to market swings than investors might anticipate. Consequently, investors should consider looking outside the traditional suite of public debt to generate the income they need to pursue their financial goals.

Private credit may be a compelling substitute. Strategies in this asset class can provide consistent return streams, driven largely by income. Private loans may also be better positioned to preserve capital, especially in tumultuous markets, thanks to improved loan structures, selective sourcing, vigorous diligence processes, and direct involvement from managers in workout situations.

In today’s market, with correlations between public fixed income and equities on the rise, investors need solutions that can bring balance to an income allocation. By strategically shifting from public debt to private credit, investors can provide stability to portfolios with increased diversification, higher current income, and lower volatility.

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Private real estate: Resilience and tax-efficient income

The classic view of a balanced portfolio makes a notable omission: real estate. Institutional investors have been historically drawn to the asset class, and for good reason – real estate can provide diversification benefits and attractive risk-adjusted returns. In inflationary environments, real estate strategies become even more compelling. Inflation can cause property values and rents to escalate, positioning real estate as a natural hedge against pricing pressures.

Real estate investments accessed via public markets face volatility, often influenced by factors that have little to do with the fundamentals of the underlying assets. Investments in private real estate can reduce exposure to the swings of public markets and gain advantages from manager control. Through direct ownership, asset managers may influence strategic decisions, helping actively manage properties, optimize rental rates, and advise on acquisitions and dispositions.

Private real estate strategies, which can be funded from either a growth or an income allocation depending on investment goals, provide portfolios with a differentiated return stream. The income produced by private real estate also benefits from favorable tax treatment, increasing investors’ after-tax effective yield.

When constructing portfolios, investors require versatile strategies that can navigate the constantly shifting conditions of the modern market. Private real estate can bring that resilience to portfolios by generating tax-advantaged income, reducing volatility, and providing insulation from inflation.

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The inflation beta of an investment is a metric used to evaluate an asset class’s ability to hedge inflation. Higher inflation beta indicates an investment performed better during inflationary periods.

Total portfolio: Driving investment outcomes with private markets strategies

When investors incorporate private market assets into a traditional portfolio of stocks and bonds, they're not simply adding new asset classes — they're seeking to facilitate specific investment outcomes. Diversifying across multiple strategies, each with their own sources of returns, can further amplify the potential benefits. Private equity, private credit, and private real estate introduce unique characteristics that, when integrated properly, can refine a portfolio's performance profile.

Moreover, employing multiple strategies can reduce the impact of unexpected market shocks, as the overall portfolio is less likely to be concentrated in a certain sector or geography. While one strategy faces headwinds, another may capture growth, and yet another might provide steady income. The result is a portfolio that is less reliant on the performance of any single market or economic condition and more resilient to the fluctuations of the global economy.

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Considerations for private market investors

Private market assets can help investors seek more consistent, predictable returns — effectively preparing portfolios for whatever the market throws at them. That said, it's essential to navigate alternatives with a clear understanding of their investment profile.

They typically require a commitment to longer time horizons, a trade-off for the potential of higher returns and lower volatility. Therefore, investors must evaluate their liquidity needs, ensuring they have sufficient access to capital for both planned expenditures and unforeseen circumstances. A thoughtful allocation to private markets should strike a balance between these assets with more liquid investments to maintain overall portfolio flexibility. However, investors may find that they do not require 100% liquidity, 100% of the time.

Investors must also consider how private market investments align with their broader financial goals and risk tolerance. The diversification benefits of private markets can be substantial, but they must be integrated into a portfolio in a way that complements an investor's overall strategy.

As with any investment, investors have several choices to make when evaluating an allocation to private markets. Choosing the right manager is among the most important. Managers rely on deep industry knowledge, partnerships, and experience to unlock value for their investors. Asset managers should possess a demonstrated track record, domain expertise, and transparent investment strategies.

Further, the asset manager's philosophy should resonate with the investor's own objectives, whether that be growth, income generation, capital preservation, inflation protection, or a combination of them all.

Modern Portfolio Theory helped create a roadmap for investors to construct balanced portfolios in pursuit of their individual goals, but the challenges of today are different from those of the past – portfolios should be different, too. By including assets beyond public equities and bonds, investors can capture the opportunity for improved risk-adjusted returns with private markets.

Endnotes

Capital IQ as of 9/30/23
Sources: Bloomberg, Cambridge Associates for the period 9/30/2018 to 6/30/2023. Public equity represented by the S&P 500. Public bonds represented by the Bloomberg US Aggregate Bond Index. Private equity represented by the Cambridge U.S. Private Equity Index.
Sources: Bloomberg, Cliffwater for the period 9/30/2018 to 6/30/2023. Public equity represented by the S&P 500. Public bonds represented by the Bloomberg US Aggregate Bond Index. Private credit represented by the Cliffwater Direct Lending Index.
Sources: Bloomberg, NCREIF for the period 9/30/2018 to 6/30/2023. Public equity represented by the S&P 500. Public bonds represented by the Bloomberg US Aggregate Bond Index. Private real estate represented by the NCREIF NFI-ODCE Index.
Sources: Bloomberg, Cambridge Associates, Cliffwater, NCREIF for the period 9/30/2018 to 6/30/2023. Public equity represented by the S&P 500. Public bonds represented by the Bloomberg US Aggregate Bond Index. Private equity represented by the Cambridge U.S. Private Equity Index. Private credit represented by the Cliffwater Direct Lending Index. Private real estate represented by the NCREIF NFI-ODCE Index.
Sources: Bloomberg, Cambridge Associates, Cliffwater, NCREIF for the period 9/30/2018 to 6/30/2023. Public equity represented by the S&P 500. Public bonds represented by the Bloomberg US Aggregate Bond Index. Private equity represented by the Cambridge U.S. Private Equity Index. Private credit represented by the Cliffwater Direct Lending Index. Private real estate represented by the NCREIF NFI-ODCE Index.

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Improving portfolio risk & return with private markets