Alternative investments have become established as valuable tools for investors seeking consistent returns, initially by institutions and increasingly by Private Wealth advisors as access has improved in recent years. The case for these investments is a story that has been told and told again, but bears repeating - the private markets have consistently outperformed their traditional exchange-traded counterparts over the long term. At the asset class level, private equity, private credit, and private real estate have all delivered greater returns with less volatility than their equivalent indices in the public markets by trading off daily liquidity. At the portfolio level, the true power of alternatives lies in their usefulness as diversifiers. Diversification is not just the only free lunch in investing, as Nobel laureate Harry Markowitz famously quipped; in the context of portfolio construction, diversification may be the only weapon allocators have to create stability in the increasingly uncertain and complex marketplace of today.
When Markowitz introduced his Modern Portfolio Theory in 1952, the essay he published was effectively a love letter to diversification. It described a practical method of building portfolios for optimal risk-adjusted returns by selecting investments across a variety of financial assets. His calculations revealed that investors could reduce the overall risk of their portfolios merely by owning combinations of assets that are not perfectly positively correlated to one another. In the example of a 60/40 portfolio (also the brainchild of Markowitz), the fixed income component is meant to be negatively correlated to the equity component. If equity markets were to experience a downturn, fixed income should move in the opposite direction, thereby stabilizing portfolio returns. However, more recent data has shown a reversal of this relationship, impacting the diversification benefits of fixed income within portfolios. In fact – over the past 15 years, a 60/40 portfolio has a correlation of 0.98 with public equities1, leaving investors to look outside stocks and bonds for solutions to restore balance.
There is a concept within Modern Portfolio Theory known as the efficient frontier, which graphically depicts a set of multi-asset portfolios that can generate the maximum expected return at a specified level of risk. The efficient frontier looks at performance at the portfolio level and considers all possible combinations of a set of assets to optimize risk-adjusted returns. The ‘risk’ that the efficient frontier refers to is market risk, the potential of an asset to fluctuate in price in response to the overall movement of financial markets, as measured by standard deviation. In the figure below, we can see a simple efficient frontier of a two-asset portfolio made up of equity and fixed income. The chart plots the annualized return and volatility of the full spectrum of potential allocations between these assets, from 0% equity 100% bonds to 100% equity with 0% bonds.
While assets from the private markets were not explicitly mentioned in the essay, perhaps they would have been had it been published today. Alternatives fit particularly well into this model given their reduced correlation to the traditional building blocks of portfolios, stocks and bonds. Observe how expanding the illustrative portfolios to include alternatives affects the graph. For the purposes of this illustration, public assets are reduced proportionately and replaced by an allocation to alternatives represented by equal parts private equity, private credit and private real estate. The inclusion of these assets moves the efficient frontier upwards and to the left in the risk-return spectrum. Said differently, bringing alternatives into the mix allows for portfolios that can boost returns while taking on less risk. As the hypothetical allocation of alternatives increases, the frontier continues to move up and to the left.
For a client nearing retirement age, bolstering income and reducing exposure from public equity volatility may be of paramount importance. Building an allocation of equal parts private credit and private real estate represents a potential solution. In this example, the current yield of the portfolio increases by 56.5% while reducing the annualized volatility by 28.6%, all without sacrificing annualized returns.
A wealthier client may identify greater absolute returns as the primary goal of their investment plan. For these growth-oriented clients, an allocation built around private equity may be more appropriate in pursuit of capital appreciation. The illustrative alternatives sleeve here consists of 60% private equity with 20% allocated to both private credit and private real estate. In this example, the annualized return of the portfolio jumps by 15.4%, volatility comes down 18.2% and current yield receives a marginal lift thanks to the private credit and real estate in the mix.
A client who is in the middle stages of their career may benefit most from a more balanced approach. By creating an allocation that includes private equity, private credit, and private real estate in equal measure, we see improvements across key metrics in the hypothetical portfolio when compared to a 60/40. Annualized returns increase by 9.3%, volatility is reduced by 23.1%, and current yield jumps by 27.5%, positioning the client to capitalize on the power of compound interest.
For advisors who are newer to alternatives and considering investing on behalf of their clients for the first time, an important step is to understand the investment vehicles by which the private markets are accessed. Broadly speaking, private investment funds can be classified into two different buckets: drawdown funds and evergreen funds.
For decades, drawdown funds have been the primary access point for alternative assets and remain that way today in the case of private equity. In this structure, investors commit capital to a fund, which generally “call" the capital as investments are identified over a period of three to five years. The lifespan of these funds is typically 7-10 years, during which investors do not have access to their capital. Investors receive their principal back as well as any gains in irregular distributions as investments are exited and profits realized. Private equity is inherently an illiquid investment thesis, requiring an access vehicle that can allow managers to execute value creation strategies. For this reason, advisors interested in allocating clients to private equity may benefit from doing so gradually over multiple years.
The other common access point, which has significantly gained popularity in recent years is called an evergreen fund. Evergreen funds are fully invested upon commitment, allowing investors to begin collecting (or compounding) returns immediately. Another key difference in evergreen vehicles is liquidity. As with private equity, the underlying strategies in evergreen funds are illiquid, but advancements in product design and fund structure have created periodic opportunities for investors to redeem their shares, typically on a quarterly basis. Line of sight on when capital will be invested and may be redeemed, coupled with typically lower investment minimums than drawdown funds, position evergreen funds as an easier point of entry for advisors allocating to alternatives for the first time.
