London (HedgeNordic) – Since the Great Financial Crisis, diversification has been easy – and perhaps too easy. The classic equity and bonds mix has delivered exceptionally strong returns, some of the highest in a century, and bonds have often helped to smooth out the volatility of equities. Applying super cheap leverage to the blend has further multiplied returns. But on a longer lookback period, sticking to a plain vanilla approach could have led to large drawdowns, for example, in the 1970s when inflation inflicted losses on both equities and bonds.
Greed and Fear of Missing Out (FOMO) may have overwhelmed fear and driven investors into long-only, long-biased and leveraged long positions, concentrated into one or two liquid asset classes, but investors with long memories or some degree of imagination will want more diversification by asset class and strategy. Many fund managers and analysts today have never lived through an extended crash (besides the Covid crash, which was recovered very fast) and some even seem to think that policymakers have succeeded in ending the economic cycle, and creating a climate of eternal steady growth.
Since the Great Financial Crisis, diversification has been easy – and perhaps too easy. The classic equity and bonds mix has delivered exceptionally strong returns, some of the highest in a century.
Smoother Valuations
Private assets offer different angles of diversification. Since they are valued less often than public markets, they will smooth out portfolio volatility due to only being valued quarterly or annually. But this is a weak argument because some allocators, such as Danish pension funds, are required to carry out more frequent valuation estimates for illiquids and the “stale pricing” phenomenon only delays the evil moment of recognizing losses, if the wrong decisions have been made.
Private assets offer different angles of diversification.
A stronger argument for reducing volatility is that private assets bring more dimensions of diversification to the portfolio, which reduces volatility by virtue of lower correlations, regardless of how often assets are valued.
Industrial Diversity
Private markets help investors to achieve more industrial diversity within and between countries and regions. Public capital markets can have heavy weights in particular sectors. European public equity markets offer limited exposure to technology and have a bias to old economy cyclical sectors. The US equity market is heavy on healthcare and technology, which many private equity investors might also find desirable, but US high yield corporate debt has a high weight in energy and gambling, which investors may want to avoid both for cyclicality and ESG reasons. The largest Asian credit market, Chinese corporate debt, has a huge property weighting, where Evergrande has defaulted this year.
Therefore, a passive or index constrained investment into public markets is actually making a big active bet on particular sectors which results in a concentration into certain risk factors. Private investments can help to balance out sector weights and fill gaps where public markets might not offer any exposure. This could even include new sectors that have not even yet been defined in traditional industrial classifications. Social media started out in private companies before they were floated. Cryptocurrencies have only become accessible through publicly listed exchange-traded funds over the past few years, and originally would need to be invested in privately.
Innovation
The number of public companies in the US and Europe has been declining over the past two decades, so private equity and venture capital may offer access to earlier stage and more innovative companies that may stay private for much longer than in former times.
Private equity and venture capital may offer access to earlier stage and more innovative companies that may stay private for much longer than in former times.
As well as investing into companies, with potentially volatile growth paths and valuations, it is possible to buy portfolios of patents or royalties on technologies or drugs, which can provide a more steady flow of income.
Millions of private companies are too small for most public capital markets, but they -or carve outs of their income streams from intellectual property – could offer interesting returns for both equity and debt investors.
Yield Pickups
Private debt and credit can offer higher yields than publicly listed debt of comparable quality and credit ratings. This is partly an illiquidity premium, which makes sense for investors who can hold for longer periods. The level of yield pickup has in some cases come down as more capital is chasing deals in areas such as mainstream European direct lending, but it is nonetheless a spread. For some investors who are constrained to very high credit ratings of AAA in some currencies, private debt might be more or less the only way of avoiding a negative yield. The top slice of a structured credit collateralized loan obligation still offers some positive yield, while the highest rated governments and companies and – even some mortgages – issuing in Euros, Swiss Francs, Swedish Krona, or Danish Krone, will often have a negative yield.
Inflation
Of course, with inflation accelerating and threatening to be more than transitory, the yields on investment grade credits are still negative in real terms, which means that they may fall short of liabilities for pension funds, insurance companies and anybody else who is worried about their purchasing power. Private assets can provide inflation protection. With some infrastructure assets, there is a clear formula linking returns to inflation, which offers clearer and more predictable protection than equity markets. With equities some companies may raise prices faster than their costs, while others will see cost pressures reducing margins.
Real estate faces opposing forces: rents should rise in line with inflation, and can often be indexed to inflation, but if inflation leads to higher interest rates, that could reduce the valuation multiple applied to the stream of future rents. That said, the same would then apply to liquid assets, so in terms of relative value, there is still a benefit in owning real assets.
Impact
Diversification nowadays is not only about investment returns. Investors also want to demonstrate a positive impact in terms of contributions towards the United Nations Sustainable Development Goals (SDGs). Private assets can offer more ways to achieve this, through specific projects focused on renewable energy, water, recycling, and also education and health in developing countries. A few banks may offer limited exposure to microfinance in some countries, but this is generally done on a smaller scale and private strategies are needed to have the maximum impact across the largest number of emerging and frontier markets, in some countries that do not yet have any developed banking system or capital markets. Investors with an appetite for long term economic growth and positive ESG impact will need to pursue private strategies to access many frontier markets.
This article featured in HedgeNordic’s “Diversification” publication.
