The new 60:40 portfolio

Investors are witnessing a democratization and diversification of the private markets asset class similar to the way Exchange Traded Funds (ETFs) changed stock investing in the early nineties. Demand for private market solutions has risen sharply, with investment managers and investors alike struggling to work through the hurdles to get private capital into the asset class.

Tanja von Erlich, Head of Wholesale, Real Estate & Private Markets

We have entered a new era of investing: geopolitical challenges, higher interest rates and downward return pressure for most capital structures combined with commodity price volatility, and labor shortages. This impacts the traditional 60:40 portfolio of private investors which invests in public stocks and bonds, and has failed to deliver sufficient returns. The outlook isn’t too encouraging. Private markets can be a real alternative to boost returns and reduce portfolio risk. Demand for private market solutions has risen sharply, with investment managers and investors alike struggling to work through the hurdles to get private capital into the asset class. Private market investors are witnessing a democratization and diversification of the asset class similar to the way Exchange Traded Funds (ETFs) changed stock investing in the early nineties. The elusive world of private equity, venture capital and real assets is opening up to private investors. The sticking points for investors had been sky-high minimum investment amounts and year-long lock-ups of money while investment managers grappled with cumbersome operational and client service requirements that made small money an unattractive source of capital.

Both a more friendly regulatory regime as well as innovative products have played a part in the accelerating trend of democratization of private markets. The long-awaited overhaul of the European Long-Term Investment Fund (ELTIF) regime in Europe as well as the newer Long-Term Asset Fund (LTAF) regime in the UK enable private investors to participate in private markets through vehicles with high levels of investor protection.

On the product innovation side, the industry is providing more alternatives to typical private market funds which were characterized by drawdown structures (difficult to administer), multi-million investment minimum amounts and complicated operational processes. In our view, the most notable development is semi-liquid or evergreen vehicles which offer liquidity at periodic intervals, subject to some restrictions. Instead of turning to the secondary market to generate liquidity, these funds allow investors to redeem their shares at net asset value. However, the liquidity provided by these types of vehicles is idiosyncratic and not systemic – in case of a market turndown, the fund will suspend redemptions in part or in full, and investors have to not only be aware, but comfortable with this, too.

Diversifying across multiple asset classes goes back to Markowitz’ portfolio theory and is by no means new. The chief investment officers (CIO)s of US University Endowment Funds like Harvard and Yale have been building portfolios based on this theory for decades. Endowment funds, set up to secure the future of their universities, are funded by donations and investment returns. Their CIOs have a history of leading the charge in new investing trends. They were amongst the first to re-allocate to equities after the 1929 crash, and again the first to pivot large parts of their asset allocation to private equity, private debt, real assets as well as hedge funds in the 1980s. David Swensen was one of the pioneers when he took the helm of the Yale Endowment fund in 1985 and has grown the endowment’s portfolio from the approximate USD 1 bn he started with to around USD 42 bn today. Some endowment funds have consistently outperformed traditional 60:40 portfolios of stocks and bonds year after year. The comparatively high allocation to private markets stands out. Endowment funds also are unparalleled in their access to capital and fund managers and have a long-term investment horizon. Is this the secret sauce for outsized returns?

Endowment funds apply the same tools as other investors, just in a different way:

1. asset allocation – universally agreed to be the number one driver of long-term returns,
2. market timing, which they, like any other long-term investor, stay away from, and
3. instrument selection, i.e. becoming an active investor. Active investors prefer asset classes that are inefficiently priced, operate in opaque markets and rely on a manager’s skill in navigating information asymmetries – in other words, private markets.

Private markets add different return drivers to a portfolio. Take private equity as an example: most companies are privately held, while the main public equity benchmarks consist of just a few companies. For example, companies like Meta and Google first became multi-billion enterprises before going public. But private companies are not easy to access as they are not listed on a stock exchange. Meanwhile, private equity managers pool assets mainly from institutional investors to acquire companies which they aim to sell at a profit.

Figure 1: Allocation to private markets by selected endowment funds

Source: Yale 2020 Endowment Update, Princo website 2023 (https://princo.princeton.edu/about/investment-strategy/), Harvard Management Company Inc., Financial Report FY2023, Stanford Management Company website 2023 (https://smc.stanford.edu/our-strategy/), NTSE is an annual survey of endowments by NACUBO-TIAA (latest 2022)

All the benefits private markets can add to a portfolio come at the cost of reduced liquidity. So defining the right allocation to private markets starts with the question of how much liquidity an investor is willing to trade in exchange for higher returns or lower risk. This determines not only the absolute allocation to private markets but also whether to go with semi-liquid or illiquid private markets instruments. The next step is to consider the desired outcomes in a portfolio context: is the investor looking for a fixed income replacement that can generate yield, or is the focus more on capital appreciation with equity-like returns? Different private markets asset classes score differently in the dimensions yield, capital appreciation and capital preservation. Private equity is the strongest contributor to capital appreciation, while private credit and infrastructure are particularly well suited for capital preservation. Real assets (real estate and infrastructure) are high performers in the yield category. Lastly, individual preferences around sustainability or specific investments are taken into account.

Depending on the factors outlined, the “right” allocation to private markets can be anything between 10-40%, with 20% frequently recommended to an investor with medium risk appetite.

Unsurprisingly, a sizeable allocation to alternative asset classes alone does not guarantee Yale-like returns. Rather, it’s manager skill that will drive performance, as well as access to the best investments at good terms. Private markets is a skill-based asset class and the dispersion in outcomes between top and bottom quartile is significant, and can be more sizeable than for public market investments. This also represents an opportunity for investors who consistently pick top quartile managers – or at least stay away from the bottom performers.

Figure 2: Difference between top and bottom quartile managers (%)

Source: Pitchbook, Bloomberg, UBS Asset Management. Dispersion of fund returns relative to median performance. Data as of September 2023.

Finding the right managers to invest with is more than working one’s way down in the industry league table, as this would imply missing out on new managers or emerging industries with high return potential. The skill differential and qualitative component in the due diligence process is even more pronounced in this segment, which is where a multi-manager platform comes in. The key value-add of multi-manager platforms is that they rival endowment funds in their industry expertise, connections to fund managers and access to exclusive investments. This allows investors to benefit from some calculated bets that will add significant manager alpha to their private markets allocation.

Apart from manager selection, minimum investment sizes are another hurdle. The math is simple: single-manager funds in traditional private markets set-ups have multi-million minimum investment amounts, which implies that investors need to have bankable assets of USD 50m+ to build a diversified portfolio. The newer semi-liquid single-manager solutions have a minimum investment requirement in the USD 25k-250k range, allowing a broader range of investors to participate, but still at high overall AuM levels. With semi-liquid multi-manager building blocks, it is now possible for investors with bankable assets below USD 1m to build a diversified portfolio, as minimum investments are in the same range as for single-manager semi-liquid funds, but investors have access to a diversified basket of underlying managers and investments. This seems like a good place to start for first-time private markets investors.

Furthermore, investors are not only paying the multi-manager platform for guidance on where to invest but also for being able to benefit from their purchasing power and reputation. This can translate into tangible benefits for investors: firstly, it solves the question of access, as many sought-after funds and investments do not accept new investors, unless they come in through the vehicle of a trusted Limited Partner like a multi-manager platform. Secondly, established platforms can negotiate fee savings, take an active role in the development of new strategies and act as anchor investors in exchange for founder investor conditions, or bring down vehicle costs by investing into co-investments which are typically accessed on a no-fee-no-carry basis.

So, next to non-monetary benefits like diversification and access to manager Alpha, investing with multi-manager platforms allows private investors to get in the heavyweight league fee-wise – part of which will go back to the multi-manager platform in the form of management fees.

Semi-liquid solutions sound like a good compromise for investors who are willing to sacrifice parts of the illiquidity premium of private markets in exchange for flexibility. But it’s important to take a close look at the liquidity mechanism of the semi-liquid vehicle in question. Liquidity is typically created on a best-effort basis, meaning that it is idiosyncratic. In the case of a systemic crisis, semi-liquid funds are unable to pay out redemptions.

The recent wave of redemption requests hitting semi-liquid vehicles have become somewhat of a litmus test for these types of solutions. Withdrawal limits – so-called “gates” – are the first bulwark against destabilizing a fund, as private markets assets cannot be bought and sold on demand. Recent events illustrate what happens when redemption requests exceed the withdrawal limits: payouts to investors are deferred in part or in full. Even though this is exactly what a fund should do to protect all other investors, investment managers fear scenarios triggered by a redemption suspension or deferral notice. We have seen some market participants take (short-term costly) action to shore up confidence in their semi-liquid structures by offering preferential terms to big institutional investors who committed to stay invested with a sizeable amount without withdrawal rights. Confidence was restored.

What about liquidity in times of crises? First of all, being unable to redeem fund shares when markets go down avoids selling at the worst possible moment. The probability of not getting the money out in times of crises varies across funds of the same asset class, because there are differences in the way liquidity is generated. The underlying asset allocation is key: a good rule of thumb is to say that direct investments and primaries are less liquid than secondaries. Co-investments sit somewhere in the middle, as they draw capital quite quickly but are concentrated in single investments. The more liquid the private markets allocation within a fund, the less cash a fund manager has to hold on the balance sheet. This is accretive to returns and reduces volatility, so is overall desirable for investors. Leverage on fund level is another item to critically analyze as it can be quite costly.

On the flip side, investors – especially those with a genuinely long term horizon and low liquidity preference – are giving up part of the “illiquidity premium”, when choosing semi-liquid over illiquid instruments. A good middle ground could be to use fully paid-in semi-liquid instruments to gain exposure to the desired asset class more quickly than through illiquid drawdown structures.

We have seen more and more semi-liquid structures emerging recently – from diversified solutions that combine different private asset classes in one instrument, to asset class building blocks. The latter are better suited to fine-tune an investor’s portfolio in line with their preferences. A key selling point for semi-liquid vehicles is that investors can constantly top up investments in an instrument they know and like, if they are pleased with the performance, instead having to find a new home for their assets.

A common concern of investors is that private markets tend to follow public market corrections. Sitting on the sidelines seems like a safer bet. As for other asset classes, time in the market beats timing the market.

We see pockets of opportunities across the asset classes. In a market environment characterized by high interest rates, low GDP growth and inflation, infrastructure, real estate and private credit are particularly well suited to offer downside protection due to the yield component. In some instances, explicit inflation protection is contractually defined, or implemented via pricing power. On the real asset side, in particular in infrastructure, we expect that the secular trends around digitalization, demographic change, decarbonization and, more recently, deglobalization continue to fuel investor demand, as reported in our 2024 infrastructure outlook.

Combined with the inflation protection properties, this is a very interesting space for investors in 2024. We believe that the entire risk spectrum within infrastructure – from yield-focused investments to private-equity like plays – is attractive and has its merit in client portfolios.

Real estate benefits from persistent supply/demand imbalances in sectors like housing and industrial. Additionally, green real estate is becoming an important trend with highly attractive risk-adjusted returns. Research we recently conducted into the two largest office buildings in New York and London finds evidence of a green premium.

For investors who place more emphasis on capital appreciation, private equity secondaries are a good place to invest in 2024. Private equity has always been an asset class that was able to access sectors and themes that are not investable on the public market, like disruptive technologies and impact investments.

Many private markets asset classes were hit by a mild or more pronounced denominator effect in the last two years, which is in the process of easing. Take a situation where an institutional investor has a strategic asset allocation of, for example, up to 10% to private equity. With a public market correction of 20% and no correction on the private markets side, he finds himself overallocated to private equity. Not only can this investor make no new investments in private equity but may also have to consider selling his private equity assets on the secondary market to re-align the portfolio. This an opportunity for investors in private equity secondaries, as these assets can be acquired at a discount.