Given their breadth, this relatively predictable market can provide untapped opportunities for diligent portfolio managers.
Financiers worldwide let out a mass sigh of relief as 2022 came to a tumultuous close. Portfolios that comprised 60 per cent stocks and 40 per cent bonds lost an eye-watering 17 per cent, their worst performance since 1999. Equity valuations — propelled to frothy highs in 2021 — came crashing back to earth when confronted by a new regime of central bank tightening.
Hope sprung in the early weeks of 2022, though proving anything but eternal. Optimists, hailing a fast-approaching interest rate peak and miraculous ‘soft landing’, were duly punished, as economic data pointed to adhesive inflation levels and a stubbornly hawkish Fed. The ensuing recalibration of expectations dragged markets through another anxiety bout, only for investors to be assaulted by yet another banking crisis.
Given these relentless market gyrations, set against a relatively slow-moving corporate landscape, financial markets appear to be relying more on sentiment than fundamentals. Somewhat more concerning was the failure of fixed income to cushion this dramatic market mood swings. Equity–bond correlation spiked from near zero in 2021 to nearly 0.4 in 2022, as bond markets demonstrated volatility not seen since 2009.
Of course, while the events of the past three years have left many with elevated blood pressure and receding hairlines, they have also proven incredibly useful as a test case for asset allocators. The stoic investor will now be absorbing these lessons, hard learned, in a bid to better navigate the cycle ahead.
One of the key takeaways, almost universally recognised, is the value of ‘systematising’ one’s allocation to alternatives, also known as ‘alts’. While all investor groups are expected to upsize exposure to alternative assets, non-institutional investors are increasingly being coached by advisers and private banks into treating this asset class as a core allocation, rather than tactical positioning. Although alternatives encapsulate a variety of asset classes, the majority of airtime has been given over to private markets.
The end of easy alpha
Global investors are driven by pursuit of alpha — or excess returns over a broader reference market — which has been increasingly difficult to achieve in public markets. To understand why, one might turn to US public equities, where increasing capital flows have been looking for a home in a shrinking set of publicly traded companies. The number of companies listed in the US shrunk by 40 per cent between 2000 and 2020; meanwhile, market cap of US equities rocketed to more than $40tn over the same period. This dynamic has both pushed up baseline valuations and siphoned obvious mispricing out of the market, making it far harder for active managers to outperform.
Against this backdrop, private markets have consistently produced returns exceeding public market counterparts. This return premium is often, mistakenly, ascribed only to the greater risk assumed; but this betrays a tendency for investors to conflate risk and illiquidity. To unwind this perception, one might compare the syndicated loan market with the private debt market: both offer similar returns, but the former provides more liquidity, whereas the latter typically provides more stringent covenants and, therefore, lower risk. This illustrates how sophisticated investors are now able to diversify portfolios across two axes, liquidity and risk, to reduce relative risk without sacrificing returns.
Balancing consideration with conditions
Of course, investors in private markets should carry a heightened awareness of the dangers of this asset class, well known for opaque mechanisms, from valuation to reporting and layered expenses, ranging from transaction fees to performance fees. It would also be naïve to think private markets are a safe haven from volatile market sentiment that proved a hallmark of the last three years. We simply need to consider the spectacular blow-up of crypto platforms, such as FTX, and the exorbitant valuations once ascribed to ‘pre-IPO’ companies like Klarna and Instacart.
Accordingly, investors must balance consideration for current market conditions, without being overly reactive to near-term noise. Given the breadth of private markets, this diligent approach need not markedly reduce the opportunity set. Investors have the option to tilt towards sub-asset classes that are well positioned to provide near-term protective features, without sacrificing exposure to long-term trends. One current example is the fast-growing infrastructure vertical, where investments are typically ‘needs-based’ assets, throwing off inflation-indexed returns. In addition, infrastructure is at the forefront of the worldwide energy transition and is, therefore, the beneficiary of long-term regulatory tailwinds.
Doubtless, the next few years will see private markets form a more structured component of private wealth portfolios. This evolution will allow traditional portfolios to escape the gravitational pull of market beta and, consequently, soften performance volatility.
Sure, critics will accuse private market managers of ‘volatility laundering’, owing to infrequent mark-to-markets and low pricing transparency, but this awards too much credit to public market pricing. Given that listed market valuations shift far faster than company fundamentals or economic conditions, it stands to reason that pricing is largely a function of mercurial investor sentiment, rather than long-term corporate prospects. So, while liquidity will always be valued at a premium, the slow, but comparatively predictable, returns afforded by private markets should bring a welcome calm to whiplashed portfolios and weary investors.
Michael Ostro is head of Private Markets Group Asia at Union Bancaire Privée (UBP)
