Information for advice professionals only.
When constructing a diversified portfolio, asset allocators choose investments based on efficiency, aiming to earn the maximum return for a given level of risk taken. Private market assets are considered attractive because of the high returns they can generate, and the opportunity they provide to diversify an investment portfolio away from traditional investments, which can reduce overall portfolio risk. Let’s explore some of these concepts in more detail.
Private market investments typically have a low correlation to more traditional asset classes, as discussed. Many private market assets also provide a hedge against inflation.
Investors have been drawn to the potential returns offered by private markets throughout history. While returns cannot be guaranteed, these assets have the potential to offer higher returns than their traditional counterparts. The caveat: capital is often tied up for much longer periods of time and investments may be subject to a higher level of risk.
Returns are measured in a variety of ways, including relative and absolute returns.
Alternative assets can be categorised as either ‘return enhancers’ or ‘return diversifiers’:
In the investment industry, correlation is the relationship between the returns of two investments. Correlation values can fall between -1 (perfectly inversely correlated) and +1 (perfect linear correlation). Investments that exhibit a correlation of -1 will post returns that move in opposite directions of each other, while investments with a correlation of +1 will move in tandem. Correlations can be calculated at an asset class level (such as hedge funds vs. equity markets), or at an individual investment level (for example, comparing two stocks).
The correlation value is largely dependent on the sources of returns for the two investments in question. The factors that drive equity market prices differ from what drives fixed income prices, buyout fund performance differs from venture capital performance, and so on. Each asset class or investment strategy is exposed to unique risks, so correlations can vary. Alternatives offer lower correlation to the market than traditional asset classes, hence their appeal. For example, real estate investment returns are mostly independent of how the public equity market is performing.
Investors who want to diversify their portfolios seek new investments which display a low correlation to existing assets in the portfolio. Many investors want to safeguard their asset pool, so do not want to expose too much capital to the same risks. If one market (security, asset, investment strategy, etc.) falls, investing in another market with different drivers can offset those losses and provide a more reliable stream of returns.
Private market assets should appeal to long-term investors, rather than those that prefer to use short-term investments to profit from the volatility in stock markets.
The correlation between alternatives and traditional assets can fluctuate as business cycles move from contraction to expansion, but they rarely fully converge. The risk to reward ratio is therefore preferential for investors that incorporate alternatives within their portfolio to spread risk.
Reasons for investing in alternatives vary across asset classes. Preqin regularly conducts surveys with investors in the industry to monitor their views on topics of interest. The chart below shows why investors allocate to each alternative asset class.
| Reason | Private equity | Venture capital | Private debt | Real estate | Infrastructure | Natural resources | Hedge funds |
|---|---|---|---|---|---|---|---|
| Diversification | 68% | 47% | 72% | 64% | 75% | 62% | 63% |
| High risk-adjusted returns | 62% | 45% | 39% | 35% | 30% | 21% | 26% |
| High absolute returns | 57% | 63% | 25% | 15% | 9% | 7% | 34% |
| Low correlation to other asset classes | 20% | 9% | 32% | 36% | 41% | 24% | 39% |
| Inflation hedge | 5% | 2% | 14% | 51% | 54% | 38% | 5% |
| Reliable income stream | 6% | 0% | 58% | 55% | 55% | 10% | 0% |
| Reduce portfolio volatility | 22% | 3% | 42% | 31% | 36% | 10% | 32% |
Diversification is stated as a key benefit across all asset classes, while the various types of returns available mean certain asset classes are more suited to certain investors. For example, real estate and infrastructure are often selected for their ability to deliver long-term reliable income streams, while private equity is selected for its potential high absolute returns.
Information current as at June 2024. This content was produced by Preqin Ltd and adapted with permission by BT Financial Group. This document may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, the Westpac Group and Preqin accept no responsibility for the accuracy or completeness of, nor does it endorse any such third party material. To the maximum extent permitted by law, we intend by this notice to exclude liability for this third party material. The content is based on the best data readily available at the time of creation, however the accuracy, completeness or timeliness of such data is not guaranteed. Content may include general financial information and examples; however, these are for illustrative purposes only, and may not be applicable to your personal circumstances or needs. The content does not constitute financial or investment advice and the content hereunder should not be considered as a substitute for professional advice. Any projections or forecasts presented may involve risk and uncertainty, and actual results may differ materially from those presented, projected or forecast. Past performance is not a reliable indicator of future performance. This communication has been prepared for use by financial planning professionals only. Except as permitted by the copyright law applicable to you, you may not reproduce or communicate any of the content on this website, including files downloadable from this website, without the permission of the copyright owner.