To effectively invest in private vehicles, financial advisors and clients must avoid buying into common myths about their returns and correlation with public funds, a Morningstar study said.
So-called semiliquid investment assets such as private equity, private credit, venture capital, real estate and other alternative vehicles require horizons of at least seven to 10 years and careful scrutiny of any managers' claims that higher returns will justify their bigger expenses, the independent research firm said in
Morningstar's study argued that, as investors and advisors consider asset managers' sales pitches, they should keep in mind that, for example, private equity funds bring diversification that is "hard to quantify and arguably overstated at face value." These funds offer opportunities to expand stock allocation beyond publicly traded ones, rather than providing "market-neutral" exposure, the study said. While the draw of potentially higher returns and diversification in a time with fewer publicly traded companies is understandable, authors Sam Hui, Francesco Paganelli and Chris Tate prescribed some rules for evaluating any semiliquid investments.
"Contrary to common marketing claims, semiliquid strategies often carry traditional equity or credit risks and are not suitable to play the role of portfolio diversifiers," they wrote. "Most semiliquid funds should be seen as expanding the equity or credit opportunity set rather than adding new risk factors. To genuinely reap the benefits of semiliquid funds, investors need three things: patience and long-term mindset, a return premium to compensate for complexity and illiquidity and proficiency in selecting the right managers. We suggest four key steps to drive portfolio construction: setting expectations on risk and returns; ensuring alignment across fund structure, assets, and investors; sizing the footprint; and building the portfolio."
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Preaching to the advisor choir
Advisors on the receiving end of industry marketing have been educating clients about alternative investments with many of these principles in mind.
Problems for investors often arise from the simple fact that many simply don't grasp "how the vehicles actually work," according to Kevin Thompson, the founder of Fort Worth, Texas-based 9I Capital Group. Many alternative managers are turning to retail clients because they're
"They're trying to raise capital," Thompson said of private equity funds. "At the end of the day, the average investor doesn't need something like this, in my humble opinion. The average investor is doing fine in something like index funds."
In the current conditions, fiduciary planners' due diligence of alternative vehicles is guarding "all the chickens in the henhouse," said Peggy Haslach, head of the Tukwila, Washington-based office of Planning for Good.
"A lot of advisors will try to solve clients' problems with what's new and hot and everybody's talking about, but, at the end of the day, is it really the right choice for that client?" she said. "Everyone is so fee-sensitive these days, so why would you put somebody in something like that?"
The fact that giant companies such as OpenAI and SpaceX "are staying private longer" has led to "a semiliquid paradigm shift," said Devon Drew, founder and CEO of AssetLink, a data-driven distribution service connecting asset management firms with advisors and wealth management companies. With higher fees, though, advisors and investors "should only swim in the deep end" if the returns "justify the complexity and illiquidity," he said.
"Fees are definitely high," Drew added. "The position must be sized carefully to really avoid eating an entire portfolio's alpha."
Such warnings stem from the simple math equation at the heart of any investment portfolio between costs and profits.
To deliver that "illiquidity premium" over public investments, private vehicles' returns must surpass them by at least 2%, according to an investor survey cited in Morningstar's report. And, besides long investment horizons,
Many semiliquid products also collect performance fees, and, if they have holdings in other funds, another layer of manager incentive costs, which make their prices and bottom-line returns even more difficult to decipher. At the same time, private equity "returns tend to correlate with public equity market returns, especially at the extremes," the report noted.
In other words, higher fees aren't always worth it.
"Setting realistic return and risk expectations means acknowledging that private assets aren't magically less volatile; rather, pricing lags smooth the data," the Morningstar report said. "Illiquidity, rebalancing limits and steep fees all shape how much private exposure a portfolio can handle."
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Helping investors understand the product lineup
With that context, the authors lined up the most common forms of private assets with comparable vehicles. Private equity and venture capital "are best considered as part of a portfolio's equity allocation, consistent with a total portfolio approach," while direct lending or other private credit vehicles bring "similar credit risk exposures as traditional corporate bonds and [fit] best within a broader fixed-income allocation," the report said. More effective diversification benefits show up in other kinds of private assets, the authors argued.
"Strategies that seek to deliver positive returns in most markets while focusing on capital preservation are still a niche segment of the private or semiliquid fund space, however, as they remain the purview of hedge fund managers," the report said. "This objective holds clear appeal in the context of a diversified portfolio. Translating that into the illiquid or semiliquid asset space is tricky. The best-placed strategies to offer inflation protection and some defensive traits are illiquid real assets such as infrastructure and real estate, specifically the most conservative subsectors, so-called core infrastructure or prime real estate. These asset classes' structural characteristics, scarcity, irreplaceability, long-term cash flow visibility and inflation indexation, make them fit for a protective function. That said, as real estate has experienced in recent years, public markets and macroeconomic factors still have a big say in returns."
Redemption requests that inevitably rise when portfolios are declining in value can lead, ultimately, to forced sales of assets and fund failures. Taking steps such as enforcing a "fee budget" or bearing in mind that venture capital represents "the most illiquid end of the private market spectrum" can help advisors steer clients away from costly mistakes, the report said.
"There is no free lunch investing in private assets," the authors wrote. "Higher returns often come with higher risks. A situation where a portfolio's expected risk falls while its expected return rises warrants great caution and reflection on the underlying assumptions. Diversification benefits from private assets in a public stock/bond portfolio may exist, but it should not be rooted in the limited pricing data for private assets."
