Financiers worldwide will let out a mass sigh of relief as 2022 came to a tumultuous close. Portfolios that comprised 60% stocks and 40% bonds lost an eye-watering 17%, their worst performance since 1999. Equity valuations – which were 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 2023, although it proved anything but eternal. Optimists hailing a fast-approaching peak in interest rates and a miraculous “soft landing” were duly punished as the economic data pointed to adhesive levels of inflation and a stubbornly hawkish Fed. The ensuing recalibration of expectations dragged markets through another bout of anxiety, only for investors to be assaulted, yet again, by a veritable banking crisis. Suffice it to say that black swans have somewhat lost their intrigue now that global markets have been attacked by a veritable flock.
Given the relentless market gyrations, juxtaposed with a relatively slow-moving corporate landscape, it appears that financial markets are broadly relying on sentiment rather than fundamentals, for their marching orders. Somewhat more concerning though has been the failure of fixed income to cushion the dramatic mood swings of equity markets. Equity–bond correlation spiked from near zero in 2021, to nearly 0.4 in 2022, as bond markets demonstrated volatility not seen (unsurprisingly) since 2009.
Of course, whilst the events of the last 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 (or “alts”). Whilst all investor groups are expected to upsize their exposure to alternative assets, non-institutional investors are increasingly being coached by advisors and private banks into treating this asset class as a core allocation, rather than tactical positioning. Whilst alternatives encapsulate a variety of asset classes, the majority of airtime has been given over to private markets.
Global investors are driven by the 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 the US public equity market, where increasing flows of capital has been looking for a home in a shrinking set of publicly traded companies. The number of companies listed in the US shrunk by around 40% between 2000 and 2020; meanwhile, the market cap of the US equity market rocketed to over USD 40 trillion 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 the market.
Against this backdrop, private markets have consistently produced returns in excess of their 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: whilst both offer similar returns, 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 their portfolios across two axes, liquidity and risk, in order to reduce relative risk without having to sacrifice returns.
Of course, investors in private markets should carry a heightened awareness of the dangers of this asset class, which is well known for its opaque mechanisms, from valuation to reporting, and its layered expenses, ranging from transaction fees to performance fees. It would also be naïve to think that private markets are a safe haven from the volatile market sentiment that proved a hallmark of the last three years (simply consider the spectacular blow-up of crypto platforms, like 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, whilst liquidity will always be valued at a premium, the slow, but comparatively predictable, returns afforded by private markets will bring a welcome calm to whiplashed portfolios and weary investors.