One chart to make you rethink your approach to private markets

 
It’s not unusual for investors to take a diversified approach to bonds and equities but rely on a single manager for their private market allocation. Here is a chart that turns that approach on its head.

Most investors are familiar with the concept of diversification. We know that if we put all our eggs in one basket our returns will experience high volatility, but if we spread our investments across several different investments, we’ll reduce the volatility of returns. In fact, diversification is such a key component of share investing that the Cambridge Dictionary even refers to the stock market in their definition of ‘diversify’: People are advised to diversify their investments in the stock market to reduce risk.

There are two types of markets investors access, public markets such as equities and bonds, and private markets. Private markets include private equity and private credit.

Private equity is the ownership or interest in a corporate entity that is not publicly listed. There are different types of private equity investment. It can involve taking control of a company either through outright purchase or through obtaining a controlling equity interest in a company (known as a “buyout”). Private equity can also involve taking a stake in the early stages of a growing business.

Private credit companies generate income by lending to and investing in non-public businesses using a variety of sources, such as debt and hybrid financial instruments. In short, they provide capital to small and medium-sized private businesses, and in turn, give investors access to the growth and income potential of private credit that are generally exclusive to large institutions and difficult to access.

While many investors are likely to have diversified equity and bond portfolios. It is likely that those investors with an allocation to private markets invest via a single manager, often via a listed investment trust (LIT) or a wholesale managed fund. We think such a concentrated exposure is dangerous and this chart Blackstone recently published shows why.

Chart 1: The range of outcomes is much wider across private managers than for public managersThe range of outcomes is much wider across private managers than for public managers

Source: Blackstone, Morningstar, returns are over a five-year period from 1/10/2018-31/9/2023 (Open-end funds): Public Equities (US Large Blend); Public Fixed Income (US Intermediate Core Bonds); Public Real Estate (US Real Estate). Preqin, returns are for 2018 vintages that have last reported between 30/9/2022-30/9/2023. (North America, Closed funds): Private Equity (Buyout), Private Credit (all Private Debt strategies); Private Real Estate (Co-invest, Core, Core+, Debt, Value Added, FoF). Investments in less liquid private market strategies are by nature risky and typically involve a high degree of leverage. The returns indicated above are long- term and represent well-known asset class indices and are not meant to be predictive of the performance of any particular fund, nor are they meant to suggest that all private funds result in positive returns or would avoid loss of principal.

If the goal of diversification is to mitigate losses while having meaningful exposure to the upside, the chart above shows that investing in a single private equity or single private credit fund is like picking a single stock: you could pick the best performer and the payoff is huge. But you could also pick the worst performer, in which case, you are missing out on the potential of higher returns of other managers in the asset class.

Innovative approaches in indexing and ETFs allow investors to diversify into private markets via a single trade and the benefit is increased price discovery and liquidity.

VanEck’s listed private credit ETF (LEND) and its listed private equity ETF (GPEQ) allow investors to diversify into these markets and mitigate the ‘manager pick’ risk. GPEQ is a diversified portfolio of 50 listed companies that provides targeted exposure to venture capital, growth and buy-out opportunities while LEND is a portfolio of 25 of the largest listed companies involved in private credit.

A by-product of ETFs, and the indices they track, in these asset classes is increased price discovery and transparency.

LEND and GPEQ each track indices calculated by LPX group. These indices allow investors to see the performance of a proxy global private credit or proxy global private equity exposure. They provide an indication of the overall health of the markets.

And we have seen this play out over the past few years, indices have provided a good guide as to the direction of many private assets, such as those owned by large superannuation funds, when they are ‘revalued’ to the current market price.

The choice between public or private markets has profound implications. In public markets, liquidity and transparency provide immediate price adjustments but also expose investors to volatility. Conversely, private markets can offer higher returns due to less competition and the illiquidity premiums, but require a long-term investment horizon, have less frequent price feedback and limited liquidity.

We think innovations in indexing and ETFs are changing this dynamic. Irrespective of which market you invest, diversification remains key. Diversification by names, sectors and managers. Because of the disparity of returns among managers in private markets, we would argue manager diversification is more important in private markets. And that is where ETFs are helping investors to access those opportunities.

Key risks

An investment in our global listed private credit ETF carries risks associated with: listed private credit, listed private equity, interest rates, credit/default, currency hedging, ASX trading time differences, financial markets generally, individual company management, industry sectors, foreign currency, country or sector concentration, political, regulatory and tax risks, fund operations, liquidity and tracking an index. See the PDS for more details. An investment in our global listed private equity ETF carries risks associated with: listed private equity, ASX trading time differences, financial markets generally, individual company management, industry sectors, foreign currency, country or sector concentration, political, regulatory and tax risks, fund operations, liquidity and tracking an index. See the PDS for more details on risk.

Published: 18 May 2024

Any views expressed are opinions of the author at the time of writing and is not a recommendation to act.

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