This question is one that savvy investors ask often. Throughout their lifetime, as their needs evolve, they’ll regularly review their asset allocation. When they do they’ll consider different asset classes and sectors, ensuring they maintain a balance of risks.
For the most part, though, high net worth individual (HNWI) portfolios allocate less than 5% towards private markets. This is in sharp contrast to the strategies of leading institutional investors, who will often allocate 40% and sometimes far, far beyond.
So should you follow the example set by institutional investors? After all, there’s something to be said for investing more in private markets during this time of macro-economic flux.
First, plenty of empirical evidence shows that if you have the courage to invest in a troubled economic landscape, you stand to benefit. Fortune favours the brave, as they say – in this case with increased upside.
Second, during turbulent periods, fortune also has fair words for the well informed. Few investors have all the expertise and time they need to manage the details of their entire portfolio, so it’s useful to invest with a professional fund manager whose interests align with your own. Crucially, what they allocate to the private market will be shielded from the day-to-day volatility that’s so present in public markets right now.
If it’s a good time to reconsider your asset allocation to private markets, what percentage should you opt for?
To make decisions about liquidity, you need to consider lifestage
When it comes to individual investors, lifestage is almost always the most prominent factor in asset allocation. This is primarily because the closer you are to retirement, the sooner you’ll need your investments to replace your employment income.
Of course, if you can derive enough income from your retirement portfolio, you won’t need to sell your assets during retirement, but for most this won’t be possible. Instead they’ll eventually chip away at their assets, reducing the size of their portfolio to add weight to their income.
So ask yourself: what life stage am I in? The further you are from retirement, the more illiquid your investment portfolio can be. You wouldn’t worry about not being able to access your pension pot before you reach your defined pension age. So what’s the point of trying to ensure you can sell your entire portfolio at any time, unless you’re at the lifestage when you need to?
If you’re investing solely in liquid assets, you’re missing out on the advantage and upside of private markets. Surprisingly, this is what many wealthy, sophisticated investors are doing – on average, less than 5% of their portfolios are made of assets they can’t sell on a daily basis. That said, this trend is rapidly changing.
Many are recognising the value of an illiquidity premium. In other words, the longer you need to commit to not selling an asset, generally speaking, the more lucrative the return should be.
Leading private equity, private credit and real assets can be expected to earn anywhere from 0.5-5% more per year than similar but liquid assets. Compounding over the course of a decade, that can make a very significant difference to your overall return and income.
But would you want to lock into an asset for a decade? Well, consider whether you want to actively trade assets every day. Very few people do, either because they don’t have the knowledge or, more likely, the time. Most investors leave their liquid assets idle for a long period anyway, but they still pay a high opportunity cost, missing out on the extra gains that can come from private markets.
What do sophisticated investors do?
As we’ve drawn attention to before, we can learn a lot from the Yale endowment when it comes to asset allocation. In the 1980s, before Swensen radically changed the investment strategy at Yale, the endowment invested mostly in liquid assets, and it was underperforming. Today, over 80% of the endowment is invested in private and alternative assets.
The top 5-10 US endowments like Harvard and Princeton take a similar approach to Yale. Pension schemes are following suit too. The Canada pension plan is an open defined benefit pension scheme serving all Canadians, and it has pushed its private and alternative investing to over 50% of the total portfolio. Similarly, the UK’s largest private sector pension scheme, Universities Superannuation Scheme, is targeting 25-30%.
Of course, institutional investors like Yale have a perpetual investment horizon, so they can behave a little differently to individuals. But while perpetuity is far longer than an individual’s 20-70 year investment horizon, as soon as you’re measuring that horizon in decades, there isn’t much difference. If individuals do not need their assets in the next five years, there’s no reason they can’t invest more in illiquid assets.
So why don’t more individual investors follow in the wake of these institutions? Well, it comes down to knowledge and access.
There are constraints… but wealth shouldn’t be one of them
Everyone should have the opportunity to invest in illiquid assets. Too often access is only granted to those who can afford a £10m minimum investment.
Instead of wealth, the determining factor in your asset allocation should be time and need. If you’re investing so that you can build up enough capital for your children to go to university, then your portfolio’s illiquidity can be based upon whatever the difference is between your oldest child’s age and 18. Or 19 if they’re going to take a gap year.
In a family office, time and need might factor in 30-40 beneficiaries over multiple generations. Individual circumstances will inevitably vary, but the same principles broadly apply.
Ultimately, it’s safe to say that just about everybody can invest more than 0% in private markets. While the exact percentage will depend on your circumstances, that number will likely lie somewhere in the region of 5-80%.
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