Does the Private-Asset Trade Still Have Room to Run?

10 August 2022
3 min read

The shift from public to private assets has been a dominant asset-allocation theme over the past decade, but some have argued recently that the sharp decline in public-market valuations and the surge in yields now make that shift to private-asset exposure unnecessary.

We disagree. That claim either displays too much recency bias or denies that the post-pandemic investing world is different. We still see a need to bolster allocations to private assets, though we think future marginal flows will head to areas that have lagged. In previous research, we’ve pointed out multiple reasons to shift to private markets:

  1. A perceived lack of return in public markets
  2. The need to find sources of diversification
  3. The role of private markets in protecting portfolios against inflation
  4. A dearth of young, high-growth companies that choose to list on public markets
  5. Revisiting the Case for Private Assets

How do these reasons stack up after the tumultuous first half of 2022? Clearly, expected returns for public equities and fixed income are higher than they were at the start of the year (note: we’re commenting on the strategic view over several years, not on tactical matters). Still, the long-run context implies lower returns than have been the norm in recent decades, so there’s still a return gap to fill.

As for the other three reasons, if anything, the need for private assets is even greater. As we pointed out recently, we expect both the level and volatility of inflation to be elevated for a prolonged period, so investors can’t take the mutually diversifying properties of stocks and bonds for granted. If bonds are less effective diversifiers of equity risk than they’ve been in recent decades, investors must find more diversification sources.

With private assets, some of the diversification offered is merely a function of the lack of live prices, so its effectiveness is doubtful, However, there’s still a genuine element of diversification in private return streams. If we’ve learned anything in the past six months, it’s the urgent need to protect portfolios against inflation. Private assets don’t have a unique claim on this, but multiple private return streams play important roles.

As we’ve pointed out before, investors’ definitions of inflation protection depends on their time horizons. Investors with short horizons need assets with higher betas to inflation, such as commodities or explicit inflation-protected instruments. But for investors with longer time horizons, we suggest that the key criterion is to find assets that continue generating positive real returns when inflation is elevated—such as real estate, infrastructure and farmland.

The fourth reason for shifting to private assets—the dearth of new public listings compared with one or two decades ago—remains. Thus, earning the equity risk premium requires a larger default level of private assets than in earlier decades.

The Need to Broaden Diversification Sources

In the Display below, we show the trade-off between nominal net return (or cost, if the return is negative) and correlation with equities. Over the past three decades, high-grade bonds occupied a unique place in the upper-left quadrant—offering positive returns and diversification. The abrupt upward shift in yields over the past six months has improved that return potential and will probably push it into positive real-return territory over the next decade.

Net Return vs. Correlation with US Equities
10-year assessments of returns and correlations of various asset types with stocks

Historical analysis and current estimates do not guarantee future results.
Note: The chart uses monthly data since 1990. Private equity, private debt, farmland and timberland series are quarterly, and we match the drawdown periods to the nearest quarter.  We assume a 10 b.p. fee for US 10-year bonds, gold, REITs, TIPS and high-yield bonds. We assume a 20 b.p. fee for long-only factors and a 50 b.p. fee for long/short factors. For timberland, farmland and private debt, we assume a 150 b.p. fee. Multi-asset trend strategy is based on 12-month momentum across equities, fixed income, FX and commodities, implemented through most liquid futures contracts with a 12% annualized volatility target. To calculate annualized return for this strategy, we add back the annualized three-month Treasury bill return and subtract a b.p. fee.
January 31, 1990, through December 31, 2021
Source: Bloomberg, Cambridge Associates, Cliffwater, Global Financial Data, National Council of Real Estate Investment Fiduciaries, Thomson Reuters Datastream and AB

However, this shift must be viewed in context of the range of other return streams available to investors. It’s apparent from the chart that there’s a “frontier” of assets with different trade-offs between return and diversification. No large asset class offers the very attractive prospect of positive return and deeply negative correlation with equities, suggesting that investors need to tap into a range of assets along the frontier as they design portfolios.

We’ve long been skeptical about expected returns on private equity; we expect the average return on the average private equity investment to be in line with that of public equities after fees. Even after applying a significant return haircut to private equity, private assets such as real estate, private debt and farmland are candidates for significant portfolio allocations, in our view. In the context of private assets, we think marginal flows from here will be headed more into areas distinct from private equity.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

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