6 days ago
Enhancing portfolios with private-market assets
[SINGAPORE] In 1985, Yale University Endowment appointed a young David Swensen to become its chief investment officer. From that year until he passed away in 2021, he took the Yale Endowment from US$1 billion to over US$40 billion in assets, despite disbursements of 5 per cent every year, and achieved an unprecedented average annual return of 13.7 per cent over 25 years.
The terms institutional investing and endowment investing are so closely associated with him and Yale that they are sometimes even called his method the Yale model or the endowment model of asset allocation and investing.
One of the key pillars of such a successful strategy was not only the portfolio's heavy equity bias over fixed income and commodities, but also what was at the time a revolutionary idea: The thesis that the Yale endowment held at its core was that liquidity was a bad thing, as you paid a heavy price in the form of lower returns. Cash or deposits are a drag on long-term returns.
This is why the Yale model pursued a heavy allocation to private markets, especially private equity (PE) and venture capital early on, and excess returns were harvested from its illiquidity premium. The idea was that, by giving up liquidity which you don't need for your long-term savings, you can generate higher returns without necessarily taking more risk, or you may reduce risk in the form of the volatility of returns.
Asset allocation drive most of the return
Many studies show that up to 90 per cent or more of long-term returns are driven by asset allocation. What that means is that it isn't the stocks you buy that matters, but how much of the portfolio is in equities versus other assets such as cash, fixed income, commodities and alternatives such as PE, private credit, private infrastructure and hedge funds.
The systematic factors behind each asset drive long-term returns. Assessing the risk and return of each asset class determines the risk your portfolio is exposed to, and the returns generated in the long term.
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Exposure to alternative assets such as PE and private credit has been shown to lower the level of realised volatility.
Many people take risks that are not compensated or rewarded, by punting on stocks or trading crypto. One must always be compensated for the risk one takes in the form of returns that are consistent and realisable. The consistency of long-term returns on traditional and alternative assets make them appropriate as core holdings in an individual or family portfolio.
More opportunities in PE?
As at 2024, there were 20 times more PE-backed private companies than companies listed in the public markets. Around two-thirds of all corporate revenue was generated by private companies, with the remaining third coming from public companies, including familiar names like Apple, Nvidia, Microsoft, Amazon and Google.
Without an investment in private markets, you miss out on a significant part of global corporate growth. Research from Nobel-laureate Professors Eugene Fama and Kenneth French suggests that small companies tend to generate better returns because of the lower base from which they start; not investing in this category means the ability to generate excess returns is diminished.
By investing in a private-market fund, you get exposure to a broader investable universe, as well as more active management of the underlying portfolio companies. In private companies, shareholders can help improve or restructure the business to create value; in contrast, shareholders of public companies don't have much control over how the business is run.
With the advent of open-ended, evergreen fund structures, there is no need to take the additional credit risk of a single-vintage, closed-end fund and the higher concentration risk that arises from investing in a narrow pool of companies. Investing in a multi-manager portfolio further diversifies risks.
The three main reasons for investors to consider investing in alternatives are to achieve greater diversification through uncorrelated returns; to bear lower volatility and risk; and to improve systemic returns by, for example, harvesting the illiquidity premium.
The global public equities market has returned an average 7 per cent per annum over a multi-decade period. There are only a few ways to improve returns above the public-equity beta over a longer-term period. These include harnessing i) alpha, ii) illiquidity premium, and iii) leverage.
There is a higher chance of alpha generation in private opportunities that are available for a smaller pool of assets. There may also be greater flexibility in achieving alpha in the absence of benchmarks, or in the case of hedge funds, the use of shorts and derivatives. It also has an illiquidity premium – that is, long-term capital that does not need to be withdrawn can demand higher returns from companies that need funding.
Alternative investments tend to have lower volatility than the public markets, as PE firms would value their funds (mark to market) less frequently, often based on 'events' such as the pricing of the company's latest fundraising round.
We talked about the diversification benefits of a much deeper pool of private companies that are otherwise not available in public markets. There is also greater flexibility to include sectors that are harder to access, such as aircraft leasing, ownership of sports franchises and intellectual property.
Will private market assets become more broadly available?
In March, the Monetary Authority of Singapore sought feedback on a proposed regulatory framework for retail investors to invest in private market investment (PMI) funds, providing them with a wider set of investment choices. If done right, we believe this is a positive step towards democratising access, making private assets available to all investors regardless of their income and the amount of assets they own.
However, we feel it does require greater effort in educating those new to the asset class. A trusted financial advisor becomes even more important to ensure that the investment is suitable. Again, we must ensure that the appropriate risk is being taken and that investors will be rewarded with better outcomes commensurate with the risk they are taking.
Private markets open up an opportunity for individual investors to reduce volatility and protect capital, or improve returns and outcomes for their investment goals – as long as the investment horizon matches their goals and is long-term enough to reap the benefits of investing in illiquid assets like PE. That would truly allow an institutional or endowment style of investing for all of us.
Samuel Rhee is co-founder and chairman, and Hugh Chung is chief investment officer at Endowus, a digital wealth platform with over S$10 billion in client assets across public and private markets and pension (CPF and SRS) funds.
