It may seem like mere semantics, but the words used to describe any investment asset class outside of publicly trade stocks or bonds matter now more than ever before. In 2022, the publicly traded stocks and bonds that make up the standard 60/40 portfolio had one of their worst performances on record. The Bloomberg Aggregate Bond Index lost roughly 13% for the year, the worst performance since it was created in 1976, according to Bloomberg data. The previous worst year had been 1994, when the index dropped 2.9%. Never before had that Index and the S&P 500 been down in the same year. Simultaneously, the S&P 500 finished 2022 down 19.4%, according to S&P
In short, there was no safety net in choosing a 60/40 portfolio in 2022. Equities and bonds sank in lockstep because Fed monetary policy has arguably been the primary driver of public market pricing dynamics since 2008, and 2022 was an extreme example of that trend. The concern for 2023 is that we continue to see a divergence between what the Fed is telegraphing about their rate hiking strategy to control inflation, vs. the market’s implied forward rates curve, and that divergence can lead to volatility.
This has put the focus in 2023 on alternatives, or “alts,” which some investors use as a hedge to broader market volatility. Yet, despite the attention, there remains a haze over “alternatives.” Interestingly, there is no formal regulatory definition for what constitutes an “alternative” investment. “Investors should also be aware that there’s no formal definition of an alternative, complex or emerging product,” according to Finra.
That means there is a vast array of investments—which may (or may not) be a relevant store and/or creator of value—that can technically be considered an alternative investment. Along with the more mainstream alts like real estate, private equity, venture capital, hedge-funds and private credit, we have also seen people put money into sports collectibles, physical metals and gems, art, fine wines, NFTs, and digital coins, and all could be designated “alternatives.”
No wonder there is a broader misconception of outsized risk for alternatives. Indeed, almost all alternative investments are less actively traded and thus offer investors lower liquidity when compared with publicly traded asset classes, and some alts do present a higher risk profile than stocks and bonds both because of this illiquidity but also because of the underlying investment risks. However, that is not the case for all alternatives. In fact, according to data from iCapital, some have proven less volatile, are backed by real assets, and have demonstrated higher performance than their public market equivalents over varying time horizons.
This sub-group of alts are invested in by managers whose strategies involve real assets or businesses in private markets where they can utilize information asymmetries. The manager makes investment decisions using non-public information, whereas there are stricter disclosure requirements in public markets, and thus can create more consistent alpha with less volatility. Private-market managers are investing in companies and asset classes that generate real products, have real-world utility, and often can benefit from value-add business plans. I would argue this group includes private equity, private real estate, private credit, and venture capital.
That’s why it’s time to differentiate between all “alts” and those opportunities that exist in private-market investments. Indeed, the investment community should begin to use more exact language so that private-market investing isn't painted with an alternatives brush.
How are private markets different from other alternatives?
Investor Base
Private markets aren’t exotic. They’re just, well, private. They offer opportunities that typically accredited investors, who have the profile of those who can understand and handle the risk of less-liquid investments, can tap. They are opportunities like private equity funds, direct company investment, real estate, venture capital, and private debt. It is true that some opportunities may be more complex than a stock or bond, but the assumption by regulators is that accredited investors are in a better position to evaluate these investments [(and financially sustain the risk of loss] because of their income, net worth, asset size, governance status, or professional experience.
Regulatory Framework
As the accredited-investor rules indicate, regulators do, indeed, watch over private-market investments. There is a misconception that private-market investments face no regulation. That is not true. While private-market investments are not typically registered with the Securities and Exchange Commission, they are under the agency’s purview. Sponsors of these funds also submit to regulatory scrutiny. For instance, it is a regulatory requirement that the financial firm selling these opportunities completes their due diligence to ensure the buyers are appropriate.
Diligence
In the cases of private equity, real estate, venture capital and other funds, investors aren’t generally only picking the underlying holdings, but also the managers. This allows for two layers of diligence. Investors can look at the track record of the managers or firm sponsor and see the past performance of their funds (understanding, of course, that past performance is no guarantee of future success). Then, they can have a comfort level that the investment team itself will perform diligence on the underlying investments.
Does all that eliminate the risk of investment in private markets? Certainly not. Yet, the combination of sophisticated investors, a regulatory framework, and proper diligence can mitigate the kinds of risks that direct investments in, say, art or digital-asset tokens don’t have. To lump a commercial real estate fund in with an NFT is nonsensical. Not only aren’t they close cousins, but they are an entirely different species.
Words matter, in life and in investments. Financial advisors and accredited investors have a range of offerings within the private markets that may provide a complement to equities and bonds. There are obviously risks to these, but the biggest risk may be that investors are avoiding these assets because the language around them—not their utility—keeps them out of portfolios.
Thomas Carroll is chief executive officer of Ballast Rock Group.