Whether clients have seen their investment portfolio returns keep up with the rising cost of living in recent years is largely a function of how much—or how little—exposure they’ve had to cash instruments and traditional fixed rate bonds; investments typically considered “safe” in the realm of portfolio construction. Over the trailing five-year period, where inflation has increased 23% cumulatively based on the CPI Index, T-bills have returned 11% and bonds -1%. Global equities have had bouts of volatility during that stretch, including two bear markets in 2020 and 2022, but overall have returned 61%, far outpacing inflation.
Further complicating matters, bonds have failed to live up to their reputation as a ballast against equity market volatility in recent years, as inflation and central bank policy has led to positive correlations between the two asset classes. And while the rate-of-change of inflation has abated since its peak in 2022, the post-Covid economy—and some of the painful whipsaws of traditional stock and bond portfolios during this period—will remain fresh in the memories of advisors and their clients for years to come.
Strengthening Portfolio Resilience
How can advisors construct portfolios that generate returns over the long-term and buffer against market volatility in the near-term? For some, portfolios that combine public market investing with alternative investments are the answer. Surveys shows that advisor adoption of this approach is on the rise. In early 2023, research by Cerulli indicated that high-net-worth clients had an average of 9.1% of their assets allocated to alts, up from 7.7% in 2020, with advisors expecting allocations to increase to 9.6% by this year.
The 2022 and 2023 calendar year experience illustrates the stability of private markets. During these two tumultuous years, private equity declined only 3.4% and private senior loans did not print a negative return. Private real estate cushioned portfolios nicely through the first 3 quarters of 2022 up 13% but digesting higher rates has led to a decline of 16.4% through 2023 year-end. However, that pales in comparison to the 37.4% drawdown in listed REITS during the period.
There are also some investment opportunities that today can only be accessed in the private market. Farmland, as an asset class, offers an instructive example. Getting exposure to such assets can build more unique return drivers into portfolios.
How To Combine ‘Apples And Oranges’
Publicly traded investments are well suited to established portfolio construction methodologies aiming to maximize risk-adjusted return: Riskier assets generally trade with more price volatility than less risky assets. To estimate the risk and correlation of a public asset class to other parts of the portfolio, there are often multiple, if not dozens, of long-tenured market indexes available.
In private markets, however, historic asset class returns are less widely available as, for example, those of the S&P 500 Index or the Bloomberg U.S. Aggregate Bond Index. For those areas that do have well-established return series, such as private real estate and private credit, they can be challenging to interpret alongside public market indexes because they are based on surveys of periodic valuations, not traded market prices. How does one estimate the risk and correlation of a private market asset class, that can’t be redeemed daily, on an apples-to-apples basis with publicly traded investments?
How Does It Work?
Analytical approaches that look “under the hood” of a prospective portfolio—quantifying how the underlying holdings of both public and private strategies fit together—can illuminate true diversification opportunities. In the portfolio analysis sessions that my team conducts with dozens of advisors each week, we estimate the exposure of each holding to different risk and return factors, with the analysis fine-tuned by the addition of specific forward-looking capital market assumptions.
With knowledge of holdings’ exposure to various factors—combined with a look at each factor's historic risk and return in different scenarios—an accurate picture of the portfolio’s expected risk behavior can emerge. For an advisor, offering a credible forward-looking perspective—not just an assumption that what happened in the past will happen again—provides a whole new dimension to building portfolios of both public and private markets.
Recent market and macro-economic turbulence heightened the private assets opportunity, but their systematic deployment is clearly here to stay. Whether incorporating private credit to meet a client’s income objective, or more thematic exposure to the low-carbon energy transition, today’s tools allow advisors to have more robust client conversations around incorporating private markets into portfolios.
Brian Griggs, CFA, CMT, FRM, is managing director and head of Nuveen Portfolio Strategy Group.