Illiquid investments: A holistic approach

In deciding how to invest in private markets, many institutional investors follow a traditional asset class model, whereby illiquidity is spread across different asset classes, such as private equity, real estate, infrastructure, real assets and hedge funds.

The main reason for creating asset classes stems from a desire to group together assets expected to perform a similar role in the portfolio. Our preference is to consider all illiquid investments holistically, in which case investors need to answer two main questions:

• How much illiquidity am I able to accept over time?
• How much of my allocation to illiquid assets should be via return-seeking strategies and how much via diversifying and defensive alternatives?

When constructing private-markets portfolios, we draw a distinction between alpha (skill-focused, return-seeking investment strategies) and beta (diversifying/defensive investment strategies). The split between alpha and beta allocations depends on the investor’s risk appetite and investment beliefs.

Unlike in public markets, there are no simple passive options in private markets. Even strategies that target market returns need an element of skill. As a result, we define them as ‘smart beta’ compared with the ‘bulk beta’ of investable benchmarks of equities or bonds.

Smart beta targets returns from illiquid and off-market portfolios that have attractive risk/return trade-offs. These strategies are supported by underlying market returns and other systematic factors that, by virtue of their risk exposures, carry return premia relative to lower risk portfolios.

A range of smart-beta strategies exist: the key ones are core real estate and core infrastructure, implemented through illiquid funds, co-investments or direct deals. Other long-term smart beta investments include agriculture, timber, natural resources and sustainable investing.

The main characteristic of the smart-beta portfolio is its diversifying and defensive nature. These investments are also often expected to generate current cash yield. Considering the illiquid nature of smart-beta investments, it is also important that they generate returns in excess of those investors could access through the listed passive option, bulk beta. Despite the element of skill involved, smart beta should be priced closer to bulk beta than alpha investments.

Private-markets alpha encompasses those investment strategies that use manager skill as the primary driver of investment returns. The range of value-creation tools for alpha generation is much wider in private markets than in listed markets, and it is natural that investors turn to private markets in search of superior manager skill and higher returns.

As with beta, the alpha portfolio is constructed from various return drivers. However, while sensible diversification principles must be applied, the availability of highly skilled managers takes priority. If there is no adequate skill in an apparently attractive theme, an investor would be better off gaining exposure through a cheaper, more liquid alternative. Identifying a pool of highly skilled, managers who are able to navigate a constantly evolving market environment through portfolio positioning is a key component of a successful alpha portfolio in private markets.

Once the broad differentiation between alpha and beta has been established, investors face the challenge of constructing portfolios of individual investments. The nature of private markets allows investors to take long-term views, explore macro themes and position their portfolios over time to benefit from medium-term trends.

We believe investors should adopt a more agile and adaptive portfolio management framework for alpha and beta in private markets. Adaptive Portfolio Management, compared with a traditional approach, uses a more thematic and flexible method of constructing a private-markets portfolio based on the medium-term outlook for financial markets and various sectors and regions.

Adaptive Portfolio Management focuses on key return drivers and the appropriate diversification of exposures to mitigate risk. It outlines a range of investment themes with a positive medium-term outlook based on an investor’s investment beliefs, and provides broad guidelines around the appropriate composition of the private-markets programme. It also guides investors on execution in terms of the number and nature of the investments (whether via funds, co-investments or direct holdings).

We live in a rapidly-changing world and the ability to ensure portfolio management is adaptive is essential. Our preferred approach has less formality than a pre-determined asset allocation, with correspondingly more focus on regularly changing the priority of investment initiatives and commitments to optimise the risk-return profile.

The figures below illustrate how alpha and beta portfolios may look over time using a thematic approach to investing and diversifying across various return drivers:

Private markets represent a complex area of investment that rewards investors via improved long-term, risk-adjusted returns relative to traditional assets. We believe a holistic approach to portfolio construction is optimal for building and managing exposure to private markets. The breadth of the opportunity set across private markets offers asset classes that provide diversification (beta), as well as a pool of high-quality managers that have demonstrated an ability to deliver returns in excess of traditional equity markets (alpha).

The Adaptive Portfolio Management approach ensures that investors are constantly re-evaluating attractive investment themes and focusing on actively managing their exposures rather than following rigid asset-class guidelines. In our view, this flexibility is necessary to achieve appropriate long-term returns in private markets.

The contents of this article are for general interest. No action should be taken on the basis of this article without seeking specific advice.

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