Finding the picks that deliver superior performance in the private markets is tricky.
There’s an absolute tyranny of choice in alternatives, with half a million private companies. Compare that to a shrinking public market with about 4,000 companies listed on public exchanges. The gap has been widening, with the number of public companies dropping by more than half since the late 1990s. Today, we see more companies staying private longer and sometimes never making it to an IPO but exiting through mergers and acquisitions.
All that choice means you can get a wide range of outcomes from private market funds compared to funds limited to the public market, where even the poorest performers may be a percentage point or two below the best funds. Top-quartile private market funds return a net IRR above 19%, while the bottom funds underperform the public markets, with a net IRR of around 3%.
This makes manager and fund selection critical to the success of an investment. It’s not just about investing in alternatives, but high-quality alternatives. A poor choice here can be costly, with some bottom-quartile funds underperforming similar investments in public markets.
You need to identify the right partners and take a long-term view to be successful in private markets. The right manager will generate returns across market cycles. Finding these individuals requires building a proper vetting and selection framework. You must understand the team dynamics and investment process and dig into how a team maximizes returns through portfolio management.
It takes time to build an alternative strategy comprising numerous asset classes across vintage years. You need industry experts to help you go more profound than the investment prospectus. You need to invest in technology and databases such as Preqin to help track managers, understand vintage years, and see who the top managers are year in and year out.
Track record is essential, but it’s important to understand the actual alpha generated by the team instead of what’s just from the market. Many factors are at play, including strategy, team, talent, sourcing, etc. Try to look through the funds to the portfolio company level to understand the sector and geographic exposures. It’s not science, and it’s not art – it’s a combination of the two.
Fees are necessary, but it’s more around how they’re structured than the absolute amount. Ask yourself these key questions:
Many focus on the percentage the GP contributes to the fund. Still, it’s essential to look at that from the GP’s perspective and see whether it’s a meaningful amount for them, given their financial situation. This naturally won’t be the same for a veteran established manager who has earnings from previous funds as it will be for an emerging manager striking out on his own.
Building an alternative strategy takes time. You need the patience to invest a lot of effort in finding the right partners for you and then correctly monitor your program. Building that infrastructure and technology to identify outstanding fund managers while maintaining oversight of performance and things like cash flow and capital calls is challenging.
This is where Gridline comes in. Our investment process and platform help you quickly discover managers that will outperform while making performance reporting and treasury management as easy as checking your stock portfolio. Our products let you tap into the resources you need to quickly and efficiently build a diversified portfolio of alternative assets without spending years building relationships and learning from failed investments.
Historically, there’s not one world of investments but two: One for individuals and one for institutions, primarily separated by disparities in access to private alternative assets, resulting in differences in portfolio mix and performance.
This article will explore these differences and how individuals can gain the advantages of typical institutional portfolios.
Institutional investors refer to pension funds, sovereign wealth funds, foundations, and endowments with large amounts of investable capital and long-time horizons. In contrast, while some individual investors have long time horizons, the amount of investable capital rarely competes with the levels managed by institutional investors. For this reason, private investment funds seeking capital typically target institutional investors, resulting in one of the main differences between individual and institutional portfolios: access to top-tier private alternative funds.
As mentioned above, institutional investors manage large pools of capital. They can use economies of scale to source, analyze, conduct due diligence, and select private alternative investments. And due to their large pools of capital and sourcing capabilities, institutions have better access to the most lucrative private investment opportunities.
In commercial real estate, “institutional quality” refers to investment products in core markets that wouldn’t be accessible to individuals, like a high-rise apartment building in Tokyo or an office building in Manhattan.
Institutions also have a significant advantage regarding private equity (PE). Sourcing a PE deal typically takes around one year, three team members, and filtering through 80 or more opportunities. Institutions are capable of high-quality PE origination, while most individuals are not. According to GIIN data, an investing pipeline may look like the below.
Further, institutions have access to better information than the average individual, fueled by their expertise in quickly trading on new market information and better technology for due diligence.
For example, the Bloomberg Terminal provides fundamental quality analysis that’s objectively superior to most of what individuals have access to. Further, institutions take advantage of High-Frequency Trading algorithms that give them an advantage when it comes time to place a trade.
Beyond technological advantages, institutions also have more valuable information networks, which often include direct contact with company management.
Because of these layers of superior access, institutions are seen as “smart money.”
As we’ve explored, institutions have better access to investment deals, whether private equity, pre-IPO, real estate, or any deal that benefits from a larger pool of capital and greater access to information. These alternative investments are desirable sources of high returns and portfolio diversification. This naturally results in institutional portfolios having a higher allocation of alternative assets.
Further, many institutions invest in alternatives because they have to. Standardized portfolio management is a requirement of most institutional investors, who are required to hold assets in line with their stated investment objectives. In other words, an institution cannot simply invest in anything that moves—it must invest according to its stated mission and risk tolerance, as its fiduciary duty mandates.
In addition to being forced to maintain standardized portfolios, some institutions use alternatives to gain flexibility within their overall portfolio management framework. Using alternatives alongside more traditional investments, such as stocks and bonds, these investors can gain exposure to more diverse asset classes.
Additionally, alternative assets have higher return potential. By their very nature, alternative assets tend to be less efficiently priced than traditional securities, providing an opportunity to exploit market inefficiencies through active management.
The typical individual investor portfolio is made up of around 70% equities, according to the Asset Allocation Survey by the American Association of Individual Investors. The Vanguard study reports similar figures on “How America Invests.” This is in sharp contrast to institutions. University endowments, for instance, allocate most of their portfolio to alternatives and just a third to equities (with the remainder in fixed income and cash).
The superior portfolio mix of institutions results in performance differences, as well. Research shows that institutional investors “may outperform standard market portfolio benchmarks,” while “the average individual investor underperforms the market,” often to a large degree.
The average individual investor’s performance is further worsening with the rise of retail trading apps like Robinhood. Robinhood has quickly grown to surpass the likes of Schwab and E-Trade by several users, with millions of inexperienced stock investors chasing easy money. At the same time, less than 1% of day traders consistently achieve positive returns.
In contrast, institutions are long-term investors with a mission that extends into perpetuity. With most endowments and foundations, a mandatory spending rate also requires focusing on finding the best long-term investments to achieve the needed returns. This long time horizon is well suited to exploiting illiquid, less efficient alternative markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.
Institutional investment mandates generally center around long-term wealth creation and preservation, which has vast advantages over individual deal investing. As institutions take the long view, they build diverse portfolios of non-correlated assets (non-correlated to the public markets and non-correlated to each other) that continue to work across market cycles.
The top-performing institutions have come to appreciate that private investments can offer more compelling returns than public market equivalents over long time horizons, and successful investors have maximized their allocations accordingly. These investors also appreciate that building a robust private investment program takes time, skill, and discipline.
Two leading institutional investors, CalPERS and CalSTRS, have benefitted from instituting emerging in-house manager investment programs. Using Gridline, individuals can find potentially talented fund managers and emphasize investing in more diverse strategies and asset classes. In other words, Gridline provides endowment-style investing for everyone.
As we’ve explored, endowment-style investing was previously hidden behind layers of access: Access to more meaningful information, technology, and pools of capital. By providing this access for everyone, we’re making higher-quality investment opportunities available to all.
The 60/40 portfolio has been the standard for decades. A simple ratio divides an investor’s portfolio into 60% stocks and 40% bonds. In theory, stock allocation provides higher expected returns (and volatility), while bond allocation provides lower expected returns (and volatility). One investment professional described it as follows:
Imagine that your portfolio is a sailboat…stocks would be the sails, harnessing the potential of the wind, and bonds would be the anchor, providing stability and safety when the water becomes choppy.
The 60%/40% (or “60/40”) asset split is the most common mix for what is termed a “balanced” portfolio. This allocation has become so ingrained in our investing culture that it has been referred to as the “Goldilocks portfolio”—not too risky, not overly safe, but just right.
The 60/40 portfolio has served investors well over many decades, providing a solid foundation for retirement income and long-term growth.
However, times have changed.
Today, institutional and retail investors are increasingly looking to alternative asset classes to provide more significant return potential with less volatility than traditional investments such as stocks and bonds. Alternative asset classes include real estate, private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and more.
81% of investors expect their allocation to alternatives to increase by 2025, with just 3% expecting their allocation to decrease. In other words, alternative assets are no longer an afterthought in portfolios; they are becoming mainstream.
What is fueling this shift? There are three main drivers:
Let’s explore each of these in detail.
One reason alternative assets have become so popular among investors is that they can generate higher returns.
Large endowments have taken advantage of this return potential for the last two decades. Yale’s esteemed late portfolio manager, David Swensen, grew the university endowment from $1 billion in 1985 to $31 billion in 2020. Over the last 30 years, their investments in non-traditional assets increased from less than 20% to greater than 70%, resulting in outsized returns and lower volatility.
Over the 20 years ending on June 30, 2020, private equity (PE) has produced average annual returns 3 – 4% above returns generated by the Russell 2000 and the S&P 500 over the same period. The chart below compares PreQIn (the Private Equity Quarterly Index), which measures private equity returns, and the S&P 500 returns from December 31, 2000, through December 31, 2014. PE has been a consistent winner over this period.
Further, real estate, as measured by the FTSE NAREIT Composite (an index that tracks North American Real Estate Investment Trusts), has consistently outperformed the S&P 500, even quickly overcoming the dramatic fall in real estate prices during the Great Recession. The situation today is even more extreme: Real estate prices are soaring worldwide, from 32% annual gains in Turkey to 13% in the US. Unfortunately, investors cannot purchase the FTSE NAREIT Composite, but several broad-based US REIT indices track various real estate market sectors.
As reported in the Knight Frank 2021 Wealth Report, several luxury investments have made outsized returns as well – though not all “objects of desire” are created equal. For example, in the last ten years, rare whiskey has provided nearly 500% returns, while cars have provided almost 200%.
Another famous alternative investment, Bitcoin, has been the best-performing asset of the last decade, beating the Nasdaq 100 by an order of magnitude.
This potential reward is part of what makes alternatives such compelling investment options today—their higher return potential provides investors with an opportunity to outperform conventional investments while reducing overall portfolio risk, which we’ll explore below.
Another reason alternatives have become so popular is diversification—alternatives allow investors to reduce concentration risk in their portfolios by spreading their bets across multiple asset classes rather than relying on one single investment strategy or sector performance.
By spreading your money across multiple strategies, you can help reduce downside risk if any individual investment strategy goes south while still benefiting from the upside potential of any successful strategies.
Diversification can also be used as a hedge against a market downturn by providing uncorrelated returns. For example, as JP Morgan shows in the chart below, the strategic selection of specific hedge fund strategies or tangible assets can provide low-correlation returns.
Diversification can also act as a hedge against inflation, with assets like gold typically increasing in value as the purchasing power of the dollar declines. This is particularly important today, with unprecedented government spending driving inflation.
While the official Consumer Price Index reports a 5.4% inflation rate, the actual figures are much higher. This is because the inflation calculation methodology has been edited and re-edited to make inflation appear lower. Calculating the Consumer Price Index based on the methodology employed before 1980 reveals an annual inflation rate closer to 15%.
While many benefits are associated with having a diverse portfolio, there are also some potential drawbacks.
Diversification may come at the cost of reduced liquidity, as alternatives, such as traditional real estate assets, cannot be readily liquidated during periods of low-interest rates. In addition, some alternatives require significant upfront costs, such as buying a business outright before profits are realized.
As we mentioned earlier, diversifying your portfolio reduces overall volatility by eliminating single points of failure – should one particular asset go down, another will pick up the slack, as visualized by the graphic below.
Alternatives also help protect against tail events – rare but potentially devastating occasions that could wipe out large portions of your portfolio – such as pandemics or geopolitical crises.
Both the financial crises of 2008 and 2020 were a wake-up call for many investors. They revealed that the stock market could turn on a dime, and many people lost money in the bear markets.
While it’s true that alternatives themselves can be volatile, they can also help you achieve your long-term goals without all the ups and downs of the stock market.
Alternative investments have been around for a long time but have only recently become mainstream. However, the financial crises of 2008 and 2020, and the subsequent government intervention, have created a new level of awareness for alternative investments.
In the past, alternative investments were typically only available for institutions or the ultra-wealthy. Now, with the help of platforms like Gridline, they are becoming more accessible to Main Street investors.
Institutional investors have been
