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Looking for Growth? Consider the Alternatives

The average investor, typically with a 60/40 portfolio of publicly traded investments, is angling in an undiversified, shrinking and over-fished pond.

By Lawrence Calcano

The number of listed U.S. stocks has decreased by about 50 percent over the past 20 years, and the rush to go public, especially for lucrative technology companies, has slowed to a crawl over the last several years. In fact, many notable tech companies, such as Alibaba, Facebook and Google, delivered the overwhelming majority of their returns prior to going public. Of the public opportunities that remain, there’s substantial analyst coverage and transparency on the securities themselves, with all the companies well-researched, and rarely do they demonstrate value that’s not already reflected in their stock prices. The public market is the ultimate level playing field.

But while U.S. equities have delivered substantial gains in the last 10 years, the average investor, often prone to poorly timed market exits and entrances, realized only a 2.3 percent return over the past 20 years and outperformed inflation by a mere 0.2 percent per year. 

Other influential factors are a growing push for privatization and a general hesitancy about prospective initial public offerings, as well as the steep regulatory hurdles required for going public, and the chronic focus on quarterly results that drain resources and may arguably discourage long-term investments. Taking a narrow, short-term view on performance can cause firms to pull back from investing in technology, research, and product development activities that don’t immediately drive “in-period” returns.

So, what should a growth-oriented investor do? How will the growth-oriented advisor advise?

There are several promising paths for advisors and investors who are seeking solutions to the risk-reward conundrum.

Look to private equity markets. Advisors who limit client portfolios to publicly traded companies are missing out on many opportunities for growth. Of the largest 185,000 companies in the United States, about 181,000 (98 percent) of them are private firms—that’s more than 45 times the number of firms represented in the public markets. While investments in the public market are passive, meaning that the investor doesn’t have the ability to impact the performance of the holding, professional private investors have the opportunity to influence the creation of real alpha during the investment period.

In fact, the best investors generate the majority of their returns in this process through tactics such as selective consolidation or driving operational efficiencies. Nonetheless, these opportunities often go unexplored due to concerns about access, liquidity or simply a lack of awareness and understanding within the advisor community.

Private credit can offer meaningful yield. Ever since the global financial crisis, traditional banks have tightened up their lending practices, de-risked their balance sheets and increased their capital reserves. As a result, there’s a huge funding gap, with private credit funds stepping in to meet the demand in the marketplace, in helping businesses’ scale, penetrate new markets, or finance acquisitions. Although more players have started to come to market, there’s still an excess demand for private financing options, providing ample opportunities to gain downside protection, harvest an alternative risk premium and in the case of floating rate loans, be protected in a rising rate environment.

Liquidity isn’t (always) your friend. Investors have long held the belief that liquidity is a good thing: it keeps your options open should the cash be needed and lets you exit an investment quickly when the asset seems to be underperforming. But liquidity can also create the opportunity for more harm than good.

Just as liquidity allows easy access to the market on the way up, it also enables rapid exits on the down cycle; history has shown that this is often a costly mistake. In contrast, the private markets are typically structured as long-term commitments to provide a built-in discipline to hold, which avoids panic selling. It’s during this hold period that the opportunity for private investors to create real “alpha” exists.

Uncorrelated assets deliver independent returns. The FAANG tech stocks (Facebook, Amazon, Apple, Netflix and Google)— blue chips in most investor portfolios—are one example of correlation in public markets. As of Tuesday, Dec. 18, they had lost more than $1 trillion dollars in total value, compared to their 52-week highs. Regardless of the idiosyncrasies of individual stock price dynamics, equity performance within a sector and even across sectors is often highly correlated, especially when the firms are collectively facing trade or monetary policy challenges, as they are today. Private markets can provide less correlated or uncorrelated performance due to the benefits of longer holding periods, with strategic exits planned carefully by the manager and an array of hedging opportunities that exist in that landscape.

Access and education to alternative investments will create mainstream opportunities. Alternative investments have traditionally been the province of institutional investors, endowments and family offices, but access to and interest in alternatives is growing with high-net-worth investors broadly. Even so, these asset classes have unique characteristics that must be taken into consideration.

There’s an important mandate for the industry to educate financial advisors and their clients on alternatives, such as private equity and hedge funds. Despite the possible benefits, investors should be highly cautious, and not proceed without this education and a thorough understanding of the differences between public and private market investing.

Questions that advisors need to ask include:

  • How do these investments fit into a client’s portfolio?
  • What are the drivers of returns?
  • Where are the risks and how are they managed?
  • What strategies make the most sense in particular market environments?

The expansion of alternative investments into mainstream markets can offer investors a wide range of opportunities and enhance diversification to strengthen resilience in a portfolio. So, providing education and support from advisors is essential for continued growth in the industry—and for investors to have the opportunity to benefit.

 

Lawrence Calcano is Chief Executive Officer of iCapital Network.

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