Portfolio considerations outside listed markets

By Jayson Forrest

Investing outside of listed markets can provide investors with the ability to generate higher returns and access strategies that consistently outperform the median. Rebecca Jacques (Mercer) and Graeme Bibby (Partners Wealth Group) consider illiquid assets as part of a portfolio allocation.

Illiquid assets — private markets (private equity and private debt) and real assets (property and infrastructure) — have long been available to institutional investors and more recently, they’re being included in the portfolios of ultra high-net-worth clients. However, these assets are now becoming more accessible to the ‘mass affluent’, but they’re investments that don’t come without their risk and challenges.

“Increasingly, due to technology, we’re seeing the democratisation of assets,” says Rebecca Jacques — Head of Portfolio Solutions, Wealth at Mercer. “We have started implementing illiquid assets directly into our managed accounts offering, but a lot of structuring has taken place to try and match the liquidity profile of investors to the actual portfolio, as well as some of the underlying investments.

“So, while it’s getting there, illiquid assets are still not totally available to every investor. It’s important to understand that these assets have differences in the way they behave, particularly in terms of how the ‘capital is called’ and how the income is paid out, which may be quite difficult for average investors to fully understand.”

Speaking at an IMAP Specialist Webinar on ‘Portfolio management considerations outside listed markets’, Rebecca believes understanding how illiquid structures function, as well as their terms and conditions, are probably the two areas that challenge investors the most.

It’s a view supported by Graeme Bibby, CFA — Chief Investment Officer at Partners Wealth Group — who adds that ‘mum and dad’ investors particularly need help understanding these investments, especially in areas like ‘capital calls’ and offer documents.

“We’ve got a job to do on behalf of investors to do proper legal, financial, operational, and investment due diligence. We also need to help them on their journey by better educating them about illiquid investments, including the opportunities and risks attached to them,” says Graeme.

When it comes to building portfolios, Graeme believes diversification is key. This includes using illiquid assets to balance the more liquid components of a portfolio, as well as using these assets to add even greater diversification to the illiquid part of a portfolio.

At Mercer, there is a strong focus on global diversification when constructing portfolios. According to Rebecca, when Mercer looks across real assets and private markets, it deliberately takes a global view, because “it broadens diversification”.

“That approach doesn’t mean we ignore what’s local, but it does mean global investments are part of the opportunity set. You want to keep your opportunity set broad, so you can access different levers of industries, sectors, and factors, as well as alpha return differentials.” 

Graeme agrees, citing public market bonds as a good example. “In public market bonds, you’re only going to get very large companies that have enough size to be able to issue in public markets. But there are many smaller companies in the mid-market space you can access through private credit that you can’t access through public markets. So, you can get a lot more diversification for your portfolio by using different drivers.”

Importantly, Rebecca says many investors are increasingly turning to private markets, not just for alpha, but for access to a wider range of investments that are not available in the public market.

However, she acknowledges illiquid assets are typically expensive for investors to access, with high fees and transaction costs. Therefore, when looking at illiquid investments, Mercer believes it’s important to consider the ‘cost-benefit analysis’ (the process used to measure the benefits of an investment/asset minus its associated costs to determine whether the investment is worthwhile) of assets from an alpha perspective.

“We focus a lot on after-fees,” says Rebecca. “For example, with private equity, we’re looking at what we can expect to earn. As a general rule when investing in a broad private equity pool, you want to be earning between 3-5 per cent above what you could earn in listed equities over a reasonable timeframe. That’s where you would expect all the variables — like the opportunity set and the illiquidity premium — to converge.

“So, we do look at investments relative to a benchmark and also to the opportunity set. Ultimately, we care about the outright return after fees. We believe fees should be aligned to investor interests and for the strategy being used.”

However, when it comes to investor misconceptions about illiquid investments, Rebecca concedes there are many, with perhaps the two main misconceptions being: investment illiquidity, and the general lack of understanding about how illiquidity works in a portfolio.

“As an industry, we always talk about private markets being illiquid, but they’re actually a constantly liquidating vehicle,” she says. “We need to understand that maybe we’re only focusing on one aspect of liquidity, which is liquidity of capital and when money can actually be withdrawn. However, perhaps we should also be focusing on the fact that private markets are vehicles that are constantly drawing and releasing capital back into the system.

“The idea that investor capital is totally locked up and can’t be accessed is a misconception. In actual fact, there is money flowing in and out of private market assets all the time. So, while you definitely can’t redeem your entire investment, that doesn’t mean these investments are truly illiquid. And that’s something to be mindful of.” 

Similar to their listed peers, the relative performance of illiquid alternatives — like private equity — can be benchmarked and measured. According to Graeme, advisers should always ask the product provider or fund manager what their benchmark is and the basis for using it. For example, in private markets, Cambridge Associates has a number of private equity indices, which are really just medians of manager returns, while there is the MSCI index for property, as well as some long-established indexes for private debt.

“Effectively, you want to get a fair representation of what you could receive if you were the market, which is basically the median return,” says Graeme. “These types of benchmarks are available for illiquid assets, and often managers will also have a performance benchmark they use.”

However, Graeme adds the caveat that advisers need to look closely at the space the manager is operating in (such as private equity), to ensure it’s using the right benchmark for their particular strategy.

When it comes to identifying the best opportunities in illiquid investments — whether that’s private markets or real assets — Graeme believes it comes down to what’s actually available in terms of the underlying assets. He says there is no shortage of opportunities available in the market, citing the significant growth in both private equity and venture capital firms over the last 20 years. However, the difficulty for advisers is working through and analysing all these investments to identify the best opportunities for clients.

“Advisers are being inundated with ‘flavour-of-the-month’ investments. There are so many opportunities available. In fact, the number of semi-liquid funds will probably double over the next 12 months, providing even more choice for advisers and their clients.”

The fact that the number of investment opportunities in public markets is decreasing, is pushing more investors into the private space. However, Graeme accepts that not all investors are suited to illiquid assets.

To ascertain whether to include illiquid alternatives in a client’s portfolio, Graeme says there are a number of key considerations that Partners Wealth Group looks at to determine whether these assets are suitable for investors. This includes closely examining the profile of the investor, including their risk tolerance and liquidity needs. It also looks carefully at potential changes in a client’s life circumstances, including the need for capital growth to fund future expenses, like aged care.

“It really depends on the individual’s overall situation, and not just age itself,” says Graeme. “Some clients may have excess capital they want to pass onto their children or grandchildren. They want to leave a legacy, so investing their excess capital in illiquid assets may be an appropriate way for them to build wealth. So, it’s important to educate clients about how illiquidity and patience with investing will help deliver them their returns.”

When considering the appropriateness of illiquid assets for clients, Rebecca believes investors can broadly be grouped on their risk profiles. This enables advisers to explore more deeply a range of issues with their clients, such as their liquidity needs, their appetite for risk, and longevity risk.

“Not only are we seeing the opportunity set in public markets decline, but we’re also seeing more frequent correlations between bonds and equities. This makes an allocation to illiquid investments more attractive, but only if the client properly understands the risk-reward trade-off.”

She believes the many risks around illiquid assets can be mitigated by adviser due diligence, and investors properly understanding the risks and opportunities of illiquidity.

“It’s important for advisers and investors to understand the nature of the investment, which includes looking closely at what’s actually ‘underneath the hood’,” says Rebecca. “Once the client understands what they’re investing in, illiquidity begins to make sense. So, advisers need to spend less time on the jargon and focus more on what’s underneath the hood of the investment.”

Graeme believes advisers should consider including an allocation of illiquid investments in portfolios that are suitable for clients and their liquidity needs. He says these assets will help generate higher returns for lower risk, enabling clients to access strategies that consistently outperform the median, and which may not be available in public markets.

“Remember, investors need patience when using illiquid investments, like lock-up funds for early stage venture capital limited partnerships. And they should also consider having a blend of both liquid and illiquid assets in their portfolio,” he says. “It’s all about portfolio diversification, where investors can enjoy liquidity through an allocation to public markets, and use their exposure to illiquid investments for growth and generally higher returns.”

It’s a view shared by Rebecca. “Increasingly, people want to be in private markets to access opportunities not available in public markets, like the mid-market, where the ability to create return upside is significant.

“Investors are also drawn to private markets because typically, you find investment opportunities in innovative areas or in industries that are evolving, which are attractive for many investors.”

Rebecca Jacques is Head of Portfolio Solutions, Wealth at Mercer; and

Graeme Bibby, CFA is Chief Investment Officer at Partners Wealth Group.

They were part of an IMAP webinar panel discussion on ‘Earning the illiquidity premium: Obtaining the diversification benefits — Portfolio management considerations outside listed markets’.

The session was moderated by Adam Myers — Executive Director at Pengana Capital.