Traditional Portfolios Benefit From Private Markets Exposure
“A few holdings with radically different types of market behavior will do more to smooth out the pattern of portfolio returns than 50 or 100 holdings that move up and down together”
Peter Bernstein, American Economist and Investor
The vast majority of investors understand the purpose and importance of diversification. From a portfolio perspective, it is important to hold a range of asset classes with varying performance characteristics to ensure a low level of correlation between individual portfolio components. The function of cross-asset allocation is to diversify (macroeconomic) systematic risk, which can impact a large number of securities to varying degrees. Although it can never be eradicated, low correlations between individual portfolio components can determine that systematic risk is substantially mitigated.
However, it is also important that each portfolio component is diversified in its own right to address (micro-level) unsystematic, or idiosyncratic, risk, which will normally only impact individual holdings or sectors. Typically, unsystematic risk will take the form of specific corporate news, which adversely impacts the securities of the company concerned and may spill over to its peer group. However, there is usually a limited risk that idiosyncratic issues will destabilize a broad index
Addressing systematic and unsystematic risk is the crux of Markowitz’s ‘Modern Portfolio Theory’ (MPT), which was first published in 1952 and subsequently earned the American Economist a Nobel Prize. MPT introduced the concept of the 60:40 (equity/bond) portfolio, which has proved a model of portfolio construction, particularly pension plans, ever since. Although the question of whether the 60:40 concept has any value in today’s trading environment is a frequent source of debate, the notion of the ‘efficient frontier’ is as relevant now as it was 70 years ago.
Source: Stableton. Schematic Illustration
‘Ultra-Modern’ Portfolio Theory
The original MPT has become outdated because of rising correlations between equities and bonds. Furthermore, in extreme equity bear markets, a bond allocation no longer provides the level of downside insulation to a portfolio of equities as used to be the case. For example, US equities suffered a peak-to-trough decline of almost 50%* when the internet bubble burst just over 20 years, but US Treasuries rallied by 31%* over the same period, providing a substantial diversification benefit.
Conversely, at the start of 2021, US equities slumped 34%* in just a few weeks as the pandemic panic took a grip. On this occasion, US Treasuries gained just 5%*, thus providing a wholly inadequate downside cushion.
One of the reasons for this is that bonds are becoming an increasingly volatile asset class as a consequence of more extreme monetary policy. Until recently, bond yields have been stuck in an unprecedentedly low range, making it difficult for prices to rally (forcing yields to fall further) to compensate for slumping equity prices.
At the same time, equities have been displaying signs of fatigue as a result of continuously scaling the ‘wall of worry’ to maintain their upward momentum. Consequently, with the benefit of hindsight, it was no surprise to see equities and bonds declining in tandem during 2022. This is often referred to as a ‘correlation one’ event, where the whole concept of equity/bond diversification is completely undermined.
The only way to construct a portfolio with an efficient frontier in today’s environment is to introduce additional asset classes to the mix, with different performance characteristics to equities and bonds. From this perspective, we could safely assert that a ‘modern-day Markowitz’ would be a huge advocate of private market assets.
More than a portfolio diversifier…
As intimated previously, it is easy to make a case for including exposure to private markets as a portfolio diversifier – lower volatility and returns that are relatively uncorrelated to public markets, because fear and greed are not primary drivers of decision-making. However, there is also a fundamental rationale for investing in venture capital – namely, the potential to capture significantly greater investment returns.
In this respect, Amazon (the company with the highest profile of all the ‘FAANG’ stocks) makes a fascinating case study.
Amazon was founded in July 1994 and launched its initial public offering (IPO), at a price of USD 18 per share, less than three years later. The shares soared so quickly that the company announced a 2-for-1 stock split just over a year after the IPO to make the price more readily investible.
This turned out to be the first of four stock splits, with the last one taking place in June 2022 on a 20-for-1 basis. If we factor in all four of the stock splits, Amazon’s public shares were effectively launched at a price of just 7.5 cents per share.
Fast forward to mid-April 2023, and Amazon shares traded at a level of around 100 USD. This meant that the stock price had appreciated by a staggering 133,000% in a little under 25 years. To put this a little more tangibly, a lucky investor who bought USD 1000 worth of shares at IPO would have been sitting on USD 1.33 million.
Furthermore, if we use the share price as a proxy for growth (which is a little dubious because investor sentiment plays a huge role in determining the share price of a publicly listed company), 99.3% of Amazon’s value creation has occurred after the company went public. However, with ‘late-stage’ privately held growth companies now staying private for longer, investors wishing to tap into such huge growth potential need to explore the venture capital universe.
The era of the unicorn…
A unicorn can be defined as a fledgling company that achieves a valuation of USD 1 billion without being listed on a public stock exchange. It typically takes five-to-seven years to achieve unicorn status. Unless they become the subject of an acquisition, such companies typically remain in private hands for more than the first decade of their evolution. As such, and unlike Amazon, a huge proportion of the overall value creation takes place prior to the IPO.
Interestingly, the unicorn universe is expanding rapidly at a time when the number of publicly listed stocks is falling. Ten years ago, there were only 39 unicorns in existence**, the number breached the 1000 barrier for the first time in February 2022***, and today the count is over 1200. Conversely, the number of companies listed on US stock exchanges has declined by around 50% since peaking towards the end of the TMT bubble.
While the reduction in publicly listed companies has constituted a harsh form of quality control, it nevertheless reduces the opportunity set and encourages crowding in the most popular stocks. Meanwhile, not only is the unicorn universe expanding, but the scope is also broadening. In the infancy of unicorn evolution, the vast majority were software companies. But, today, more than 15 industries are represented, with the breakdown of the largest five illustrated in the chart below.
This means that there is more scope for VC practitioners to add value through company selection, while a larger universe provides significantly greater potential for passive indexation, which, until now, has been a largely untapped opportunity in the private markets universe. Index tracking also opens up private markets to a much broader range of investors.
Much more fundamentally based
In an environment characterized by an anaemic global economy and rising interest rates, investors are desperately seeking companies with the potential to grow in an unfavorable trading environment. This is clearly evidenced by the performance of the Nasdaq 100 index of leading US growth stocks, which entered bull-market territory at the end of March 2023, having rallied by 20% since the December 2022 trough.
Public equity markets, in general, appear to be shrugging off concerns of a meltdown in the banking sector, as investors focus on a prospective peak in the prevailing interest-rate cycle. The issue is that the (relative) growth versus value dynamic in public equity markets is becoming increasingly stretched. In the years prior to the Global Financial Crisis, value stocks were in ascendancy as the macroeconomic backdrop was supportable. When interest rate hikes relent, and economic momentum picks up, the yawning gulf between the relative valuation of the growth and value investment ‘styles’ is likely to become increasingly apparent, which will significantly impact investor sentiment.
In contrast, valuation measurements in the late-stage growth equity arena are much more fundamentally based. Private markets reward potential and achievement, rather than the vagaries of investor sentiment and behavioral bias. These companies have a proven and robust investment model, are already (or imminently) profitable, and are still growing rapidly at this stage of their evolution. As such, an allocation to late-stage growth equity is likely to boost performance and enhance the diversification of any portfolio of traditional investments, thus leading to a substantial improvement in risk-adjusted returns.
Sources: *. CNBC. **. Hubspot. ***Statista.
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