In years of crisis, you have to invest in alternative assets

In the latest weeks, global financial markets have given us a gentle reminder of what crisis level volatility and a market dip look like. Announcement of global pandemic, thousands of people working from home and a sudden start of an Oil price war between US and Russia have wiped out ~20% of value of major indexes over the last 4 weeks. This Wednesday alone, on March 11^th, S&P 500 dropped 9.99%, majorly affecting most institutional and personal portfolios.

The correlation between allocation to private investments and long-term returns becomes apparent when we take a look at the long term (20-year) returns of over 130 of the large reporting institutional investors in the US, presented in Chart 1.

While most institutions have managed to produce returns in the range of 6-7%, those with allocation of 15% or more have significantly outperformed their pears, delivering on average 8.2% return on the entire portfolio. So why does higher allocation to Private Investments produce better long-term returns?

Chart 1: Mean Private Investments Allocation vs Investment Return (20-year period ending June 30^th, 2018)

One significant reason for such a difference in returns is the correlation of Private Assets to the Public Markets. As shown in Chart 2, among major private investments strategies, Venture Capital is the least correlated market to the wider public (S&P 500 index is used as a proxy). Buyout and direct lending are more correlated to the public markets but are still able to provide portfolio stability during periods of high market volatility. This is due to the fact that private assets are not marked to market on the daily basis, and as such are not subject to short term market shocks. Hence, assets in Private markets portfolios will not immediately lose value due to market sentiment.

Chart 2: Selected alternative assets correlations with S&P 500

Furthermore, the effect of the low correlation to the public markets can be seen by observing real-life performance of the reporting financial institutions in the US during the crisis years (Chart 3). The chart below demonstrates the performance of S&P 500 Index versus US Endowments and Foundations with allocation to Private Assets of +40%. As can be seen, the difference in performance is significant, in the range of 7-13%. To understand these numbers better, it is interesting to consider long term implications of such decrease in value. For instance, in 2001 and 2002 S&P 500 index has lost ~30% while the financial institutions with large allocation to Private Assets lost only ~8%. More importantly, however, is the future return needed to coming back to pre-2001 levels. In case of S&P, this represents a necessary 43% increase in value, whereas in the case of E&F with allocation to alternatives of +40% this represents only 9%, a significantly more realistic return in the years following the recession.

Chart 3: Performance of Financial Institutions in the US with allocation to Alternatives of +40% versus S&P 500 Index