The lesser-known concentration risk facing this asset class

Most investors understand the concept of diversification and its crucial role in reducing volatility. If you spread across several different investments, you can reduce your volatility of returns, while if you 'put all your eggs in one basket', your returns will experience high volatility. 

Despite this, it's not unusual for investors to take a diversified approach to equities and bonds while relying on a single manager for their private market allocation, often using a listed investment trust (LIT) or wholesale managed fund.

It's a direct contradiction to the tried and true wisdom of diversification - and a recent chart from Blackstone highlights why such a concentrated exposure could actually be dangerous.

Source: Blackstone, Morningstar, returns are over a five-year period from 1/10/2018-31/9/2023. More details in disclaimer. 

If the goal of diversification is to mitigate losses while having meaningful exposure to the upside, the chart above shows that investing in a single private equity or single private credit fund is like picking a single stock: you could pick the best performer and the payoff is huge. But you could also pick the worst performer, in which case, you are missing out on the potential of higher returns of other managers in the asset class.

In only using a single exposure, investors also disregard the depth of private markets. That single exposure could only touch on one aspect. 

What do private markets encompass?

Private markets include private equity and private credit.

Private equity is the ownership or interest in a corporate entity that is not publicly listed. There are different types of private equity investment. It can involve taking control of a company either through outright purchase or through obtaining a controlling equity interest in a company (known as a “buyout”). Private equity can also involve taking a stake in the early stages of a growing business.

Private credit companies generate income by lending to and investing in non-public businesses using a variety of sources, such as debt and hybrid financial instruments. In short, they provide capital to small and medium-sized private businesses, and in turn, give investors access to the growth and income potential of private credit that are generally exclusive to large institutions and difficult to access.

Simple ways to diversify in private markets using indexing and ETFs

Private markets have traditionally been opaque and difficult in the past for investors other than high net worth or institutions to access. That has all changed in more recent years.

Innovative approaches in indexing and ETFs allow investors to diversify into private markets via a single trade and the benefit is increased price discovery, liquidity and transparency.

And we have seen this play out over the past few years, indices have provided a good guide as to the direction of many private assets, such as those owned by large superannuation funds, when they are ‘revalued’ to the current market price.

The choice between public or private markets has profound implications. 

In public markets, liquidity and transparency provide immediate price adjustments but also expose investors to volatility. Conversely, private markets can offer higher returns due to less competition and the illiquidity premiums, but require a long-term investment horizon, have less frequent price feedback and limited liquidity.

We think innovations in indexing and ETFs are changing this dynamic. Irrespective of which market you invest, diversification remains key. Diversification by names, sectors and managers. Because of the disparity of returns among managers in private markets, we would argue manager diversification is more important in private markets. And that is where ETFs are helping investors to access those opportunities.

Find out more about the investment opportunities within corporate entities that aren’t publicly listed (private equity) here.