Wealthy individuals often look to private or alternative investments as a means of diversifying their portfolios. These financial assets differ from stocks and bonds as they remain outside the public market. To access one of these investments, a qualified individual turns to an investment fund. Hedge funds and real estate are two of several private investment fund sectors today.
Growth in This Market
While a person will quickly see that the capitalization of the private investment market remains small when compared with the public market, investors continue to show interest in these partnerships. In fact, the private investment market increased from $4.1 trillion in 2010 to $10.8 trillion nine years later. Experts predict it will reach $17.2 trillion in the next three years.
Individuals aren’t the only ones taking part in this market. Institutions are choosing to do the same. They have doubled their portfolios’ allocation to private investments between 2003 and 2020 when a person looks at this on a dollar-weighted average basis. In contrast, high-net-worth investors only increased their allocation by four percent for the period from 2017 to 2020. Why is there increased interest in this asset class?
The Role of Private Investments in an Investment Portfolio.
Qualified investors often look to private investments as a way to diversify their portfolios. They want to reduce the volatility of their existing portfolios while producing high returns adjusted for risk. They also want to see high absolute returns. Nevertheless, diversification remains the primary reason they choose to turn to private investments. HK Wealth Facts (hkwealthfacts.com) explains what qualifications a person or institution must meet to diversify their portfolio using this method.
Investors find diversifying with the help of private investments allows them to improve the risk-return profile of their portfolios. They do so by investing in assets that lack a correlation. Much as gold and silver tend to rise in value as the dollar declines in value, assets with low correlations tend to move in opposite directions.
An investor should choose a private investment that has little correlation with the public market. Doing so allows more diversification while also minimizing the overall risk exposure. The portfolio volatility decreases, and investors are better able to maintain their overall performance expectations.
Investors appreciate having access to assets that may provide enhanced returns not seen in the public market. This is due to the minimal investment constraints placed on fund managers. In addition, the investors have a larger investment universe.
Hedge funds serve as a good example of this. The primary investments in a hedge fund are public market assets. However, the fund manager may choose to use strategies, such as short-selling, to generate a larger return. Venture equity opportunities also allow an investor to put their funds into a private company when they could not otherwise invest. However, the investor must understand the increased risk they take on with private investments.
Private Investment Risk Characteristics
Risk characteristics of the public market differ from those seen with private investments. Regulators don’t monitor private investments the way they do the public market. As a result, private investments typically aren’t as transparent and cannot be easily liquidated. This lack of regulation deters some investors.
A private investment fund is not required to share information about its investment positions or returns with the public. As a result, investors must be diligent about researching each fund to ensure they are choosing a reputable one.
Investment managers often use risky strategies in the hopes of achieving big returns. They rely on complex legal structures and distribute the bare minimum when it comes to information about investment strategies and returns. Only accredited investors, institutions, and qualified purchasers may put their money in these funds because there is little transparency and regulation.
Investors will often find it difficult to sell their shares in a private investment fund. The term for this type of fund typically runs from three to ten years, although hedge funds are an exception. A lack of liquidity remains a concern for those who choose to put their money in these funds. They find the market is small if they do wish to sell.
An investor will need to manage their overall liquidity to ensure all funds aren’t tied up in private investments. If they are, problems could arise for the investor. In addition, the investor needs to ensure they have a balanced portfolio. It’s hard to pull back from a non-liquid private investment when the portfolio is tilted toward one sector or strategy.
The fund manager rarely calls all capital at once. They do so when an investment opportunity comes up. These opportunities can be sporadic, and an investor must worry about lost opportunity costs.
Each investor must manage their capital inflow and outflows to ensure they have the capital when the fund manager calls for it. Another concern when it comes to funding is market downturns. The fund might need more capital than the investor originally agree to provide.
These serve as a few of the reasons private investments remain open to a select group. However, some risks can be mitigated.
Active fund managers can exploit market inefficiencies to mitigate risks seen with private investments. For this reason, an investor needs to consider the experience of the investment manager and their ability to implement given investment strategies when choosing where to put their money.
Illiquidity becomes less of a concern when a private investment fund requires regular distribution over the term of the fund. In addition, certain strategies allow an investor to make a partial or complete withdrawal of capital after a predetermined period. However, the investor’s commitment must be fully funded upfront regardless of whether investment opportunities are available.
An investor must consider many factors when choosing where to put their money. This includes their risk tolerance and liquidity needs. They also need to have clearly defined investment objectives and ensure the fund fits with these objectives.
Due diligence is crucial when it comes to private investments, and this needs to go beyond the fund. An investor should never overlook the fund manager, as they play a significant role in the success or failure of the investment. Individuals who remember this often find their private investments pay off in a large way.