To PE or not to PE—that is the pressing dilemma for asset owners today. As institutional investors hunt for yield, the allure of alternative investments has intensified. However, while the old-school stocks and bonds portfolio is increasingly supplemented with private investments, specialists suggest this shift might be unnecessary.
Imagine you are the CIO of a pension fund with a fiduciary duty to your pensioners. It’s your job to optimize the returns for beneficiaries. You know that the returns of alternative assets are high. Maybe a tad too high to leave untouched. It’s easy to argue that therefore, alternatives should be part of the asset mix, but Giulio Renzi-Ricci, Vanguard’s head of asset allocation in Europe, advises caution.
“Unless you have specific goals for achieving very high - expected - returns, or you need hedging against downside risks or inflation, most of the time, a multi-asset balanced portfolio of equities and bonds will serve you best, no matter what circumstances,” he told Investment Officer.
The supposed benefits of allocating a significant portion to alternatives are “overstated” and “misplaced”, he says, contrasting the latest developments in institutional portfolio management.
The temptation of alternatives
The year 2022 was an unusual anomaly when both equities and bonds declined simultaneously, causing the traditional 60/40 portfolio to suffer one of its worst years in over a decade, with a nearly 16 percent drop.
This rare occurrence has driven many institutional investors—except for the Norwegian sovereign wealth fund—to increase their exposure to private equity. For pension plans struggling to meet their targets, private equity has become a go-to strategy and a diversifier from the seemingly correlated stock and bond markets.
The Thinking Ahead Institute’s Global Pension Assets Study shows that allocations to ‘other’ asset classes, which include private equity, have significantly increased from 12 percent in 2003 to 20 percent last year.
Laurens Swinkels, executive director at Robeco and finance professor at Erasmus School of Economics, noted that those seeking a broadly diversified global index fund might find that the stock market no longer fully represents the global economy, potentially missing out on significant returns. However, investing in private equity comes with unique challenges.
“This category is particularly challenging because it is less transparent, and its returns, risks, and valuations are difficult to determine and compare.”
Laurens Swinkels, Robeco
“Investors face extra organizational costs for finding a good private equity manager—who usually commands much higher management fees—and, as a pension fund, they spend a lot of time monitoring a relatively small investment category. This category is particularly challenging because it is less transparent, and its returns, risks, and valuations are difficult to determine and compare,” Swinkels explained.
“Depending on the type of investor, liquidity is also important. For long-term investors, this might be less of an issue, but even they sometimes have to deal with changes in regulations or organisation.”
“Liquidity can thus be useful even for a long-term investor. Therefore, an investor who wants to keep things simple can probably achieve an equally good risk-adjusted net return without private equity investments,” Swinkels said.
Renzi-Ricci acknowledges there’s nothing inherently wrong with investing in alternatives—Vanguard does offer private equity solutions for high-net-worth clients in the US—but he emphasizes that unless investors can tolerate the additional level of risk and illiquidity and have the ability to find and access high-quality General Partners (GPs), the 60/40 portfolio remains a reliable and effective strategy.
“It’s still the ‘blue suit’ for investors,” the Vanguard strategist said, one of the largest providers of index funds and exchange-traded funds (ETFs) typically used in a traditional 60/40 portfolio.
Understanding correlations
Renzi-Ricci emphasizes that there are no structural reasons to expect a fundamental shift in the equity-bond relationship moving forward. “Stock bonds correlation tends to turn positive when during supply side shocks and coherently when inflation is rising faster than expected. Once this dissipates, we would expect the equity/bond correlation to go back to levels close to zero,” he noted.
Given the current economic landscape, with central banks in developed countries remaining reactive rather than proactive, Vanguard does not foresee any dramatic changes in equity-bond dynamics.
“We’re not in a situation like the 60s and 70s when central banks were more proactive in their monetary policy. Today, they respond to real economic conditions”, Renzi-Ricci said.
Zero alpha
Some experts argue that the higher returns from private equity might be illusory, with even some insiders acknowledging a probable decline. Ludovic Phalippou, a professor of finance at Oxford University and a fierce critic of private equity, asserts that pension funds generate “zero alpha.” He suggests that the average annual return of 12 percent is “ok, but not extraordinary given the risk”.
Brendan Ballou, a former lawyer in the private equity division of the U.S. Department of Justice, is also skeptical. According to him, a growing body of research indicates that when accounting for all the management fees and other costs associated with private equity investments, these investments don’t necessarily offer better risk-adjusted returns than public equities.