Is Your Portfolio Truly Diversified?
CHARLESTON, SC - October 31st, 2024
Author: Christian Salomone
Chief Investment Officer
At Ballast Rock Private Wealth we believe that diversification is a fundamental part of helping our clients manage risk. Achieving attractive risk-adjusted returns for any given strategy or asset class, consistently over time and through differing economic cycles is exceptionally challenging. This makes diversification the most effective tool to hedge against the risk of changing technologies, macroeconomic backdrops, and geopolitical environments.
Genuine diversification can only be achieved by considering the entire investable universe which includes both public and private companies. Private companies produce approximately 88%¹ of the US economy’s Gross Domestic Product, while publicly listed companies generate only around 12%. We believe that a truly impartial advisor has the capacity and expertise to recommend both public and private market investments where appropriate for a client.
The 60/40 Rule for Public Market Asset Allocation
The unwritten rule when it comes to asset allocation in public markets is the 60/40 approach where, in general, investors allocate 60% of their assets to equities and 40% to bonds.
According to Goldman Sachs², the S&P 500 has generated a 27% annual total return over the last two years, far higher than the long-term average of 11%. While the last 10 years saw annual returns of 13%, Goldman’s forecast for returns over the next decade are far lower at just 3%. Meanwhile an industry survey of 21 asset managers average predictions for U.S. equity returns over the next 10 years is 6%, largely because of the now unprecedentedly high levels of concentration of the U.S. public indices in a handful of mega-cap technology companies.
As for fixed income, Vanguard’s outlook for U.S. bonds over the next decade is a return of between 4.6% to 5.6%³, which is broadly in line with long-term historic returns for bonds.
Based on those forecasts, a typical investor’s portfolio of U.S. bonds and equities using the 60/40 model would be expected to generate annualized returns of approximately 5.5% over the next decade. When you consider that we have seen the S&P fall by 20%⁴ and the Bloomberg U.S. Aggregate Bond Index fall by 13%⁵ as recently as 2022, one would rightly ask if a diversified portfolio of bonds and equities is going to provide investors with the target returns, risk diversification, and the stability they require to achieve their investment objectives.
Furthermore, there is a lack of diversification in the U.S. stock market due to the increased concentration risk and influence of mega-cap stocks on broad market indices. According to JPMorgan, the Magnificent Seven delivered 101% of returns for the S&P 500 index in 2023 versus the equal weight index, which yielded just 2.5% (i.e. almost all the performance of the index was driven by these seven stocks that year). Just one of the Magnificent Seven stocks, NVIDIA, has a market cap of $3.43 trillion; more than the total equity market cap of five of the seven Group of Seven (“G7”) countries⁶.
Enhancing Diversification to Better Match the Contribution to the US Economy
Investing in alternatives isn’t just attractive from a potential return perspective, it also significantly enhances investors’ ability to diversify their portfolios⁷. As JPMorgan said in its May 2024 piece on alternatives⁷, “Limiting your investment approach to public markets means missing out on the vast opportunity set in private markets.”
While the number of public corporations has been declining for the past two decades, the number of private companies has been growing, and there are now more than 25 million private companies in the United States vs. approximately 4,000 publicly listed ones⁸.
Source: iCapital – U.S. Companies Private vs. Public, by Revenue
Though many of these private companies are small or sole proprietorships, many larger private companies are staying private for longer, and, with the right diligence and rigor, it is possible to invest in (or lend to) private entities with significant scale. As can be seen in the graph above, 87% of all U.S. companies with revenues in excess of $100 million are private⁹. In addition, there are more private companies generating over $1 billion in revenue today than there are public companies of the same size and, according to Forbes, the 10 largest privately held U.S. companies had combined total revenue of over $600 billion in 2023¹⁰.
Source: Compustat, Bureau of Economic Analysis, Federal Reserve.
Not only are there more private companies vs. their public counterparts, but they are also more profitable. According to a June 2024 study¹¹ by the Federal Reserve Bank of San Francisco, private companies are increasingly more profitable than public corporations.
This can be seen in the graph shown to the right taken from the study. This graph demonstrates the estimated rise in capital returns for privately held companies versus publicly traded companies.
Private companies are also more representative of the underlying economy, e.g., they account for 77.4% of employment¹² and 88% of GDP¹³ in the U.S. According to the Bureau of Labor Statistics, there are now over 32-times more private companies than public companies with at least 100 employees¹⁴.
The Evolution of the 60/40 Model
As can be seen in the graph below¹⁵, among the mass-affluent in the U.S., portfolio allocations to alternatives are estimated to be limited to approximately 6%. In contrast, alternatives have long been a key portfolio allocation for institutional investors, endowments and ultra-high-net-worth individuals.
In fact, according to Professional Wealth Management¹⁶, individual investors account for more than 50% of global assets under management, yet mass-affluent and high-net-worth individuals own just a small fraction of alternative assets due to lack of access and education in the wealth advisor community.
Increasingly, however, wealth advisors like Ballast Rock Private Wealth, have been advocating for higher allocations to alternatives for individual investors. A recent evolution of the traditional 60/40 model has been the 40/30/30 model, which suggests 40% in equities, 30% in bonds and 30% in alternatives. A 2022 study¹⁷ by Kohlberg Kravis Roberts found that a 40/30/30 portfolio had a higher annual return than a 60/40 portfolio from 1927 to 2021, including both high-inflation and low-inflation periods. As a result, they found it delivered more diversification, lower volatility, and better overall returns.
The Challenges of Investing in Private Asset Classes
Strict qualification criteria, regulatory restrictions, high minimums, onerous subscription processes, a lack of manager relationships, and an inability to conduct due diligence are just some reasons that have historically kept all but the wealthiest and most sophisticated investors from investing in alternatives.
While new regulations, structural innovations, and increased interest by alternative asset managers have all helped to make access to alternatives easier in recent years, gaining exposure to private investments remains a challenge for many individual investors because:
Access to invest in private companies is difficult, as (1) the companies often choose to be private because they may not wish to take on external capital investment, and (2), if they do choose to take some limited external capital, opportunities to invest are limited for individual investors and can be difficult to identify.
The level of information made available to individual investors can be limited, making the due diligence process substantially more complex.
Identifying and accessing top-quartile asset managers can be challenging.
Thankfully, the investing landscape has been shifting in recent years. As the alternatives market has continued to expand, with Kohlberg Kravis Roberts estimating the industry will grow to $24 trillion in assets under management by 2028 (up from $15 trillion in 2022)¹⁸. Alternatives are becoming an increasingly important part of the asset allocation process for both institutional and individual investors alike.
True Diversification
We believe that diversification is a fundamental part of helping our clients manage risk and true diversification can only be achieved by considering the entire investable universe. As Edmund Shing, Global Chief Investment Officer at BNP Wealth Management, said, “I'm not a believer that the traditional 60/40 portfolio is the right long-term solution for clients anymore, because the economic regime has changed.”
We have built the core of our investment philosophy around bespoke investment advice that incorporates both public and private markets. In addition to providing custom public bond and equity portfolios, we believe having the ability to conduct due diligence on, access, and manage allocations to best-in-class funds across private equity, private credit, venture capital, and real estate allows us to best serve our clients and deliver the diversification they need. This is important because, unlike public markets, the difference in performance between upper and lower quartile managers in private markets is material, e.g., according to JPMorgan, over a 10-year time frame (ending Q3 2023), "Top-and-bottom-quartile private equity managers, have had, on average, a 21% performance differential."¹⁹
As with most things in life, execution is key. Investing in alternatives may involve a greater degree of risk than investing in equities and bonds driven by factors including lighter regulation, less access to information, and additional liquidity risk. Because of that, working with an experienced advisor is critical and that is where our experienced team of wealth advisors can help.
Everybody’s needs are unique, and each investor needs to fully understand both the benefits and the risks of allocating to alternatives before incorporating such strategies in their investment strategy. If you are interested in learning more about our truly diversified approach to asset allocation, please click on the link below and one of our team will contact you.
