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Investors of all sizes have faced a torrid time in 2022. Inflation, supply chain challenges, the war in Europe and rapid moves in interest rates have seen the S&P 500, an index of 500 large companies listed on stock exchanges in the United States, fall 17.4% over the year to date at the time of writing. Historically, investors have commonly diversified their equity exposure by including fixed-income investments in a portfolio, but these are also down this year. The largest U.S. bond fund, Vanguard Total Bond Market Index, is down 12.4% over the year to date at the time of writing and is set to record its worst year on record. Faced with these challenging market conditions, more and more investors are looking at private markets to generate returns, diversify and hedge against inflation.
In this article, we explore some key questions on the difference between public and private markets. What makes investing in public markets so accessible, and can private markets help investors balance risk and reward?
The idea of a company selling shares to investors, effectively selling a part of itself, stretches back to the 17th century when the Dutch East India Company sold shares to investors in Amsterdam to finance trade voyages. Going public, or listing, means that companies can raise money from a range of investors who then share in the future profits of companies, whilst having ample opportunity to buy and sell holdings, something called liquidity. The price of shares is determined by the market, with buyers and sellers factoring in a range of considerations that may affect the performance of the underlying companies in the future. As we have seen in 2022, this can mean global megatrends like inflation, energy crises and wars that can cause large, sudden changes in share prices. This volatility is an inescapable part of public markets, and even a diversified portfolio of publicly traded shares will be impacted.
Investing in the public markets can be done in a variety of ways, from buying a share of a single company to mutual funds or exchange-traded funds (known as ETFs), which are run by specialist managers who pick shares in line with their expertise. Investors are not limited to just buying shares in companies, either. Asset classes such as corporate or government bonds, real estate and infrastructure are accessible through public markets, but investors face varying levels of control over individual investments and fee structures that can add significant cost to investing.
A key trend for institutional investors such as pension funds, insurance companies, sovereign wealth funds and other large professional investors, over the last decade or so has been increasing allocations to private markets.
Private market investments are typically made through third-party investment firms, which raise money from a number of investors and find the best possible deals in their area of expertise. These firms will make investments from a fund, intended to be held over several years, creating a long-term portfolio. For institutions, these investments serve a number of purposes: private markets have historically outperformed public markets, they are a way to diversify a portfolio and generate a steady income stream as well as being a hedge against inflation.
In addition, the underlying investments made have different characteristics from those that are more readily available to the public. Private equity investments, for example, are typically acquisitions, where the fund manager takes a majority equity stake in the company. This enables the investor to have significant input on the company’s operations, by expanding its management team, for example, and working towards long-term objectives. In contrast, equity investments in public companies will likely be for a very small or even fractional percentage of the company, and the quarterly reporting requirements and real-time pricing mean that management can often be more focused on short-term goals. In other asset classes, the financing requirements and cash flow profiles of assets don’t lend themselves to being publicly listed.
Private investments in real assets, tangible assets with intrinsic value such as real estate, commodities and infrastructure that generally produce a yield, have recently seen increased interest from institutional investors. These investments can offer protection from inflation; annual rental income increases from a real estate investment may be pegged to inflation rates, for example. They also typically have a low correlation to other asset classes, providing protection to investors through diversification.
In another contrast to public markets, traditional private investments are less liquid and tend to be locked in for extended periods of time. This means they are priced infrequently, and therefore can be shielded from wider volatility. This is something that institutional investors prefer and that individual investors can benefit from.
Given market developments in 2022, many individual investors are aware of the need for diversification and are anxious to find investments that offer the possibility for returns, as well as a shield from volatility, where equity markets are subject to broader economic malaise. Studies have shown that adding private investments as an asset class to a portfolio of shares and bonds increases returns and reduces risk through diversification. This allows a portfolio to weather the worst of volatility, as each segment is impacted by different factors and assets are typically held for longer periods of time.
Technology now allows a wider variety of eligible investors to enter the private markets space without the requirement for making six-figure investments. Private markets are partly insulated from the wider volatility of public markets and can provide access to high-quality opportunities that institutional investors see every day.
Private and public markets offer different investment strategies and outcomes, dependent on the individual’s desires and budget. More investors now have the freedom to invest like their institutional counterparts, and consequently to access the same potential financial benefits.
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