Do Alternative (Private) Investments Deliver Better Returns?
Brennan McCarthy, CFP®
Investment opportunities extend far beyond traditional stock markets, with private investments often presenting an enticing avenue for high-net-worth individuals and institutional investors seeking diversified portfolios. However, it is essential to understand that historical data suggests private investment returns have generally not outpaced the overall stock market. Then why does this narrative seem to persist through financial media?
Understanding Private Investments:
Private investments encompass a wide range of strategies, including venture capital, private equity, real estate, and hedge funds, among others. These investment vehicles often provide access to non-publicly traded companies or less liquid assets not available on public stock exchanges. While private investments can offer unique opportunities for growth and diversification, their returns are typically subject to different risk and return dynamics compared to publicly traded stocks.
Why Private Investment Returns Lag Behind:
1. Liquidity Constraints: Private investment vehicles are often illiquid and lock up investors' capital for extended periods. This lack of immediate liquidity can significantly impact the overall returns, as investors are unable to realize gains or reposition capital when desired. Conversely, the lack of liquidity can actually boost overall returns for many investors, because the funds are often locked in during the worst return periods, which also tend to be the worst times to sell an investment.
2. Market Efficiency: Public markets are widely regarded as efficient due to the availability of vast information, transparency, and regulations. In contrast, private investments operate in an environment with less transparency and fewer regulatory requirements. This lack of information and efficient market mechanisms can limit the ability to accurately evaluate and price private investments, potentially hindering returns.
3. Manager Performance: The success of private investments largely depends on the expertise and skill of the fund managers. It’s true that there are exceptional managers who consistently outperform the market, but finding them can be challenging. Identifying skilled managers with a track record of consistently generating strong returns is crucial, but no guarantee can be given. Think about investing during the dot com boom in the late 1990’s: most investors in that space put a lot of money down on Yahoo and/or AOL being the corporate players that would last for our lifetimes. Unfortunately for them, Google and Apple came onto the scene and essentially made those companies obsolete.
4. Risk Factors: Private investments often entail higher levels of risk compared to public markets. These risks include limited diversification, higher operational risks, and the possibility of investing in early-stage companies or unproven business models. The high failure rate of start-ups and volatile market conditions can weigh on private investment returns. Higher risk can often yield higher returns, but just like in baseball, the home run hitters also tend to strike out the most. While most fans are okay with that tradeoff in baseball, a “strikeout” in this analogy would be losing most (or all) of your investment.
5. Selection Bias: It is important to note that private investments operate within a selective universe. Not everyone has access to or can invest in privately held companies or funds. This selection bias can create an illusion of higher returns for private investments since only successful and high-potential investments are included in the data set.
While private investments can offer unique opportunities, high-income young professionals need to approach them with careful consideration and realistic expectations. Historical data indicates that private investment returns have generally not outpaced the overall stock market. Factors such as liquidity constraints, market efficiency, manager performance, risk factors, and selection bias contribute to the performance gap between private investments and public markets. It is crucial for investors to diversify their portfolios, conduct thorough due diligence, and seek professional advice to navigate the complexities and potential pitfalls associated with private investments.