(Bloomberg) – A shift to private markets is protecting many of the world’s biggest investors from the damage wrought by runaway inflation and soaring interest rates.
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The big question now facing the giants from China’s $1.2 trillion sovereign wealth fund to California’s public pension, the largest in the United States, is how long these private bets will remain isolated as the economic outlook darken.
The ten largest global funds that disclose holdings in non-public markets have doubled their combined weightings in assets such as private equity and credit, real estate, infrastructure and hedge funds to around a quarter of their portfolios since the global financial crisis, according to Bloomberg analysis of investment documents.
The shift was largely at the expense of stocks and bonds for the $7.7 trillion group, which also covers Japan’s repos in Canada and Norway’s sovereign wealth funds in the Middle East. The most dramatic change is that of China Investment Corp., which has increased its exposure to private assets and hedge funds from virtually zero in 2008 to almost half of its holdings, according to its latest update.
Private assets may be harder to sell and subject to less frequent revaluations, but the global pivot has helped offset some dire losses for these investors. Central banks that unwound years of accommodative monetary policy wiped out a quarter of the value of global equities and a fifth of bonds in 2022, with the prospect of even more pain to come. U.S. private equity, meanwhile, is expected to outperform major asset classes over the next decade, according to data compiled by BlackRock Inc.
“Equities could face more downside from here and bonds could continue to face headwinds from rising rates,” said Kim Bowater, advisory director at Frontier Advisors, which advises investors representing nearly of $400 billion in assets. “Having more components in the portfolio that behave in different ways can provide strong returns when traditional asset classes don’t.”
A 7.1% gain for unlisted real estate helped the Norwegian sovereign wealth fund limit its fall to 14.4% in the first half of this year. By comparison, global equities fell 21% over the period and bonds 14%. Korea National Pension Service’s alternative portfolio jumped 7.3%, reducing its overall loss to 8%.
Japan’s mammoth Government Pension Investment Fund returned 21.4% from alternative investments in the year to the end of March, the latest performance period published, four times more than the broader portfolio.
The funds analyzed by Bloomberg came from a list of the largest investors compiled in November by the Thinking Ahead Institute, a professional body representing asset owners.
The upper end of the assignment ranges was used when no specific number was listed. One of the ten funds reviewed by Bloomberg, the Federal Retirement Thrift, held no alternatives during the period.
No sure bets
Still, outperformance is not a safe bet. The cost of debt used to fund large buyouts has jumped as rates climb. Unlisted assets are also rarely priced – a process known as “marking to market” – which can make them artificially attractive.
“The fact that private equity is not marked to market hides the problems,” said David Elms, head of diversified alternatives for Janus Henderson Investors. “The markets are continuously falling. This will have to go through valuations.
Harvard University’s endowment also warned, though private assets have helped it limit losses over the past academic year. Investors in this space have done well, but it “may indicate that private managers have not yet marked their portfolios to reflect general market conditions,” said NP “Narv” Narvekar, CEO of Harvard Management Co.
Yet assets such as toll roads and airports can adjust prices with relative ease, offering attractive inflation protection. A global index of publicly traded infrastructure companies – a rough approximation of their private peers – suffered around half the losses of global stocks this year as the market slumped.
Ports, Wind farms
The private agreements of China Investment Corp. included a Turkish port and a fund launched with Goldman Sachs Group Inc. to invest in US private companies. Norway’s $1.1 trillion sovereign wealth fund is banned from private equity but has built stakes in renewable infrastructure that includes one of the largest wind farms in the world.
“Suddenly, diversification pays off,” said Rich Nuzum, chief global investment strategist for Mercer Inc. He recommends large investors opt for “private debt over publicly traded debt and private equity.” rather than publicly traded stocks,” given the likelihood of further monetary tightening. .
Global macro hedge funds, which bet on the impact of political and economic events, are also doing well. A monthly index compiled by Credit Suisse Group AG that tracks the strategy jumped more than a fifth this year through August.
Australia’s $150 billion sovereign wealth fund holds more than half of its assets in alternatives. The Future Fund increased investments from global macro funds last year after correctly forecasting that deglobalization and difficult geopolitics would boost inflation.
“There has been incredible enthusiasm for private market assets, especially private equity,” said Ben Samild, the fund’s deputy chief investment officer. “The main factor driving returns is that there’s a bit more excess return potential.”
That said, the structural shift to private assets that trade infrequently can also have serious and unintended consequences for markets. Investors are forced to sell their most liquid holdings – typically stocks and bonds – in times of crisis, adding further selling pressure in listed markets while unlisted assets are isolated.
Disclaimer in UK
This dynamic played out last month when UK pension funds narrowly avoided disaster. As the value of UK government debt fell alongside a controversial budget plan, repos had to sell more bonds to build up collateral to back derivatives positions. This fueled a rout in the government securities market that forced the Bank of England to unveil an emergency bond buying programme.
Investors are on alert. The risks of similar outbreaks could become even more extreme given the outlook for tighter financial conditions, war in Europe and sluggish growth in the world’s largest economies.
“Part of the problem lies in the fundamental questions of the monetary authorities which must curb a wage-price spiral. Then there is the Russian-Ukrainian issue and all its impacts,” said Nuzum de Mercer. “This year we are nine months away and it still looks ugly.”
(Adds comments on Harvard University’s Private Endowment Markets)
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