With top down policy noises coming out of the Treasury, the sentiment that investing in both the U.K. whilst simultaneously addressing areas such as climate change and natural capital are; noble, purposeful, societally just and potentially useful in terms of our economy. However, in terms of allocation and implementation, in this, his latest blog for Wealth DFM, JB Beckett poses whether the move to increase retail exposure into private markets is truly democratic – or simply profiteering? So, grab yourself a coffee and let JB talk you through – with his usual style and clarity – just some of his latest thinking on this potentially transformational journey ahead. We’re pretty sure it’ll get you thinking too.
I keep hearing the same phrase used time and time again by distributors, that giving retail investors access to private markets and infrastructure is the great ‘democratisation’ of our industry. That in some way offering a broader investment universe balances the opportunity scales between mass retail, sophisticated and professional investors. Many providers will sell that story, be they mutual fund managers, ETF vendors or closed-end investment companies. They will all want to feast on the new transition economy, and Reeves’ public-private strategy, to shore up a deficit somewhere between £700bn to £1.6 trillion, in the Government’s infrastructure strategy, reported by Ernst and Young.
I have recently attended an excellent Evenco fund selector event entitled ‘Alternative Investments: Expanding Portfolios Beyond Traditional Assets.’ It is fair to say that much of the discourse positively aligned to selling, investing and allocating more assets into private markets and infrastructure. In of itself that works on many levels. However, in terms of allocating assets for clients, I found myself more akin to the grit against the collective grain of the day.
Of course, capitalism aspires to some derivation of democracy and the notion that investor choice appears to neatly befit such ambition. However, our industry has, for decades, repeated a common error in this regard. That is to confuse suitability and innovation. We also confuse choice versus investor protection in this very neoliberal dystopia. As an industry we all too readily conflate diversification with complexity. By its very nature to compete, the industry perpetually seeks to innovate. Adding more asset classes in and of itself does not guarantee that your clients’ portfolios will be more diversified but it does guarantee that they will be more complex. That simple correlation data can often disguise the belying interconnections cross-asset that, at times, remain inert and at others unstable. Think of the recent volatility in U.K. Gilts and equities that occurred at the same time in 2022. The expected portfolio insurance assumed from Gilts collapsed as markets faced a rising inflation environment. With it the 60:40 allocation had a very noisy prolapse. Yet the complexity involved was far simpler example than what advisers may next face into with private markets and infrastructure.
Meanwhile, in the US, Bloomberg reported last December of the continued growth and profit opportunities in what is now a $37 trillion market. This is being led by hedge funds like Blackstone. Bloomberg noting that private markets can “double related fees for alternatives managers, up $22 billion a year, in 15 years”. Following a cycle of tougher controls both sides of the Atlantic looks set to benefit from some degree of regulatory easing. Given the dominance of low cost ETFs in listed markets; and the significant gearing effect presented going into alternatives, it is no surprise that private equity has been buying up U.K. asset management firms at pace; just as private markets are eyeing up the retail market.
Allocation issues ahead
When then adding more complexity of asset types then the risk premia (fancy allocator language for the economic bets taken) both increase and proliferate. This means more risks that need to be modelled, diversified and ideally hedged in the portfolio. Owing to their long maturity and lack of liquidity we cannot assume such assets can be easily used in tactical asset allocation unless through a derivative or proxy asset like an index. Instead, private markets and real assets will more likely be held for the longer term and in which they could offer some strategic benefits. However, they typically carry more liquidity, financial risk and duration (interest rate sensitivity) and their risk premia are far more esoteric than say in your typical Balanced Managed fund invested in equities and bonds.
Personally, I support a multi-asset portfolio that diversifies some risk away from and between equities and bonds and do welcome various forms of hedging. However adding new assets creates a risk exchange not a risk cancellation unless using risk free assets or said hedging. Only through competent allocation can diversification offer some surety. Consequently, advisers are right to challenge any assertions of diversification, as to whether the portfolio is indeed more diversified or simply becoming more complex. Whilst it is alluring to allocate away from the daily volatility of public markets and capture premiums from illiquidity and the risks inherent but these in of themselves are not diversification.
One of the easiest ways to understand how each asset feeds into overall portfolio risk, is to gauge how convincingly the manager explains how each asset type contributes risk to their overall budget (the maximum amount of risk they seek to take for the portfolio). In knowing first hand that there are modelling challenges in the allocator’s engine room, then this is far from straightforward. We know many propositions rely on similar long-run actuarial capital model assumptions. Those assumptions often have little or no models for private markets or infrastructure. Thus they will need to either provide or else will simply proxy-in public market and property data in many cases. In 2024 many still proxy cash for absolute return strategies! Cash!?
To give you just one working example, consider a wind turbine project. How do you model the expected risk and return with less data than for mainstream assets and data that itself had been skewed by low inflation and government subsidies? With difficulty. Consider too that different infrastructure projects will not model in the same way but asset managers may seek short cuts to get the allocation approved. Secondary access through loans, private equity or debt will be modelled differently again. How then does that risk and return change over time from land acquisition, construction, working life through to eventual termination? How does inflation change the cost of capital to finance those projects over time? Any net present value and expected return estimates used will need to adjust accordingly.
Whether moving existing assets or redirecting new subscriptions. There is a cost. These allocations will in all likelihood come from easy to sell listed securities noting that many asset managers have either shuttered or reduced their property books with only a few stalwarts remaining. With high streets in secular demise many property portfolios suffered from increasing void rates and falling yields and valuations. Evolving long-term property portfolios to answer Reeves’ political strategy would favour those propositions with property books, in doing so benefiting from genuine diversification and duration benefits.
Regulation and risk
Given the UK’s sluggish savings ratio yet stable auto enrolment take-up, then it appears that change will likely come from policy change. Whether that is through Treasury imposed limits for pension schemes, to invest domestically, or into certain assets, or through industry osmosis; the market has already been readying itself for a shift. In 2023 the FCA issued policy statement 23/7 to expand the invest-ability of Long Term Asset Funds (LTAF) which thus far had proven as popular as an actuary at a dinner party. Most notably the changes now allow up to 35% exposure for Defined Contribution schemes (Eg. GPP) and up to 10% exposure for Self Invested Personal Pensions (SIPPs). Previously LTAFs were restricted to sophisticated and professional investors only. If fully utilised we could be talking hundreds of billions of retail pension money being allocated into private markets and infrastructure. Add to which the growing marketability of LTAF to wealth managers, the recent liberalisation of Investment Trust charges and the growing innovation from ETF providers and the retail shift to alternatives could be at some scale.
Then, when you roll up all those various assets and risks up to the portfolio level then many propositions endeavour to model and squeeze the portfolio into an overall risk-rating, for a given level of volatility or tracking error. This has been to some extent nurtured by the adviser community over the years by putting such third party risk ratings on pedestals. I would not quickly assume that either the providers or third party ratings suppliers will necessarily know (today) how they would incorporate a large shift in allocation to more esoteric asset types whilst maintaining such notional categories of risk. Riskier assets such as equities and credit tend to swell overall portfolio volatility. The fallacy is if then presenting lower overall volatility by switching out of liquid public securities; owing to periodic valuation of illiquids. Given in terms of total portfolio risk (complexity) the budget will likely need to rise.
Considering this, what advisers can do is to start looking at the provider’s capability and track record in those markets and also whether the rate of change and transition appears to offer a “prudent spread of risk” (et FCA COBS 13). Reviewing the communications and portfolio changes not only in terms of the new investment but the divestment of existing assets to facilitate. Ask ‘what is the opportunity cost?’ The money for the reallocation has to come from somewhere. If not from new inflows then that money for private assets and infrastructure has to come through sells. In the euphoria of innovation, and none more so than in righteous purposeful capital, then the trade-offs in investment risk and return should be communicated. The FCA has stipulated that any significant portfolio changes will require client communication.
Liquidity risk inherent
Another area that will need to be traversed with care is liquidity management. Once, as an institutional investor, investing in illiquid assets could be matched with accuracy to the required cash flow. What many refer to as Asset-liability Matching (ALM) or Liability Driven Investing (LDI). Often such allocations were into offshore funds, commonly private funds and partnerships, with long lock-in periods and clear contractual terms and penalties enforced. This is the antithesis of today’s retail market and the liquidity of many alternative assets are to me ill-fitting for many retail portfolios. Indeed there was a reason why the Alternative Investment Fund Manager Directive (AIFMD) restricted the types of funds/assets that could be accessed by retail investors and also required firms to understand the liquidity demands of their investors. Easy to do when one or two big investors, difficult when a thousand smaller ones.
When there is a liquidity mismatch between portfolio and investor then we need only look to the likes of Arch Cru, Connaught, Woodford and daily dealing U.K. Property funds to understand that liquidity risk can and has ended badly. Very badly. Runs that we have seen on portfolios often occurred with fear and herd behaviour. I am watching the US commercial real estate space with $1.8 trillion of debt due to refinance in the next 2 years according to McKinsey that describes as an “impending debt wall”. When investing in illiquids we need to think about the finance structure and liquidity needed not just today but potentially for the next 10 years or more. Larger supertanker funds can have economies of scale but are not impervious to investor runs or liquidity issues; indeed they can suffer more so than smaller funds particularly in retail. For retail to access illiquid assets requires a level of fortitude and patience.
Many would suggest a post Jack Bogle era of index based ETFs have democratised the market by lowering the cost of investment in public markets. The evidence is compelling. However, we have also seen the problematic gestation of active ETFs. Whilst ETFs could offer easy access, lower costs, liquidity and scale; the structure belying looks far more vexing for the Authorised Participants (APs) needed to stabilise the NAV, trade the portfolio and keep the walls from falling down. Synthetic infrastructure ETFs are possible but you then need to factor counterparty risk. Moreover, with a financial ecosystem that is speeding up; when I think of liquidity risk and fortitude then moving away from the very flawed concept of daily dealing is essential, let alone intra-day for private markets and illiquid assets.
Of course pensions provide some degree of fortitude owing to the lack of access until the ages 55-58 (currently). However this does not prevent switching activity inside a SIPP say, and pension transfers likewise pose a risk. Again liberalisation is not necessarily democratic. Here I can see closed-ended funds offering a solution as trading in and out rarely has a direct bearing on the portfolio assets and Real Estate Investment Trusts (REITs) are well attune to investing in infrastructure. That said the scale of the sector remains relatively constrained for larger pension propositions; there is a lack of homogeneity, dealing depth can be shallower than expected, price to NAV can be volatile whilst for direct retail investors I still reserve caution, in lieu of the new FCA regime, in terms of their light regulation and absent protections. Thus for me closed ended funds and other alternative funds work most effectively for multi asset and DFM portfolios, or when some other fiduciary is responsible for the outcomes.
Complex costs and glide-paths
Another tricky area for pensions is the relaxation of limits for defined contribution schemes by exempting performance fees (common in private markets and hedge funds) from the auto-enrolment charge cap. This to me appears to be a reverse logic against the recent value for money regime. How transparent such fees will prove and how easily they can be priced and reported, at the unit-link level, will be challenging. Advisers, Investment Governance Committees and Master Trust boards will need to take a keen interest.
Life-styling also poses challenges for advisers on both a needs and cash flow basis. We know that in the growth phase of your client’s portfolio (accumulation) they should be net buyers of volatility for they have the benefit of time to allow markets to move up and down. They use that volatility to outstrip inflation. Yet in drawdown (decumulation) your clients want to sell that volatility to avoid unexpected sequencing risk; whilst taking income from the portfolio. In a similar vein investors often over-spend for liquidity during their accumulation phase and under-spend in decumulation. A simple example being most public equities are very liquid and very volatile; whereas bonds are less volatile (most of the time) and less liquid. What role should less liquid private assets and infrastructure play in life-styling? I would say they could work better for growth portfolios; opportunity cost notwithstanding. Inside the portfolio the transition from accumulation to decumulation can be at times both prosaic and clunky in terms of switching from one asset to another. You are right then to ask if adding very illiquid assets like infrastructure works in life-styling at all.
Here I would suggest your questions probe the way the life-styling de-risks from one set of assets (portfolio allocation) to the other. For example providers will most often either apply a vertical or horizontal slice; in other words sell units proportionally across all assets or selectively from some assets but not others, this will come down to the models and tools employed. Across the industry the length of de-risking also still varies to this day. Propositions that have continued to invest in property, to my mind, should be more adept to investing in private markets and infrastructure in the future. But you are right to consider the manager’s capability in the specific asset classes too. Indeed, this applies to all of the above and the questions do become nuanced and more technical for private markets and infrastructure. Do advisers and wealth managers have the support, information and education needed to commit?
Will the inevitable push to private markets and infrastructure truly be democratisation for your clients, as vendors will claim or will it be a; political push to pay a public deficit, the opportunity to diversify your client portfolios over the longer-term or simply innovation and liberalisation to sell you more expensive products? Perhaps all apply.
About JB Beckett
Across 30 years, JB Beckett has delved through the contentious and taboo of our industry, speaking around the world. In 2015 JB wrote “New Fund Order” and “NFO 2.0” in 2016 and co-wrote a number of books on digitalisation of asset management. Since 2020 JB has hosted the New Fund Order podcast – NewFundOrder.Buzzsprout.com. A multi-asset allocator for over 20 years, until 2018 JB was a fund gatekeeper at Lloyds and Scottish Widows. Today, JB is a member of Royal London’s Investment Advisory Committee and remains Emeritus of the Association of Professional Fund Investors and external specialist for the CISI.
