Why portfolio diversification in the private markets can help combat the impact of COVID-19

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The spread of COVID-19 has led to unprecedented impact on the global public markets, with no indications of when it will slow down. On March 18th, the Dow Jones plummeted to a 3-year low as investors scrambled to exit their positions. With investors exiting the public markets, many believe that the private markets may offer less volatile results during these uncertain times. 

Why is this the case? The scenario that we are currently dealing with is one fraught with questions and unknowns. The economic impacts relevant for real estate and other private markets hinge on how severe the outbreak is and how long it lasts. At this time, there is still uncertainty on both, which leads to a very uncertain outlook. Where the private markets differ from the public markets, however, is that data on the economic impact is limited, but the economic data is backward looking. Part of the reason that the stock market has seen higher levels of volatility is due to the fact that it is forward looking in nature and declines are indicative of concern about the economy in the future. As Jim Cramer on CNBC says, “markets often overshoot the fundamentals.” 

The general practice for valuation of private real estate portfolios is to seek appraisals for portfolio holdings to get current private market value estimates. This would include recent private market (not public REIT) transactions. Interestingly, things like bankruptcies and business closures can be muted given that these organizations typically are required to pay rent until bankruptcy. That coupled with lower interest rates giving lower borrowing costs will have an indeterminate short term impact on private real estate valuations. Retail commercial real estate has seen challenges in recent years , while the residential and industrial sectors have been doing well. We have seen more mixed results in the office sector, given the trend towards more open office environments and reduced space needs to accommodate this. With the expectation that the virus could dissipate in the Summer/Fall timeframe and the sales and valuation cycles in the  private markets, it is less likely we will see similar impacts to the private commercial real estate market that we have seen in the broad public markets. Illiquidity can however create a separate risk to investors as they will have a limited ability to withdraw capital in declining markets and markets where their illiquid investments are underperforming. In short, illiquid investments can provide meaningful diversification in the event of short-term market volatility, but do not prevent against underperformance during long-term economic downturns or individual investment underperformance. There is an emerging trend in the private fund market that are offered digitally and provide or more immediate liquidity options.

Volatility has a dramatic impact on long-term investment goals and market scholars such as David Swenson from the Yale Endowment and other institutional allocators discovered many years ago that the inclusion of illiquid, real estate and alternative investments can improve the potential for portfolios to achieve their investment goals. Historical data suggests that private markets’ performance is often lowly correlated to the performance of the public markets and offering higher Sharpe ratios, resulting in a strong diversification benefit.

The previous weeks have stressed the importance of portfolio diversification through investment in public equities, bonds, private real estate and alternative investments, and cash. We hope to have more clarity regarding the global economy’s situation over the coming weeks, but diversified portfolios may be best suited to weather this storm and future storms for the long haul.

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January 21, 2022

Around the Block (1/21/22)

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