By Ellen Hazen, CFA®, Chief Market Strategist

June Takeaways:

• The Federal Reserve (“Fed”) increased its estimates of inflation, unemployment, and the longer-term Federal Funds rate, while keeping short-term rates at 5.25%-5.50%. The Fed’s quarterly Statement of Economic Projections showed an increase in participants’ expectations for 2025 Personal Consumption Expenditure Index (PCE) from 2.2% to 2.3%, and an increase in expectations for 2025 unemployment from 4.1% to 4.2%. Consequently, participants’ estimates of the end 2024 Federal Funds rate increased from 4.6% to 5.1%, and the longer-term Fed Funds rate from 2.6% to 2.8%
• Equity markets continued their appreciation. Growth stocks were the best-performing. Value stocks and the stocks of smaller companies declined in the month. The Russell 1000 Value Index declined by 0.9% while the S&P 600 Small Capitalization Index declined by 2.3%
• Headline inflation was consistent at 3.3%. The Consumer Price Index (CPI) has ranged between 3.0 and 3.8% for the past year, with the most recent reading at 3.3%. The Core Personal Consumption Expenditure Index (PCE) has continued to decline, with the most recent reading at 2.57%. Both of these are above the Fed’s longer-term 2.0% target and support higher-for-longer interest rate assumptions
• Bonds appreciated. The Bloomberg Aggregate Bond Index appreciated by 0.9% in the month of June, cutting year-to-date losses from 1.6% to 0.7%
• Global central banks eased. During June, the Bank of Canada, the Swiss National Bank, and the ECB all cut their overnight interest rates. The Fed is expected to follow perhaps later in 2024 or early in 2025, but has not yet followed. All else equal, this could bolster the strength of the US Dollar
• Unexpected election results. From Modi’s smaller-than-expected victory in India to Sheinbaum’s unexpected landslide in Mexico to Macron’s defeat in France’s snap elections, citizens in democracies are expressing dissatisfaction with the status quo. All else equal, this could increase risk premia globally, putting a cap on investment returns across asset classes

What We Are Watching In July:

• Employment. Monthly nonfarm payrolls created in the month of June will be released on Friday, July 5. Economists are currently estimating that in June the economy added 190,000 new jobs. This compares to 272,000 created in May and an average of 247,000 monthly so far in 2024
• Corporate earnings reports. Companies will report Q2 2024 earnings starting in the second week of July. Currently, analysts estimate that earnings of S&P 500 stocks will grow by 9.0%, on revenue growth of 4.4%. The fastest-growing sectors are currently expected to be Technology, Healthcare, Communications Services, and Consumer Discretionary, with Materials accelerating later in the year
• Smaller company earnings. Small-capitalization company earnings are expected to be lower in Q2 2024 than in Q2 2023, but return to growth later in the year
• Fed meeting July 30-31. We expect the Fed to continue to hold the Fed Funds rate steady at the current 5.25%-5.5% range

Observant investors will have noted the recent rapid increase in private investment opportunities available to investors traditionally considered too small to invest in private markets. Over the past several years, dozens of semi-liquid funds have been launched, providing access to private equity, private credit, infrastructure, venture capital, and other illiquid asset classes. Why have these products been launched, and are they worthy of consideration?

First, a few definitions. Private equity is, as its name implies, an equity shareholding in a company that does not trade on a public stock exchange. Private credit funds hold individual private loans. Venture capital provides funds to start-up companies in exchange for an ownership stake, while infrastructure funds invest directly in income-producing hard assets, such as roads, bridges, or ports.

These private investments typically require investors’ money to be locked up for several years. They also have historically required fairly large minimum investment sizes – on the order of $1 million or more. Because of these characteristics, these investment classes had until recently been the purview of very large pools of money, including pension systems, endowments and foundations, and sovereign wealth funds, among others.

These asset classes have also historically provided higher investment returns than more pedestrian public stock and public bond investments, typically by 2 to 3 percentage points per year. This has been known as the “illiquidity premium”: investors are compensated for this illiquidity via higher returns.

Private illiquid investments increased in visibility after David Swenson led the Yale endowment to double-digit returns over 10- and 20-year periods starting in 1985. Returns in private assets were higher than in public markets, and correlations were lower, so institutional investors flocked to private assets. Smaller investors, however, were excluded because of high minimum investments.

Newer wrappers that have enabled access for smaller investors include Business Development Corporations (BDCs), private Real Estate Investment Trusts (REITs), and interval funds (SEC-registered funds with daily pricing but only intermittent liquidity). Many of these come with simpler tax forms, including 1099s rather than K-1s.

Growth in More Liquid Private Investment Vehicles Has Accelerated

So why are these investments becoming available to smaller investors now? We are often skeptical when new products are rolled out to individual investors, because this has sometimes occurred at exactly the wrong time, when returns are about to decline. Understanding why these semi-liquid products are now being made available to individual investors can provide us with a clue as to the sustainability of the asset class. We see at least a few reasons why they are being rolled out now.

First, demand has been swelling for access to private investments from high net worth and ultra-high net worth individuals and families. The 2021 Ernst & Young Global Wealth Research Report reveals that Alternative Investments is the sub-asset class with the highest expected growth over the next three years for both high net worth and ultra-high net worth respondents. Arguably, the demand has been there for years; what has changed is the proliferation of investment vehicles that enable individual investors to access private investments.

On the supply side, a few trends have converged that have led managers to create a wide variety of private products that are accessible to individual investors. It doesn’t hurt that interval funds and other individual products provide more steady, predictable returns for publicly traded private asset managers than do the traditional closed-end drawdown vehicles historically invested in by the world’s largest investors.

High net worth and ultra-high net worth investors currently have fairly small allocations to private investments, in contrast to large institutional investors, who have been investing in private investments for years and may have invested as much as their boards feel comfortable. Cambridge Associates estimates that endowments already have 25% of their portfolios committed to private investments, while Morgan Stanley estimates this at 27%. Individual investors have much lower allocations and therefore are a more attractive growth segment for which private asset managers are increasingly tailoring products.

Is the development of more products good for smaller investors? Absolutely. Let’s explore some benefits and considerations.

The current trend of access democratization to these higher-returning, lower-correlating assets provides smaller investors with attractive investment opportunities that were previously unavailable. This can enhance those investors’ risk-adjusted returns and provide additional diversification.

Individual investors can access not only the higher returns from these funds, but access types of income streams that were previously unattainable. One example is infrastructure. It is difficult for an individual investor to directly access the regular income stream that a port or toll road provides, yet one can readily see that such an investment could provide diversification because of its lack of correlation to traditional public equity and fixed income markets.

Because these are different than the fully liquid stocks, bonds, mutual funds, and exchange-traded funds to which many individual investors are accustomed, there are a few characteristics to note. One obvious difference is liquidity. These funds can be “gated” to prevent full withdrawals at will. This is because the underlying private investments remain illiquid; they cannot be bought and sold daily. Despite innovations like placing these private assets in a more-liquid wrapper, one cannot conjure liquidity from thin air. The funds address this by maintaining a liquidity buffer with some publicly held and therefore easily tradeable assets, but if redemption requests exceed the liquidity buffer, redemptions may be pro-rated, and investors may be unable to withdraw as much as they desire.

As with any investment, any time money flows into an asset class, there is the risk that too much money chases too few opportunities. Because these funds charge fees from day one, they are incented to deploy capital from day one, regardless of whether opportunities in the private world abound or are scarce. Thus, as the fine print always says, past performance of private assets may not be indicative of their future returns.

Other considerations are fees, investor qualifications, and valuation marks. Fees for these funds are generally higher than public equity and fixed income funds, so returns must continue to be that much better for after-fee performance to be additive. Depending upon the specific wrapper, investors may be required to qualify (via minimum income or asset levels too complex to list here) as Accredited Investors, Qualified Purchasers, or Qualified Clients, to even purchase the fund. Finally, because the underlying investments are sometimes marked to market more slowly than public investments, valuations generally lag public markets. This can be viewed as positive, as it tends to smooth out both public investor euphoria and panic.

Because so many funds have been launched over the past few years, analysis and diligence of possible investments is critical. What is the fee structure? What are the management incentives? What is the asset management company’s track record? How much debt does the fund anticipate taking on? Should dividends be reinvested or cashed out?

Our conclusion is that this represents a leap in the breadth of the investment landscape available to individual investors. Because of the complexity and sheer number of recent offerings, we believe careful analysis is critical. Not all of these will prove to be good investments, and we believe that the enormous number of newly launched funds increases the probability that some of them will have significant organizational and investment weaknesses. We generally favor investments from smaller, private asset managers who do not need to respond to their public shareholders and who may be nimbler than their larger brethren, although occasionally a large household name manager has a compelling product. Our final thoughts: Be open-minded, look carefully into the details, and prepare to take advantage of appropriate new opportunities.

Disclosures