It’s time to re-evaluate the traditional idea of a balanced portfolio. Despite the recovery in stock markets, high inflation remains a major challenge for investors seeking to achieve real wealth growth. Relying on the 60/40 split between stocks and bonds is insufficient for those aiming for higher returns.

Equities should remain the cornerstone of a long-term portfolio, with the strongest potential for growth. But to optimize returns and diversify without sacrificing performance, investors should explore other equity exposures, including private equity. Unlike fixed returns from deposits and bonds, which fall short in sustaining long-term growth, a diversified equity strategy can better meet rising expense expectations. But what allocation of equities and indeed, private equity, is appropriate for an individual investor?

The Importance of Equities

Equities have long been the foundation of an investor’s portfolio and the primary driver of capital growth. The type of equities included in a portfolio depend on the investor’s long-term goals, such as capital gains or income, and the level of risk that is acceptable. As such, they could be segmented by size, style, geography or economic activity.

By investing in equities, as an owner, investors can benefit from corporate growth. However, the positive development of a company’s valuation takes time, and so to maximise wealth creation from equities, it is key to stay invested for the long-term. Ultimately, there are many benefits of adding equities into a portfolio:

• Capital Appreciation: Equities offer the potential for significant capital gains over time, though patience is often required to realize these higher returns.
• Opportunities to Diversify: Equities provide a broad range of investment opportunities across different sectors and regions, enhancing portfolio diversification.
•  Dividend Income: Many companies distribute a portion of their earnings as dividends, providing investors an income stream.
• Hedge Against Inflation: Equities can act as a hedge against inflation, as companies can adjust prices and costs in response to inflationary pressures.
• Shareholder Engagement: Investing in equities allows investors to engage with company management and influence corporate governance practices.

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Combining Public and Private Equities

We have discussed private equity at length in other articles, and whilst they differ to investing in public equities, it’s clear that there are many similarities. At its most base level, both are ongoing businesses seeking to develop and grow, impacted by economic events.

Pension funds have been allocating large parts of their portfolios to private equity for decades, but wider exposure to private markets has been growing over the past ten years. Investors are increasingly aware that almost 90% of large companies are still privately owned and 60% of unicorns (privately held startups valued at over $1bn) reach their potential before becoming available for investment.

Investors are likely to be aware that private equity investing offers the benefit of higher returns, mainly as it is more difficult to trade shares in private companies than publicly listed companies.

But, due to their similarities, many also assume that there is a high correlation of returns between public and private equities. This is not necessarily the case, especially in Europe with a 3-year rolling correlation between European private equity (Buyouts) and the MSCI Europe since 2003 of only 0.57. For North American private equity and the MSCI North America, the correlation is higher, but still lower than one may expect at 0.82¹.

Combining public and private equities also offers significant diversification and risk mitigation benefits. Adding private equity to the portfolio enables investors to expand their options of investing at different stages of a company’s lifecycle. Sectors across geographies also represent different stages of development, which can aid diversification. For instance, the tech sector represents only 1.1% of the FTSE100², compared to 29.2% of the S&P 500. This does not mean that the UK doesn’t have any tech investment – it’s just that most of it is within the private sector.

Higher Returns When Private Equity is Part of the Portfolio

We have alluded to it above, but it is worth highlighting again: historically, private equity returns have significantly outperformed public market returns. It is important to state that investing in top-quartile private equity funds is crucial to achieve such expected outperformance. Over a 20-year period, the global private equity index achieved a 12.2% annualised return, compared to public markets at 5.2%. However, when considering top-quartile private equity funds, annual returns rise to an average of 20%, while often doubling their investor’s capital, and over multiple time periods. The idea of the illiquidity premium associated with private market investing means that the more private equity forms part of the portfolio, the higher the expected potential returns.

What Should Your Allocation to Private Markets be?

The optimal allocation to private markets depends on individual preferences, including risk tolerance, investment horizon, and the need for flexibility. Institutional investors, such as university endowments, can often allocate up to 30% or more of their portfolioto private markets, although on average the allocation is closer to 23%.

But is this appropriate for individual investors?

A private equity risk-adjusted returns analysis by Neuberger Berman shows how incorporating private equity can impact a portfolio. Introducing 20% private equity in place of public equity in a portfolio with 70% equities and 30% bonds can enhance returns by almost 1.5%, while also lowering overall risk.

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Additionally, industry experts propose a 30-30-40 distribution for investors' portfolios: 30% in private markets (equity, debt, real estate), 30% in public bonds, and 40% inpublic stocks. This new industry benchmark of 40-30-30 has delivered higher returns over the past 15 years compared to traditional portfolios with a 60-40 stocks-bonds mix.

How Does Private Equity Exposure Aid the Shariah-Compliant Investor?

Diversifying a Shariah-compliant portfolio is more challenging due to the limited range of available products. As such, private equity should be central component of a Shariah-focused long-term portfolio, rather than simply a diversifier. Indeed, building private equity exposure offers several advantages:

• Risk Sharing: Private equity aligns with the principle of sharing risk and enjoying uncapped upside potential.
• Lower Zakat Impact: A shareholder in a company is responsible to pay Zakat on its net Zakatable assets, with Zakat due on the share of ownership. It is generally the case, that equity tends to have a lower Zakat impact compared to other investments.
• Venture and Growth Funds: These types of private equity funds are most likely to comply with Shariah principles, focusing on ethical and growth-oriented investments.

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Expanding Opportunities for the Shariah-Compliant Investor

Private equity assets under management reached USD 13tn by 2023 growing at around 20% per year since 2018 and notably rising at a faster rate than public equities. As private equity becomes increasingly viewed as a primary asset class, investors can start exploring its widening range of strategies – from primaries, secondaries and co-investments to venture, growth and buyout funds.

As traditional investments struggle to meet expectations, building private equity exposure becomes more crucial and as interest in private equity rises, the ‘appropriate’ allocation to this asset class will also increase as well.  Mnaara is playing a pivotal role in enabling individual investors to access these opportunities. With a lower ticket entry point, building a more diversified equity exposure, with the potential for higher returns over the long-term, is now much more feasible.

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Author

Saad Adada, CFA

_Sources: ^‍

_{1 https://www.abrdn.com/en-gb/institutional/insights-and-research/private-equity-as-an-investment-portfolio-diversifier}

_{2 https://siblisresearch.com/data/ftse-100-sector-weights/}