Private equity's potential for strategic portfolios

November 5, 2020

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Investor interest in private equity is on the rise. A new Vanguard research paper examines the role private equity can play in a strategic, long-term portfolio and introduces a new portfolio construction framework that accounts for private equity's unique risk and return characteristics.

Highlights:

  • Although private equity and public equity share some risk and return characteristics, there are key structural differences. Private equity investments are illiquid and so must be actively managed, introducing both illiquidity and manager idiosyncratic risk to the multiasset portfolio. Investors, therefore, must carefully consider their willingness and ability to handle a long-term lack of liquidity, constraints on rebalancing, and uncertainty around the timing and size of cash inflows and outflows (when private equity is owned through a fund structure), among other challenges.
  • The paper introduces a new portfolio construction framework that accounts for private equity's risk and return characteristics—something conventional asset allocation approaches generally fail to do. This framework underlies the Vanguard Asset Allocation Model (VAAM), our proprietary analytics tool. For this paper we used VAAM to construct optimized multiasset portfolios based on different risk and return assumptions.
  • Our research findings indicate that assuming private equity can be perfectly rebalanced tends to overestimate optimal allocations. We also confirmed that higher levels of active risk aversion lead to lower allocations to private equity while higher private equity expected alpha or lower expected active risk lead to larger allocations.

Portfolio analyses and simulations performed using VAAM demonstrate that private equity can play a significant role in strategic, long-term, diversified portfolios. There is no single recommended allocation for all investors, however. Private equity allocations depend on each investor's specific set of circumstances, such as the degree of risk tolerance and ability to access high-quality managers.

Read white paper  

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • Past performance is no guarantee of future returns.
  • Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Private investments involve a high degree of risk and therefore should be undertaken only by prospective investors capable of evaluating and bearing the risks such investments represent. Investors in private equity generally must meet certain minimum financial qualifications that may make it unsuitable for specific market participants.