Private equity won't diversify your portfolio

Low interest rates can lead people to rationalize all sorts of bad ideas: investing in companies that will never make a profit, financing share buybacks with debt, spending billions on terrible streaming content, to name a few. But maybe the most irrational belief encouraged by a low-rate environment is the notion that private equity provides diversification for your investment portfolio.

It's possible, of course, that it could, especially if your portfolio doesn't have many publicly traded stocks to begin with. But even if that's the case, there are cheaper and more efficient ways to get diversification.

Private equity as an asset class has grown tremendously in the last decade, increasing more than fourfold to about $7.6 trillion. There are many explanations for its growth - public pensions chasing yield, for example, or fewer companies going public - and a common justification is that it provides diversification to an investor's portfolio. And it does that, the thinking goes, because it is a so-called alternative asset.

The purpose of diversification is to reduce risk. If you invested all your money in Apple in the 1980s, for example, you'd have made a fortune compared to investing in the S&P 500. But it would have been a much riskier investment, because Apple could have failed. Diversification does not just mean lots of stocks, it can also mean lots of asset classes: commodities, bonds and, lately, alternatives such as private equity. If you get the right mix of assets, theoretically, you can strike the perfect risk/reward balance - the highest possible return for the least possible risk.

At a certain point, however, adding more assets does not alter the risk/return calculus. In fact, depending on how the asset correlates with the rest of your portfolio, a new asset may even increase risk. And that is what private equity generally does, depending on the type of fund. Often private equity simply adds leverage to a portfolio without much diversification. This can increase expected returns, but it does not reduce risk.

Private equity funds can include investments in venture capital, real estate, infrastructure and, lately, private debt. If these funds contain investments that can't be found in public markets, they can potentially provide diversification. But often "private equity" funds are just buyout funds, which accounted for 28% of the market in 2022, measured by assets under management. These funds collect money from investors, take on debt (leverage), then buy a significant stake in a company - either taking a public one private or buying an existing private company.

In many ways this is no different, from a risk perspective, from buying shares in a publicly traded company. Measuring private equity returns and comparing them with those in the public markets is not a trivial task. Private investments are illiquid and there is no objective market return. Funds do report internal rates of return, but they are easily manipulated and not updated very frequently. Even after all that, the returns are highly correlated with those of the public markets.

When economists account for the actual cash flows from private equity funds, the market Beta - the correlation between the private equity and the public market - for leveraged buyout funds is between 1 and 1.3, suggesting little diversification value from public markets. Private equity does provide higher returns, but that is because of the leverage and the equities selected by the manager. A 2020 research paper shows that taking on leverage and investing in value stocks can offer a similar return and risk profile - and offers more liquidity and much lower fees. Though the paper concedes that private equity fund managers may be skilled at asset selection, it also notes that their strategy can be "easily and cheaply mimicked."

So why would someone want to invest in a private equity fund? Maybe they want more risk and illiquidity, and are willing to pay a fee for it. And from the standpoint of the larger economy, private equity can play an important role in helping make some of the companies it invests in more efficient. (Though that has been less true in the last decade, as the industry grew and there were more low-quality funds chasing yield.) Still, even the best case for investing in private equity cannot claim that it offers both greater diversification and higher return.

In the markets as in the rest of life, eventually reality catches up with us. Interest rates are higher now, making leverage more expensive and the chase for higher yields less desperate. Already there are signs the private equity industry is shrinking. Hopefully, so will the belief that leveraged buyouts reduce risk in your portfolio.

(COMMENT, BELOW)

Allison Schrager, a Bloomberg columnist, is a senior fellow at the Manhattan Institute and a contributing editor of City Journal.

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