Elevating Goals-Based Investing with Private Markets

Most advisors are familiar with goals-based investing, as a staple of the industry. You work with clients to identify and prioritize their financial goals, such as sending their child to college, buying a home, or retiring early, and then creating a portfolio tailored to those objectives. 

A goals-based approach takes into account an investor’s risk tolerance, time horizon, and financial circumstances, and considers factors such as inflation, taxes, and market volatility. 

It is always important to consider how close a client is to meeting their goals. The further a client is from meeting their goals, the more risk they will need to take to maximize their chance of success. Great advisors help craft efficient, customized solutions that maximize the probability of success while managing the risk of “bad outcomes” for the client. 

Private assets ideally suited to a goals-based approach

Private markets can play a highly constructive role in helping achieve these goals, and we would argue are an under-utilized tool among advisors. To use an admittedly overused analogy, just using public markets is like only using a hammer when you also have a drill. Hammers have a useful purpose, but when advisors ignore private markets, they are missing out on an effective set of tools to address a wide range of clients’ financial needs. The right portfolio with the proper alternatives allocation can increase the probability that clients hit their financial goals, with potentially a lot less headaches on the road to success. .

Access to private markets, while somewhat fragmented,  is now widely available for high-net-worth investors (HNWIs), and demand and clients’ willingness to seek out new providers continue to rise. This makes sense, as private funds have characteristics that make them well suited to goals-based investing, such as:

1. Customization: Private funds focus on individual managers and deals, with specific thematic, strategic, and industry focuses, so they allow investors much more flexibility to align their portfolios with their goals and interests than traditional broad-based mutual funds and ETFs. Many traditional products tend to rely on scale with a one-size-fits-all solution, while successful private managers tend to identify a specific niche in which they perceive they have a competitive advantage.
2. Longer-term focus: For investors with business-cycle-length horizons, private funds’ lifecycle may be better aligned. While many of these vehicles lack liquidity, this helps discourage emotional investing decisions that could negatively impact long-term outcomes, either on the part of the investor themselves or third parties. Long-term, consistent bases of capital can help clients stay the course and see their goals through.
3. Access to unique opportunities: In addition to diversification benefits, private funds can provide access to investment opportunities unavailable in public markets: Fewer than 15% of companies with revenue exceeding $100M are now publicly traded, according to S&P Capital IQ data. There is a whole universe of exciting innovations out of the reach of public market investors. Some of these unique private assets may have very specific risk and return profiles that match more precisely to a client’s goals.

Navigating private markets can seem difficult from a cold start.. There are definitely extra administrative processes associated with bringing private funds into a client portfolio, and new return terminology and investment processes to understand and communicate. However, the right guide can help you streamline these processes, simplify client reporting, and even help you determine the correct asset allocation for your clients. A guided approach keeps you, the fiduciary, in the driver’s seat of client success, but adds a growing and diversified set of options to craft more effective strategies, win new clients, and help existing clients meet and exceed their goals.

If it seems complicated, it is important to remember that fundamentally these investments can be boiled down to serving the same three goals as any other investment in a portfolio: increasing growth, boosting cash income, and reducing risk. But the level of specialization and active management for many private strategies may allow them to target these goals with more precision and client-focused customization.

Our hypothetical client personas below illustrate how private assets could be incorporated to help clients meet their goals most effectively, including analytics taken directly from our product (we break down our methodology at the end of the article) illustrating their impact on a public market portfolio in terms of:

• Returns, demonstrating a cone of potential performance at the 10th and 90th percentile level
• Yield, the amount of income generated by the portfolio
• Max drawdown, the largest expected drop in value from peak to trough
• Volatility, the frequency and magnitude of price movements, both up and down

In all three scenarios, our detailed modeling shows how adding private markets exposure could help you better meet a client’s goals.¹ And of course, what’s good for your clients, is good for you and your practice.

¹ See important information in the disclaimers. Hypothetical private allocation replaces existing equity and fixed income allocations on a pro rata basis, i.e., replacing allocations in proportion to their existing level.

Hypothetical Client Personas

Profile

• Oscar started a business right out of college and after a decade of hard work sold his company. This liquidity event left him flush with cash.
• He has low fixed costs, with a primary focus on growing his wealth over the long term. Specific goals include setting up trust and college funds for his young children and enabling an early retirement.
• Oscar would like to get as close to an annual 8-9% return as possible. His longer time horizons mean he is willing to tolerate more risk if necessary, and income is not yet a priority. He is unconcerned about illiquidity (and sees the value of having capital locked up in productive uses).

Proposed Solution

• Oscar’s goals argue for creating a basket of growth-focused instruments in both public and private markets.
• His private market allocation can be focused squarely on meeting his growth goals over a long-term investment horizon: specifically private equity and venture capital.
• Opto’s portfolio construction modeling² (see below) shows that incorporating a 20% allocation to private equity (14%) and venture capital (6%) funds in his portfolio increases the probability that he achieves the growth he needs to meet his goals.
• Most importantly for Oscar’s goals, our modeling suggests that even median performance from these funds over 15 years would lift his returns by 1.4% annually (an estimated additional $5.9M in wealth) while actually reducing drawdown risk and volatility. Yield would inevitably fall a little with the replacement of some income-generating assets with growth-focused ones.

² Our modeling uses granular, customized capital market assumptions with performance metrics net of manager fees and derived from historical data. Sources: Burgiss total return series, vintage year return data & cash flows, Preqin, Pitchbook, Refinitiv public markets data. For historic data we are using the following to represent asset selection: Large cap equities – S&P 500, Small cap equities – Vanguard Smallcap Index, Real assets – 80% FTSE Diversified REIT and 20% S&P GSCI All Commodities, Fixed Income – S&P US Aggregate Bonds Index, Cash rate – Fed Funds Effective Rate. We incorporate a model of realistic investment behavior over the specified time period. Please see methodology and disclaimers. For more details, feel free to reach out to our team at: [email protected].

Profile

• Meredith has been working for the last 20 years as a successful orthopedic surgeon. She has built up her practice over the years and paid off her medical and business debt, while her children have both left for college. She has a busy job, and is too occupied with that to moonlight as a stock picker or angel investor.
• She plans to continue to work for a little while yet, but is thinking ahead to her eventual retirement. 
• Meredith’s time horizons and goals means she still wants to grow her wealth but without too much risk. She can lock up some of her money for a period of time.

Proposed Solution

• Incorporating financial instruments outside public markets may help reduce overall portfolio volatility and increase the chance of her meeting her return targets.
• Her goals, risk, and illiquidity budget suggests Meredith would benefit most from incorporating a private markets portfolio with a mix of funds focused on growth and managed risk.
• This balanced, all-weather portfolio should help provide consistent risk-adjusted returns in an array of financial conditions.
• Opto’s portfolio construction modeling (see below) predicts that incorporating a 15% allocation to a mixture of private equity (10.5%), private credit (2.5%), and both growth- and income-focused real estate (2%) funds, could – at just a median level – improve returns (an estimated $7.4M improvement over 15 years) while reducing both volatility and maximum drawdown potential. 
• Yield would fall marginally over the modeled timeframe, but with retirement still some way off, a tactical tilt towards income would be possible closer to that time.

Profile

• After 40 years advising corporations on best legal practices across the globe, Charles is getting ready to leave his law firm, where he rose to become a partner, and enjoy his retirement. 
• His priorities have gradually shifted in recent years from maximizing portfolio performance to making sure he will have money to take his grandkids with him on trips he missed out on during his busy career.
• Charles’ situation demands a stable, low-risk portfolio, with steady income and limited volatility. He is willing to lock up only a limited amount of his wealth.

Proposed Solution

• With uncertainty over the future performance and hedging capabilities of bonds, certain private market asset classes can help diversify the income component of Charles’ portfolio, and potentially elevate overall portfolio performance.
• Replacing public fixed income with exposure to private credit, and private infrastructure adds diversification to lower risk and may enhance his income.
• Opto’s portfolio construction modeling (see below) shows that incorporating a 13% allocation to a mixture of private credit (9.3%), infrastructure (3.8%) could potentially improve both yield (an additional $1.36M in cash flow) and returns (an estimated $6.4M over 15 years), without any extra volatility or drawdown risk. Higher performing funds would exceed that greatly.

Customization the new frontier for RIAs in private assets

As we mentioned earlier, access to private markets is now well established for individual investors (with the caveat of continued stringent accreditation requirements for clients). Until recently, however, HNWIs had typically only been able to invest in large funds from established managers, and in a limited range of strategies. Though those funds could, of course, perform well, you should not settle for “easily accessible”, but should seek out “high conviction”.

Investing effectively through a goals-based framework demands not just access to asset classes with particular risk-return profiles or income-generating characteristics, but to best-in-class funds within each of those asset classes.

At Opto, we offer completely customized funds for your practice with tailored exposures for whatever client goals you need to meet. Our investment analytics were built to help you decide on what shape those allocations might take, while our established networks and ability to make investments up front help us to access some of the more coveted fund managers in each sector and asset class.

Your clients want investments that are tailored to their needs and wants, not just off-the-shelf solutions. It is a harsh reality, but if you can’t provide them, they may find another practice that can.

Opto Investments is a technology-enabled end-to-end solution designed to help RIAs craft tailored private market investment portfolios comprising funds from coveted managers in private credit, private equity, real estate, venture capital, and infrastructure. 

To learn more, attend the webinar we are joint-hosting with Riskalyze to discuss how to tap into exciting private investment trends to attract and retain clients. Register here.

To start a conversation with Opto about building a custom private market fund for your clients, please visit our website.

Methodology

Returns/Risk: To establish a “cone” of outcomes for portfolio upside and downside, we calculate top and bottom decile manager excess returns through time, and project them forward using risk-free rates today. For public markets assets, we take the rolling 10-year volatility and assume a 1.5z (standard deviation) move in either direction as possible. (Top and bottom decile returns are roughly equivalent to a 1.5z move). We then take the portfolio-weighted average of these upside and downside scenarios to get the portfolio downside and upside cases.

Yield: We model expected forward yield by calculating historical average excess yield over the risk-free rate and applying the current expected 10-year average risk-free rate. We proxy historical yield in private asset classes with yield using their average distribution yield over their first three years.

Volatility: For private assets, we calculate historical volatility levels from Burgiss sub-asset class total return series (which take changes in net asset value for existing funds every quarter). We annualize these numbers. For public assets, we use the same frequency of data from total return series and annualize as well. We use these historic volatilities and historic correlations of all series (all marked at quarterly frequency and annualized), to project volatility at the portfolio level.

Max Drawdown: We use the average drawdown historically for sub-asset classes across the financial crisis, dot-com bubble, and COVID-19 and assume a correlation of 1 across asset classes to project max drawdown at the portfolio level.

—

Jacob Miller is Head of Advisory Services at Opto Investments. 

Disclaimers

Lonsdale Investment Management, LLC (the “Firm”) is an SEC-registered investment advisor. Registration with the SEC does not imply a certain level of skill or training. SEC registration does not mean the SEC has approved of the services of the investment adviser.

Unless otherwise indicated, commentary reflects the personal opinions, viewpoints and analyses of the author and should not be regarded as a description of services provided by the Firm or its affiliates. The opinions expressed here are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual on any security or advisory service. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice. While all information presented, including from independent sources, is believed to be reliable, we make no representation or warranty as to accuracy or completeness. We reserve the right to change any part of these materials without notice and assume no obligation to provide updates. Nothing on this site constitutes investment advice, performance data or a recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Investing involves the risk of loss of some or all of an investment. 

The performance discussed herein is based upon investments made by third party fund managers who are unaffiliated with the Firm. It should not be assumed that future investors would experience returns, if any, comparable to those illustrated herein. Past performance is not indicative of future returns. Investment results will fluctuate. Returns are not guaranteed. All investments are subject to the risk of loss, including the loss of principal. No representation is being made that an investment account has, will, or is likely to achieve profits or losses equal to the profits or losses shown. Actual returns will vary greatly and depend on personal and market conditions.

Hypothetical returns reflect the returns generated by our proprietary portfolio modeling engine. Hypothetical returns are presented to inform potential clients about the Firm’s risk tolerances when managing the strategy and to provide information useful to a client or potential client when assessing how the Firm’s strategy fits within the investor’s overall portfolio. Hypothetical returns are not actual returns nor are they guarantees or promises of future return. 

This information contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of the depicted investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting operations that could cause actual results to differ materially from projected results.