A liquidity event, whether it’s the sale of a business, an initial public offering, or any other kind of asset disposition, brings on a new challenge: investing the proceeds in a manner that preserves wealth and aligns with your long-term needs.
To achieve this objective, portfolio diversification is key. But before we dive further it is important to understand a fundamental “secret” of diversification: correlation.
Diversification is Low Correlation.
Diversification isn’t about investing in 100 stocks and hoping for the best: diversification is best achieved when investing across several asset classes (equities, real estate, private equity) with low correlation with each other.
Alternative investments such as private real estate are an important consideration for your portfolio. Private real estate has historically produced consistent returns with low volatility, and low correlation to public markets (equities, bonds).
However, there’s a trade off between traditional investments, such as stocks, and alternatives, such as private real estate: liquidity.
(The S&P 500 is the leading indicator of US Large Cap Equities. **The IYR ETF seeks to track the investment results of the Dow Jones US Real Estate Index, which measures the performance of the publicly traded real estate sector of the US equity market. ***NCREIF Property Index is a quarterly measure of the unleveraged composite total return for private commercial real estate properties held for investment purposes only. The above graph also reveals that the returns of REITs and the S&P 500 are more correlated to each other than private real estate. Too much correlation inside a portfolio, especially in volatile investments, could result in unnecessary risk. There may be more volatility to come and your portfolio should be well positioned to manage the risk. Private real estate investments provide some relative stability and help investors diversify their holdings.)
Alternatives and Liquidity
When assessing the trade off between public market investments and alternatives, it’s important to consider personal preference.
While large institutional investors such as the Harvard Foundation have skewed their portfolios heavily towards alternatives (due to market volatility/inflationary concerns), they have less need for short-term capital, creating a willingness to accept lower levels of liquidity.
As an individual high net worth investor, your short-term capital needs may be different. You may need to be more liquid. Your objectives may require a larger allocation in stocks/cash equivalent investments to maintain liquidity.
Inflationary risk is another consideration when allocating and diversifying a portfolio. With long-term interest rates continue to hover at historic lows, an inflationary period in the future is a serious concern for many investors.
As you can see in this chart, private real estate has historically shown superior returns during inflationary periods. Private real estate returns showed a more than 40% positive correlation of returns to inflation between 1978 and 2008, materially higher than traditional investment vehicles such as stocks, bonds, and REITs.
Diversification Within An Asset Class
Diversification goes beyond just investing in one or two assets across several asset classes. You would not buy one or two stocks for your equity portfolio, so why invest in just one or two real estate deals for the real estate portion of your portfolio? Real estate covers a wide swath of property types, property qualities, and real estate investment strategies. There is also variance between sponsors/managers of real estate investors, both in terms of strategy and asset specialization.
But diversifying the real estate portion of your portfolio may not require committing money to multiple managers: MLG knows private real estate, and our funds invest with a strategy that offers both diversification and specialization. This could help make private real estate an impactful piece of your alternative investment bucket.
How MLG’s Funds Offer Both Diversification and Specialization
At MLG Capital, we can provide the best of both worlds-diversification (geographic, manager, and asset type/quality) and specialization (our 30+ years of relationships in multiple markets).
During the great recession, MLG Capital had an “ah-hah” moment. We determined that combining our historic operations (direct acquisition strategy) alongside a parallel private equity strategy would bring our investors the best of both worlds, and deep deal flow:
Direct acquisitions, when stated, means an MLG historic acquisition market (i.e., Wisconsin, Texas or Florida), where MLG has deep local relationships to source opportunities and personnel and has historically owned and operated real estate investments.
Private Equity, when stated, means that a pari-passu investment (i.e., equal priority investment return and return of capital) with a local real estate manager occurs. For several reasons, this provides a unique opportunity for diversification into markets that MLG does not operate in. In these markets, we surround ourselves with the best partners we can find in markets we want to be in.
This unique combination extends us to over 1500 contacts from coast to coast, allowing us to know about and consider a wider net of opportunities.
- To preserve wealth realized after a liquidity event, build a proper portfolio diversification strategy.
- The secret to diversification is low correlation: investing across multiple asset classes with low correlation to each other may help you construct a low volatility portfolio.
- Take your personal liquidity needs into account when considering alternative investments; there may be a liquidity trade off.
- It is important to consider inflationary risk. Private real estate has historically shown strong performance in inflationary markets relative to stocks/bonds.
- Diversification within asset classes is as important as diversifying across asset classes.
- With MLG’s unique direct acquisitions/private equity hybrid strategy, investors get the best of both worlds: diversification and specialization.