As a general rule, the longer your investment time horizon, the greater your ability to distribute a significant portion of your stock investments. However one last survey found that high-net-worth investors 43 and older are allocating just 28% of their portfolios to publicly traded stocks, about half the exposure of older investors. Meanwhile, Gen Z and millennials are holding 17% of their portfolios in alternative investments such as private equity, which is more than three times the allocation of Gen X and baby boomers.
There are many explanations for this seemingly counterintuitive trend, but they tend to focus on emotional reasons. Some believe that Gen Z and millennials are moving away from stocks to seek greater returns in alternative assets such as cryptocurrencies. Others think that younger investors may shy away from publicly traded stocks out of fear, given how many Black Swan events have occurred in their short lives.
But there's a much simpler and completely rational reason why younger investors are embracing the private markets, and that's Investing 101.
The case for new investors in the private markets
The fact that new investors are adopting private market investments at a higher rate should come as no surprise. Younger investors have longer time horizons, less need for liquidity and a higher tolerance for risk than their parents or grandparents. As a result, they are better positioned to take advantage of opportunities in longer-duration assets that have historically offered greater return potential than other asset classes.
In the past, average investors didn't have an easy way to access private equity—which was the exclusive domain of institutional investors—so they held greater exposure to public stocks. Twenty-somethings in the 1990s might have felt comfortable holding 80% or more of their portfolio in stocks. At the time, however, there were about 8,000 US-listed companies to choose from. That number has since been cut roughly in half, with less than 4,000 public shares today. Compare that with more than 17,500 private businesses with more than $100 million in annual revenue that millennial and Gen Z investors can now gain exposure through funds that invest in private equity and other private assets.
Younger investors have also historically been early adopters of new asset classes, investment vehicles and strategies such as cryptocurrencies, exchange-traded funds, robo-advisors and impact investing. Private equity, private credit and private infrastructure may be next, as they are being democratized through easily accessible means such as gap funds. These are SEC-registered, '40 Act funds that are as easy to buy as mutual funds, while offering daily prices and a measure of liquidity at periodic intervals.
A new path to active management
Millennial and Gen Z investors have also grown up in an era of passive investing, where conventional wisdom says to own the broad market and not worry about picking a security. However, indexing has been tested in recent years by a number of market shocks, including the global financial crisis in 2008 and the COVID-19 market carryover in 2020. Today, passive strategies are being driven by just a handful of mega-cap tech stocks. -cap (eg, Magnificent Seven), as market breadth has narrowed to record levels, raising real questions about whether this is the best long-term way to diversify an investor's portfolio.
This has allowed new investors to rethink their assumptions about active investing – but in the private markets.
When active management was the default strategy for many investors 30 years ago, the average market value of US publicly listed companies was $1.8 billion. That average market cap has since grown to more than $7 billion, approaching large-cap territory. It's no coincidence that the last time active management was the dominant strategy was when the typical public stock was much smaller and when there was much less information about each company, especially smaller businesses with less analyst coverage. This led to a wider dispersion of returns and gave active managers an opportunity to benefit from information arbitrage.
What happened to all those smaller companies? Many were absorbed by other public companies or taken private through M&A activity, and others have simply chosen to remain private. Today approx eight out of 10 middle market companies— those with annual revenues between $10 million and $1 billion — are private. These businesses constitute more than 30% of private sector GDP and employ about 48 million people, which is more than a third of the private sector payroll.
Moreover, these private businesses have shown much better earnings growth in recent years than the S&P 500. Private equity markets have also become more long-term oriented, focused on financing strong and proven companies, which which may be one reason why, on a relative basis, private markets have historically outperformed public markets.
The Need for Greater Education
If history is any guide, new investors are likely to increase their exposure to private markets as they learn more about these investments, such as with ETFs. Nearly 20 years ago, when they first became available, ETFs owned only $300 billion in total assets. At the end of last year, the total net assets of ETFs in the US exceeded $8 trillion.
For advisors, this trend toward private investment presents a generational opportunity. The democratization of private markets is taking place against the backdrop of a large transfer of wealth from Baby Boomers to younger generations who are increasingly open to alternative investments. Advisors who want to appeal to this next generation must understand the history of the private market and be willing to educate their clients.
This educational message should emphasize that this is not simply about finding another asset class to add to the mix; it is about allocating uncorrelated assets that have outperformed on a relative basis over the long term and that can improve the long-term risk-adjusted return characteristics of an overall portfolio. It should also be noted that private markets are where public markets were 30 years ago, when investment choices were plentiful and information was sporadic, creating an environment where active management, research and selection of fund managers actually mattered.
Michael Bell is the CEO of Meketa Capital.