Assessing the Risks of Semiliquidity and Fees in Private Markets

Are private assets as calm as they look? Not necessarily. The smoother market fluctuation lines can be reassuring, but it also masks trade-offs investors need to understand.

In this video, Jack Shannon, Principal, Equity Strategies, pulls back the curtain on how to evaluate private funds and their risk. Learn how public and private assets differ in daily market fluctuation, and why that matters for client expectations, as well as the risks of semiliquidity and fees.

Jack Shannon:

Hello, I'm Jack Shannon, Principal, Equity Strategies, for Morningstar Research Services. Do private investments offer better returns with inherently less risk? Not necessarily. While they often appear calm, that doesn't make them safer or more likely to outperform. Today, we're going to pull back the curtain on private funds and show you how to truly evaluate their risk.

The perception of lower risk and private assets often comes down to something that's been labeled as “volatility laundering”. Here's a chart comparing the daily fluctuations of a daily traded ETF with the far less frequent valuations of a semiliquid fund which invests in similar underlying assets. The jagged line reflects the day-to-day reality of market opinions of public assets. The much smoother curve shows return smoothing in private assets, and this isn't because the underlying assets are inherently less risky, it's because their valuation isn't reflecting daily price changes.

In private portfolios, fund companies themselves often determine the underlying securities value, and there can be an incentive to keep valuations stable, making the return numbers look more stable than they truly are. This can conceal the true risk, giving investors a false sense of comfort.

Investors are often sold the semiliquid private asset funds on a lower risk or diversification story. It can sound like hey this has low correlation to the market, so traditional financial theory says it should add value to a holistic portfolio. But it is risky, and when real economic turmoil hits, you may be in for a surprise.

An additional risk in semiliquid funds is that they offer limited windows for investors to sell their shares. So if a fund only offers to repurchase shares once a quarter for example, that limited liquidity itself is a risk, as investors may not be able to turn their investment into cash in a timely manner. Investors in semiliquid private market funds need to be highly conscious of how they're tying up their capital, and we haven't even talked about fees yet.

Funds investing in private assets are notoriously expensive, so even if you think you're going to get a public market beating return, you have to clear that fee hurdle to actually net out into positive territory. Recognizing these challenges, the Morningstar Medalist Rating has expanded to include semiliquid funds, taking into account liquidity, valuation and transparency risks. These ratings give advisors a guidepost on how to assess semiliquid funds in which we think can beat a public benchmark over a theoretical full market cycle.

The key takeaway is this: Private assets may look calm, but that doesn't inherently make them low risk. It's important to remember private companies face the same macroeconomic pressure and opportunities as their public peers and are subject to the same underlying economic risks. So don't be fooled by the smoother lines. See how Morningstar Direct can help you evaluate risk across both private and public investments, giving you the clarity you need.