Public / Private SAA

Zermelo’s Top 3 Papers on Public / Private asset class combinations

Private assets have a number of characteristics that make them more difficult to include in standard optimization...

February 21, 2021

Private assets have a number of characteristics that make them more difficult to include in standard optimization frameworks. For example, smoothed valuations, lack of data, illiquidity and the requirement to have a strategy for how capital is committed on an ongoing basis to maintain an allocation.

Investors therefore need a different approach to evaluate the optimal allocation of private assets within a strategic asset allocation.

We explored how different asset managers are thinking about this topic and have set out our top three papers below.

1. The Tradeoff Between Liquidity and Performance, PGIM

In this paper, PGIM proposes a simulation-based asset allocation framework to - "Maximize horizon portfolio value provided I am sufficiently confident of meeting my cash flow obligations".

The framework helps investors determine their optimal allocation across both private and public assets, and the sensitivity of the optimal allocation to changes in assumptions about the risk and return characteristics of both private and public assets.

The analysis shows that as the liquidity requirement increases, the horizon value decreases, with steeper drops at higher liquidity requirement levels.

2. A Better Way to Build Private Asset Portfolios, BlackRock

BlackRock have developed a framework that addresses the complexities of determining the optimal allocation to private assets through a three-step process: 

  • Forecast a distribution of performance for possible investment opportunities across time and asset classes.
  • Use the forecasted risk/return distribution across opportunities to optimize a series of possible portfolio allocations as a function of a risk aversion parameter.
  • Simulate a series of plausible cash flow curves for each opportunity whose returns are consistent with those forecasted in the first step and aggregate them into portfolio-level cash flows for each of our optimized portfolios.

3. Ying and Yang, How Private Assets and Derivatives Work Together, Schroders

In this paper, Schroders discuss how the use of derivatives can help address the liquidity concerns that often prevents investors allocating higher amounts to private assets.

They suggest it is usually the risk of significant downside volatility in the liquid public market component of a portfolio that limits how much the investor can afford to allocate to private assets.

Schroders conclude that using equity risk management techniques can create more capacity for holding illiquid private assets. This can improve overall portfolio efficiency on a variety of metrics.

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Ed Studd

CEO, Zermelo

Ed is passionate about helping institutional investors meet their goals through better custom solutions. Prior to Zermelo, he gained extensive experience across asset management, investment banking and investment consulting.