Are private markets damaging advisers’ tracking error?

Financial advisers have expressed concern about the impact including private market exposure is having on their tracking error budget, according to MSCI.

Private markets have become a popular asset class recently but some advisers are still hesitant regarding their transparency and liquidity while the corporate regulator ASIC is undergoing its own sector review. 

Speaking to Money Management, Hassan Suffyan, head of wealth management for EMEA and APAC at MSCI, said the index provider had noticed advisers were particularly concerned about the impact it was having on their tracking error.

Tracking error budget is the standard deviation of the difference between two portfolios and advisers will have a certain limit or tolerance around how much the portfolios can deviate from each other.

“A lot of our clients struggle with the complexity of the asset class and adding private market exposure and finding it taking up a lot of tracking error budget, that’s a very real example,” he said.

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“They say clients are asking them for private markets but every time they add, it consumes their tracking error budget.

“We are doing work with our clients to help bring private markets into their strategic asset allocation (SAA) so it is viewed as a long-term play and they can go further through the investment process.”

By adding private markets to long-term SAA, this reduces the active risk as well as allows advisers to think long-term about how the exposure might play out in portfolios, the risks and upsides and the asset’s suitability. 

Suffyan said: “If I already have a view that I will be allocating to private markets in my long-term SAA, when I add it to model portfolios then the tracking error will seem similar which reduces active risk. If I don’t have it in the SAA and I do add it to the model portfolio then the active risk will be higher, this isn’t necessarily a bad thing but I will have a limited active risk budget.

“You can still have different SAA for different client portfolios, it is no different to having an ESG overlay where some portfolios include it and some don’t.”

But without sophisticated data, it can be difficult for advisers to manage multiple portfolios side-by-side and creates operational complexity within the practice.

“There is operational burden and complexity which comes with costs and regulatory risk because if you are not acting in a structured way then things can go wrong and it’s only when they go wrong that you uncover the weakness.”

What can they do?

Suffyan said when it comes to fund selection, advisers need to consider the balance they want to have between public and private markets, especially being aware that some semi-liquid vehicles may include more public exposure than they expect.

Opting to include a portion of public exposure is a way that fund managers have found to improve the liquidity profile in semi-liquid or evergreen funds. 

“Typically, private markets have an opportunity cost. Assuming today that your clients are not invested in private markets then by adding it, you’re taking away some of their public market exposure and that brings about an opportunity cost.

“Advisers need to understand that and the diversifying effect, understand where that exposure may be closely correlated with public markets. Public markets are not immune from country risk so if there’s a slowdown in economic growth then public and private will experience the same effect. 

“In evergreen funds, they are investing also in public markets so the diversification effect is weakened, you have to understand how the liquidity is being offered. The quality of manager selection and research cannot be overlooked.”