A juxtaposition of the risk/return profiles of private equity, public equities, and real estate reveals a surprising spectrum

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Risk and Return Spectrum

Across a large, longitudinal study of major vehicles of investment, private equity had the highest long-term annualized return of 13.7%, tying emerging market equities but with significantly lower risk. Ranking volatility (risk) from lowest to highest, emerging markets had the highest, while private equity came out fifth out of the eight classes, edged out slightly by hedge funds, though hedge funds produced a more modest 9.5% return. Real estate was even less risky, ranking third but sixth in annualized returns. Is that the whole story though?

The chart below shows the results of this long term study between the eight classes, plotting returns on the y axis and volatility on its horizontal counterpart.

From 1Q86 to 4Q20 where data is available, deemphasizing 2008 and 2009 returns at one-third the weight due to the extreme volatility and wide range of performance, which skewed results. Using MSCI AC World Gross USD for Listed Equities; Barclays Global Agg Total Return Index Unhedged USD for Fixed Income; Cambridge Associates Global Private Equity for Private Equity; HFRI Fund Weighted Composite Index for Hedge Funds; and Barclays US T-Bills 3-6 Months Unhedged USD for Cash. Source: Bloomberg, MSCI, Cambridge Associates, KKR Global Macro & Asset Allocation analysis. This data is historical, for illustrative purposes only. Past performance is not an indicator of future results.

The chart above illustrates risk and return for these classes in a straightforward way, but it still requires investors to make their own weighted calculation of reward per unit of risk based on their investment profiles, which is like handing them raw chicken, cheese, and ham and saying, “Here, make your own dinner.”

Ranking the Returns Per Unit of Risk

To aid the cuisine above, we have divided the return by the risk of volatility in each class and then ranked them, effectively serving up a ready-to-eat, cordon bleu made of money below:

In the second column entitled “Return/Risk” the returns were divided by the volatility in order to standardize a comparison. The highest figures were ranked first, representing the highest amount of reward per unit of risk. Setting aside the unsurprising winner of cash, which frequently offers the lowest risk relative to its just as frequently yawn-inducing reward, private equity comes in first with 1.6 units of reward per unit of risk with real estate close behind at 1.4.

Of course, many options within each class exist for investors, each yielding their own spectrum of risk and reward, control and passivity, thrill or nausea. Each investor should match-make their investment profiles to the best choice for them, and hope for the best long term reward possible.

Characteristics of Class

Private Equity

Private equity is a smooth term for a multi-faceted industry. It could include buying private companies that are well-run, buying private companies that are poorly-run, buying public companies and taking them private, buying private companies with the goal to eventually take them public, adding value, selling valuable divisions, acquiring, franchising, etc. Much of the long-term return of private equity often stems from value creation initiatives, such as operational enhancements or strategic positioning. Patient investors can also benefit from increased valuation multiples over the holding period. Private equity offers options to both active and passive investors, giving not only control over the amount of involvement but also the operations of the company.

Stock Market

With their massive price to equity valuations and with their limited allocation of voting shares, many public equities follow a structure that disallows an average investor any impactful control over the operations of the company. On the other hand, the instant liquidity of the stock market and the multifarious choices across company size and industry make investors spoiled for choice. Like a virtual amusement park with no lines and endless rollercoaster choices, this liquid market offers investors a “hop-on and hop-off”, transaction-free experience, letting them learn for themselves which run thrills them and which makes them sick, all while giving them no control over the ride.

Real Estate

If there were a combination of the control of private equity and the wild ride of the public markets, albeit at a slower pace, it might look something like a local couple fixing and flipping a single family home during a jaw-dropping, hyper-inflation period for residential homes. Real estate can provide the impactful control of private equity while its simple remodel or long term hold strategy can avoid the complexity of private equity business ownership. Within real estate investors also suffer under the load of options including: development, opportunity zones, industrial, office, multi-family, raw land, land leases, etc, each with their own advantages and shortcomings as well as rewards and risks.

Wrap Up

Investors navigating the complex landscape of financial markets are often confronted with the choice between private equity, public markets, and real estate as vehicles for wealth creation. One crucial aspect influencing this decision is the historical performance of each asset class. In this article, we explored a comparison of their long-term average return and risk profiles. Each asset class presents distinct advantages and risks, and a judicious combination tailored to individual investment objectives can optimize the overall risk-return profile. Investors are encouraged to carefully evaluate their goals, risk tolerance, and time horizon when considering these avenues for wealth creation.