11 Apr 2025
Private markets have been firmly embraced by investors over recent years, their role in potentially enhancing investment returns now well understood. But perhaps they have an additional and equally important role. Portfolio diversification is a key objective in portfolio management. Simon Sharp examines whether private markets are set to disrupt traditional approaches to diversification and further boost the appeal of this growing asset class.
Historically building a balanced investment portfolio has rested on a central principle. In order to manage volatility, a portfolio needed to be diversified, comprising a mix of both equities and bonds. The rationale has been as equities and bonds historically are negatively correlated ie move in the opposite direction to each other, allocating to both can manage return volatility within a portfolio. This is typically referred to as a ‘60/40’ portfolio where 60% of a portfolio is broadly invested in equities, 40% in fixed income.
For the last two decades, up until 2020, this negative correlation largely held true. However, recently this relationship appears to have broken down with both asset classes tending to move in a positive, rather than negative, manner¹. Why has this unusual situation arisen, is the traditional ‘60/40’ approach still valid, and is now the time for investors to find alternative sources of diversification?
Investment portfolios, particularly pension funds, often require a stable return profile due to their role in providing retirement income. For the last 20-30-years, equities have been relatively volatile (upwards and downwards). By contrast, bonds have consistently delivered reliable but modest positive returns¹. The less volatile behaviour of bonds lowers overall portfolio volatility and risk. 2022 was a rare exception with both equities and bonds falling together due to global supply shocks resulting from Ukraine and COVID-19.
"higher interest rates can be negative for both equities and bonds"
But 2022 is a useful case study as it highlights the central role inflation plays in driving the correlation between equities and bonds. Both asset classes fell in tandem in 2022 as global supply problems caused a sharp spike in inflation. Central banks responded by hiking interest rates. And higher interest rates can be negative for both equities and bonds.
If inflation is so important in determining the correlation between bonds and equities, which inflationary scenarios would be expected to lead to equities and bonds either moving in tandem with each other, or moving in opposite directions?
Negative correlation. If inflation is under control, focus moves more towards growth expectations for economies. Any GDP growth surprises, positive or negative, would impact corporate earnings. For example, if GDP surprised on the upside, equities would be expected to rise as earnings expectations would be higher. However, bond prices would likely fall as stronger GDP growth could result in higher inflation and subsequent higher interest rates. Higher rates hurt bond prices due to a higher discount rate. In this ‘growth-led’ scenario’, the correlation between bonds and equities would be negative.
Positive correlation. In contrast to the above, when inflation is either or both high and volatile (ie 2022), the driver for asset class correlation shifts decisively away from GDP growth and firmly towards inflation expectations. High inflation is negative for bonds as both their principal and coupons are quoted in nominal terms. At the same time, as seen in 2022, high inflation prompts higher interest rates which is not good news for equity prices, increasing corporate borrowing costs and disincentivising new investment. In this ‘inflation-led’ scenario, the bond/equity correlation would be positive.
There has now been a sustained period of volatile and high inflation, prompting the question, if the traditional negative correlation between equities and bonds can no longer be relied upon, are there other allocations within a portfolio that can be made to address this lack of portfolio diversification?
Private markets have been a favoured destination for institutional investors for several years, now accounting for c.12% of allocations (Aviva Private Markets Study, 2024). Private and wholesale investors are far behind with only 5% of their investments held in private markets (Bain, 2023), limited so far by accessibility and liquidity concerns.
"private market performance typically moves independently from either equities or bonds"
However, the private markets universe has now become too large for any investor to ignore. Public equity and debt markets are valued at US$152 trillion (JP Morgan, 2023). Whilst far smaller at $14.3 trillion (UBS, 2025), private market investment is expanding more rapidly than either public equity or fixed income. Indeed, Preqin forecast private markets are likely to more than double in size to $30 trillion by 2033.
The relevance of private markets to portfolio construction, and specifically their role in delivering portfolio diversification benefits, lies in the fact private market performance typically moves independently from either equities or bonds. The charts below illustrates their low or negative correlation with both of these asset classes (US Treasuries taken as a proxy for bonds):
Private markets correlation
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Source: Morningstar, Pitchbook. March 2024
A positive correlation of +1.0 indicates different assets will perform in tandem, whilst a negative correlation of -1.0 indicates assets will move independently of each other. For global equities, the chart shows a positive, but still relatively low correlation between different private markets and global equities. However, the relevant question is whether making an allocation to private markets would provide greater diversification to public equities compared to public bonds. The data suggests this would not in fact be the case: the correlation between public equities and public bonds (US Treasuries), at -0.04, is considerably lower than global equities’ correlation with any private market.
This however would not hold true relative to bonds. As the chart illustrates, in every instance, each private market has a negative correlation to public bonds far in excess of the -0.04 public equities/bonds correlation. This suggests reducing part of an existing public bond allocation, and adding some private markets exposure, would likely enhance diversification within an existing equity/bond portfolio.
There is an important caveat. A large part of the low/negative correlation from private markets to either bonds or equities will likely have been driven by disruptive market events, or periods of weak economic growth/recessions. If there was a sustained period where economic growth was strong, these correlations may be less pronounced.
Compounding the diversification benefits from having low/negative correlations with the two main asset classes is the further discovery that private markets, in no way a homogeneous set of markets, are in fact lowly correlated to each other:
Examples of different private market correlations
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Source: Morningstar, Pitchbook. March 2024
This table shows that whilst positive, the size of the correlation between different private markets is low, adding further to the risk mitigation benefits from making an allocation to private markets within a balanced portfolio.
"private markets comprise a diverse array of strategies"
This conclusion should not come as a surprise given private markets comprise a diverse array of strategies, sensitive to different market and economic dynamics and events. It should be expected that they will likely perform differently to each other at different times.
In addition to lowering overall portfolio risk, the precise blend of different private markets within a portfolio will likely be driven by the portfolios’ investment objectives. As the asset class includes forms of equity, credit, real estate, infrastructure etc, weightings between different private markets will be led by whether an investor is prioritising growth or income:
Investment objectives
Growth:
Income:
As well as the diversification benefits of including private assets within a balanced portfolio, can the asset class tempt investors with further attractions? Fortunately, the answer may well be ‘yes’, specifically due to the economic and corporate exposures it can access.
"private capital is able to access the broader economy"
The wider the investible universe, the greater the opportunity to identify mispriced opportunities and enhance portfolio return. Within the US, 87% of companies with a turnover in excess of $100 million are privately owned and not listed on public exchanges (Capital IQ, 2023). Private capital is therefore able to access the broader economy, unlike public listed investment which will be restricted to a far smaller opportunity set.
In addition, the return potential of private markets is supported by key global growth trends within which private markets occupy prime position. These are multi-year/decade-long growth trends which align with the extended investment horizons many portfolios, particularly pension funds, will have. There are several key global trends within which private markets are likely to be principal beneficiaries:
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With many governments constrained by historically unprecedented levels of national debt, it is almost inevitable that essential infrastructure investment will need to be ‘outsourced’ to the private sector, with private capital taking a lead role. The technological revolution is also set to accelerate with AI at the forefront, but also a deeper digitisation of society with smaller, more innovative (and private) companies likely to be at the forefront.
While many investors may focus on the ability of private markets to diversify and lower overall risk within their portfolios, the ability of private markets to meaningfully enhance return cannot be overlooked. The long-term nature of many private market investments, such as private equity and real assets, make their potentially enhanced return profile even more appealing to pension funds. Additionally, as private market investments are unlisted, short term ‘mark-to-market’ valuation volatility within a portfolio, likely at certain times with listed investments, need not be a concern.
Important considerations
Despite the benefits shown to exist by incorporating private markets into a balanced portfolio, there are some unique characteristics of the asset class which investors need to be aware of:
Liquidity
Private markets, by definition, are private – they are not listed on public exchanges. However, this does not mean they are entirely illiquid, requiring investor lock-ins lasting several years. Indeed, some parts of private markets can be traded on a daily basis. For institutional investors who require the ability to liquidate holdings to meet redemption requests, for example, liquidity considerations will be a factor. This however can likely be managed through efficient portfolio management ensuring sufficient portfolio-level liquidity exists via either the equity/bond portion of the portfolio, or the mix of private market investments.
For private and wholesale investors, it is more complex with these investors having less options. The emergence of ELTIFs and LTAFs in Europe and the UK is welcome with these vehicles offering partial liquidity via periodic trading windows.
Accessibility
For institutional investors, such as large pension funds, the meteoric growth of private markets has made them an increasingly viable option. The larger the overall size of the private market universe, the easier it is to make the size of investment required.
While institutions have been the dominant private market investor, this is not an area completely unknown to private investors: high/ultra high net worth investors have invested in the space for many years. However, for other private and wholesale investors the situation is more complex with these investors largely relying on the aforementioned ELTIF/LTAF vehicles to achieve a degree of access.
Due diligence
The nature of private market investing requires a deeper degree of due diligence on possible investments than would be expected with public investments. A large amount of required financial information will not be in the public domain, and close and continuing engagement with investee management teams is often essential. Research and analysis of prospective investments can therefore be complex and time consuming.
Finally, private markets manager selection is crucial to success given there is a high dispersion in fund performance between managers. This is perhaps inevitable given the difficulty of comparing manager performance across different investment vintages. The lack of benchmarks in private markets also makes manager comparisons difficult.
A disruptive force
Private markets, now widely embraced by many institutional investors, have proven to be a disruptive force challenging the conventional 60/40 approach to balanced portfolio construction. However, this has not been without good reason. With portfolio managers anxious about a recent breakdown of the traditional negative correlation between equities and bonds, private markets have emerged as a credible saviour.
Whether looking at their low correlation with equities and bonds, the alignment with longer term investment horizons, or leverage to high growth global secular themes, private markets have certainly proven their worth. With an increased focus on securing genuine portfolio diversification coupled to the continued expansion of the asset class, it appears certain private markets are set to become a larger and more permanent component within many investors’ portfolios.
ELTIFs are illiquid in nature because their investments are long term. For investors, this is an investment that has low liquidity. ELTIFs may not be suitable for investors that are unable to sustain such a long-term and illiquid commitment. Only a small part of a portfolio should be invested in an ELTIF.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast and they should not be considered as a recommendation to purchase or sell any particular security.
1 Schroders, 'Allocating to private markets', 2024