As a general rule, the longer your investment time horizon, the greater your ability to allocate a sizable portion of your investments in stocks. Yet a recent survey found that high-net-worth investors 43 and younger are allocating only 28% of their portfolios to publicly traded equities, which is around half the exposure of older investors. Meanwhile, Gen Z and millennials are holding 17% of their portfolios in alternative investments such as private equity, which is more than three times the allocation of Gen X and baby boomers.
There are plenty of explanations for this seemingly counter-intuitive trend, but they tend to focus on emotional reasons. Some believe that Gen Z and millennials are shifting out of equities to seek greater returns in alternative assets like cryptocurrencies. Others think younger investors may be shying away from publicly traded stocks out of fear, given how many Black Swan events have taken place in their short lives.
But there is a much simpler and completely rational reason why younger investors are embracing private markets, and it’s Investing 101.
The Case for Young Investors in Private Markets
The fact that younger investors are adopting private market investments at a higher rate should not come as a surprise. Younger investors have longer time horizons, fewer liquidity needs, and a higher risk tolerance than their parents or grandparents. As a result, they are better positioned to take advantage of opportunities in longer-duration assets that historically have offered greater return potential than other asset classes.
In the past, average investors did not have an easy way to access private equity—which was the exclusive realm of institutional investors—so they held greater exposure to public stocks. Twenty-somethings in the 1990s might have felt comfortable holding 80% or more of their portfolios in equities. Back then, however, there were nearly 8,000 listed U.S. companies to choose from. That number has since been cut roughly in half, with fewer than 4,000 public stocks today. Contrast that to the more than 17,500 private businesses with more than $100 million in annual revenues that millennial and Gen Z investors can now gain exposure to through funds that invest in private equity and other private assets.
Younger investors also have historically been early adopters of new asset classes, investment vehicles and strategies such as cryptocurrencies, exchange traded funds, robo advisors and impact investing. Private equity, private credit and private infrastructure could be next in line, as they are being democratized through easily accessible vehicles such as interval funds. These are SEC-registered, ‘40 Act funds that are as easy to purchase as mutual funds while offering daily pricing and a measure of liquidity at periodic intervals.
A New Route to Active Management
Millennial and Gen Z investors have also grown up in an era of passive investing, where conventional wisdom says to own the broad market and not worry about security selection. Yet indexing has been tested in recent years by a series of market shocks, including the global financial crisis in 2008 and the COVID-19 bear market in 2020. Today, passive strategies are being driven by just a handful of mega-cap tech stocks (e.g., the Magnificent Seven), as market breadth has narrowed to record levels, raising real questions if this is the best long-term way to diversify an investor’s portfolio.
This has allowed younger investors to revisit their assumptions about active investing—but in the private markets.
When active management was the default strategy for many investors 30 years ago, the average market value of publicly listed companies in the U.S. was $1.8 billion. That average market cap has since swelled to more than $7 billion, which is approaching large cap territory. It’s not a coincidence that the last time active management was the dominant strategy was when the typical public stock was much smaller and when there was much less information on each company, especially smaller businesses with less analyst coverage. This led to a greater dispersion of returns and provided active managers an opportunity to take advantage of information arbitrage.
What happened to all those smaller companies? Many were absorbed by other public companies or taken private through M&A activity, and others have simply opted to remain private. Today, approximately eight out of 10 middle market companies—those with annual revenues between $10 million and $1 billion—are private. These businesses account for more than 30% of private-sector GDP and employ approximately 48 million people, which is more than one-third of private-sector payrolls.
Moreover, these privately owned businesses have exhibited far better revenue growth in recent years than the S&P 500. The private investment markets have also become more long-term oriented, focused on financing strong and proven companies, which could be one reason why, on a relative basis, private markets have historically outperformed public markets.
The Need for Greater Education
If history is any guide, young investors are likely to boost their exposure to the private markets as they learn more about these investments, as with ETFs. Nearly 20 years ago, when they first became widely available, ETFs held only $300 billion in total assets. At the end of last year, the total net assets of ETFs in the U.S. exceeded $8 trillion.
For advisors, this trend toward private investments presents a generational opportunity. The democratization of the private markets is taking place against the backdrop of the great wealth transfer from Baby Boomers to younger generations who are increasingly open to alternative investments. Advisors who want to appeal to this next generation must understand the private market story and be ready to educate their clients.
That educational message needs to highlight that this is not simply about finding another asset class to add to the mix; it’s about allocating to uncorrelated assets that have outperformed on a relative basis over the long term and that can improve the long-term risk-adjusted return characteristics of an overall portfolio. It must also underscore that the private markets are where the public markets were 30 years ago when investment choices were abundant and information was sporadic, creating an environment where active management, research and fund manager selection actually mattered.
Michael Bell is CEO of Meketa Capital.