How to Incorporate Semiliquid Funds Into a Portfolio

Semiliquid funds can play a role in portfolios, but only when investors are clear-eyed about both their benefits and their trade-offs.

In a series of articles, I’ve explored how investors should understand whether semiliquid funds can help them meet their investment objectives and what it takes to succeed. Here, I’ll look at how they can fit into an investor’s portfolio.

Morningstar proposes a four-step approach to portfolio construction that involves producing realistic risk and return forecasts, matching the right structure to the right assets, sizing positions with care, and using a framework that keeps the whole portfolio in view.

Step One: Set Risk and Return Expectations

Forecasts help guide portfolio allocations that align with an investor’s return objective and risk tolerance. No one can accurately predict the future, but the process of forming expectations or building capital market assumptions forces investors to understand their various investment options better.

While investors explore different approaches to return estimates, equal attention, if not more attention, should be placed on the expected risks of private assets. The returns on private assets often appear less volatile than their public market counterparts because of the lack of trading and real-time market pricing, which makes a good marketing story but is far from a genuine indication of their risk. This risk must be quantified, such that we can have more realistic expectations of the impact of private assets’ allocations in a traditional public stock/bond portfolio. Some industry participants, including Morningstar Investment Management, approach risk by desmoothing the return stream of private assets to increase the volatility of the returns.

With these estimates, investors can assess how private assets change the expected risk and return of a traditional global 60/40 public stock/bond portfolio. On the surface, higher return expectations on private assets coupled with their low expected correlation would likely lead to meaningful allocations.

There is no free lunch investing in private assets, however.

Higher returns often come with higher risks. A situation where a portfolio’s expected risk falls while its expected return rises warrants great caution and reflection on the underlying assumptions. Diversification benefits from private assets in a public stock/bond portfolio may exist, but it should not be rooted in the limited pricing data for private assets.

Step Two: Understand the Investment Vehicle

In private markets, there’s more to consider than the asset class or the underlying investments. The fund structure and underlying assets need to properly align, as well as with the end investor. The appeal of mandated liquidity in certain vehicles may overshadow the structure’s mismatch with underlying illiquid assets.

For example, venture capital sits at the most illiquid end of the private market spectrum. The Wildermuth Fund offered a cautionary tale of the risks of misalignment between fund structure, underlying assets, and end investor liquidity expectations. When public equity markets fell in 2022, portfolio valuations declined, and redemption requests increased—a dynamic the interval fund structure could not accommodate without forced asset sales, ultimately contributing to the fund’s failure.

Asset-Vehicle Alignment

The chart above is intended as a high-level guide rather than a strict one-to-one mapping between asset classes and vehicle structures. Both sides of the illustration involve meaningful nuance. Asset classes contain subsegments that can be more or less liquid than implied by their broad category labels. Vehicle structures also vary widely in terms such as what can be held in the portfolio, redemption frequency, liquidity features, and regulatory constraints. As a result, the placement of any asset or vehicle should be viewed as directional, acknowledging that real-world implementations often fall along a spectrum rather than fitting neatly into a single box.

Investors also need to be aware of who they’re investing alongside, because they may be competing with them for limited liquidity. Ensuring a fund has a diversified investor base across client types, geographies, and distribution channels can help reduce the risk that investors all rush to the exit at the same time.

Size the Footprint

The trade-off between risk and return is important when investors size a position.

Regular portfolio rebalancing helps bring the portfolio’s risk back to a level that aligns with an investor’s risk tolerance and long-term goal. This can be difficult with private assets, though, given their illiquidity. When the allocation to private assets is modest, investors should have less trouble adjusting the overall portfolio’s risk by changing the mix of other public assets. Larger stakes in private assets magnify this challenge.

Having a fee budget in mind is essential when sizing an allocation to private assets. Fees eat directly into returns. Investors can build a global stock/bond portfolio at low cost using passive exchange-traded funds, but such options are not available for private assets, where costs are often extortionate. The average prospectus-adjusted expense ratios for interval funds and tender-offer funds are roughly 2.70% and 3.90%, respectively, compared with 0.60% for US-listed ETFs, as illustrated in the chart below.

Adding insult to injury, semiliquid fund fees are complex. Many charge performance fees on top of management fees. There are also different layers of fees, some of which may be less visible. For instance, when a fund invests in other funds, it must disclose acquired funds’ fees, but performance fees of the underlying funds are usually not included. So, if a fund invests heavily in private funds, it can be difficult for investors to measure the all-in costs.

Step Three: Build the Portfolio

Once all the ingredients are in place, investors can tackle portfolio construction. Portfolio construction starts with a choice of framework. Two common approaches—mean-variance optimization and the total-portfolio approach—offer different ways to think about how private assets fit into the mix.

Mean-Variance Optimization

The standard approach of mean-variance optimization looks to find the best portfolio allocations that maximize return for a given level of risk, creating what is known as an efficient frontier of optimal portfolios. This approach seems straightforward and logical, but its output is highly sensitive to the input capital market assumptions, including the expected return and volatility of each asset class and the expected correlation between those asset classes. This is a challenge even with public assets, but it becomes amplified for private assets, given the extra complications in producing reliable capital market assumptions.

Understanding the hidden volatility of private assets and taking that into account in forecasts makes the mean-variance optimization model more realistic. The exhibit below shows that the efficient frontier for a portfolio of purely private assets (red line) forecasts a higher return and lower risk than a portfolio where the private assets are desmoothed (blue line). As a result, the instability of the model means that even if it can serve as a reference, it should not be the signpost.

Mean-Variance Optimization

Total Portfolio Approach

To overcome the limitations of summary statistics like return, volatility, and Sharpe ratio, the so-called total portfolio approach represents an alternative asset-allocation framework. Under this model, investors have one integrated portfolio, not asset-class silos. The investor starts with objectives, such as a real return target, income, or capital preservation. Then constraints are identified, such as liquidity needs, time horizon, or drawdown tolerance, before a risk budget is determined, and how much volatility or downside is acceptable. Only after these steps are assets or vehicles selected.

The framework is asset-class-agnostic. Public versus private assets is a secondary consideration. It focuses on sources of risk, be it equity, credit, liquidity, or inflation risks. Allocations are opportunity cost-driven; every investment competes with all others for capital, and allocations can change with relative valuations and market conditions. This facilitates competition for capital within the constraints of the portfolio.

Risk budgeting is integrated. Instead of a 10% allocation to private equity and private credit, the question is how much equity and credit risk I want to allocate to. How much illiquidity risk am I being paid for? Private equity is thought of as leveraged equity risk, long-duration growth exposure, and the illiquidity premium. For instance, some argue that private equity is the new small cap in the US, as backed by the surge of private capital, high-growth-potential companies are staying private for longer, and there is an increasing number of small-cap stocks being taken private. Meanwhile, private credit is viewed as credit risk plus an illiquidity premium and shorter duration.

Capital is not allocated based on prescribed asset-class budgets but on marginal contribution to the total portfolio. All told, decisions are no longer about fitting strategies or assets, not a specific silo, category, or bucket. It’s about improving the total portfolio.

Step Four: Stay Focused on Your Whole Portfolio

Semiliquid funds might not be for every investor. Setting realistic return and risk expectations means acknowledging that private assets aren’t magically less volatile; rather, pricing lags smooth the data. Structure matters as much as the strategy itself, and the fund structure must align with the underlying assets and the investors’ needs. Positi sizing also requires discipline, as illiquidity, rebalancing constraints, and high fees all limit how much private exposure a portfolio can reasonably support. Ultimately, portfolio construction should remain focused on improving the whole portfolio, with frameworks and optimization tools used to inform decisions rather than dictate them.