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Over the past 20 years, there has been a propensity for both institutional and individual investors to diversify aggressively no matter what the consequences. A major part of this push has involved increasing allocations to alternative investments, ranging from hedge funds to private equity to venture capital to private debt to real estate.
In my latest commentary, I analyze both the hedge fund and private equity (PE) industries, which have been large beneficiaries of the shift into alternative investments. Specifically, I will discuss whether they have been successful in producing their intended objectives. Importantly, I recognize that there has and will always be a tremendous difference in performance between individual funds and investments and have limited my observations to generalizations on these asset classes as a whole.
Hedge Funds: From Alfred Winslow Jones to $4.8 Trillion
While writing an article for Fortune Magazine in 1948, investing pioneer Alfred Winslow Jones had the unique idea of managing the risk of holding long stock positions by selling short other stocks and using leverage to boost portfolio returns. In 1949, he raised $60,000 from four friends, added it to $40,000 of his own money, and began the first “hedge fund”. In 1952, Jones opened the fund to new investors. He also added a 20% incentive fee as compensation for himself as manager whereby he would receive 20% of any profits generated by the funds (this idea was based on the practice of Phoenician merchants who kept one-fifth of profits from successful voyages).
Hedge funds have come a long way since Jones’ time. They have been a large beneficiary of the shift into alternative assets. According to BarclayHedge, over the past 20 years ending December 31, 2021, hedge fund assets under management grew from $370 billion to $4.8 trillion.
The Emperor Has No Clothes
Given the explosive growth in hedge fund assets, most people would be surprised by the investment performance of the hedge fund industry. As the following table demonstrates, on average hedge funds have neither produced attractive returns nor have they provided effective diversification from public equities.
Hedge Fund Returns: Past 20 Years Ending July 31, 2022
Over the past 20 years ending July 31, 2022, the HFRX hedge fund index had an annualized rate of return of 1.8%, as compared to 8.5% for the MSCI All Country World Stock Index. Moreover, the HFRX Index lagged the 3.3% annualized return for the Bloomberg Global Aggregate Bond Index while producing similar volatility.
Hedge funds have also come up short from a diversification perspective. The correlation of the HFRX index to global equities has been 78.8% while that of bonds has been only 22.9%. In other words, over the past 20 years bonds have provided both higher returns and better diversification than hedge funds.
With standard annual fees of 2% of assets and 20% of profits, hedge funds distinguish themselves more as a compensation structure than as an asset class. According to Warren Buffett, “A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors.”
Private Equity: Not as Advertised
Another big beneficiary of the push to enhance returns and/or lower overall portfolio volatility has been the private equity industry. Investors are told that these private equity funds produce superior returns, while providing portfolio diversification. As a result, private equity has become the hottest home for a variety of sophisticated institutions and individuals. Since 2017, investors have poured more than $1 trillion into PE funds. According to McKinsey, this amount dwarfs the amount of cash directed to venture capital, real estate funds, private debt, hedge funds and just about any other form of alternative investment.
Like hedge funds, PE firms have been hard-pressed to deliver their stated objectives. Michael Cembalest, the chairman of market and investment strategy at J.P. Morgan Asset Management, stated, “Since the financial crisis, the industry has had a tougher time outperforming public equity benchmarks.”
Ludovic Phalippou, professor of finance at Oxford’s Said Business School, came to a harsher conclusion. In a 2020 research paper, he analyzed private equity performance for funds launched between 2006 and 2015. Phalippou found that investors could have done nearly as well with a stock index fund during that period. When interviewed, he said that “The big picture is that they’re (PE firms) getting a lot of money for what they’re doing, and they’re not delivering what they have promised or what they pretend they’re delivering.”
Private equity funds are far less liquid than investments in public securities, with lockup periods of invested capital generally ranging from five to seven years. Conventional wisdom (not to mention economic theory) suggests that returns on less liquid investments should be higher than those from their more liquid counterparts. Illiquidity is a bad thing, and, all else being equal, you should receive a premium return for bearing it.
This begs the question why capital has been flooding into PE funds despite their widespread inability to deliver returns that are superior to public equities. Many institutions and individuals may invest in private equity because they perceive that such investments are uncorrelated to stocks and thus provide valuable portfolio diversification benefits. However, this lack of correlation is largely fictitious, which means that PE rather than being a true diversifier, is merely a diversification illusion.
Liquid, accurately priced investments let investors know exactly how volatile they are, and they smack them in the face with it. By contrast, illiquid investments are far more opaque. Not only are illiquid investments valued far less frequently and less subject to the fickle vagaries of stock market participants, but also may be subject to rosy valuations and artificial smoothing.
John Burr Williams, who pioneered the concept of intrinsic value with respect to valuing companies, wished for a day when experts would set security prices. He believed that expert valuations would result in “fairer, steadier prices for the investing public.” The PE industry would seem to have made Williams’s dreams come true. Experts, rather than markets, determine the prices of PE-owned companies. Even better, those experts are the PE firms’ employees! Predictably, this results in dramatically lower volatility. The hurly burly of the public markets is replaced by the considered judgment of an accounting firm that just so happens to be employed by the PE fund. In a recorded public presentation, the CIO of the Public Employee Retirement System of Idaho called this the “phony happiness” of private equity.
In 2014 and 2015, energy prices crashed over 50 percent. The S&P 600 Energy Index of small capitalization energy stocks dropped 52 percent during the period from December 31, 2012, to September 30, 2015. Yet as of September 30, 2015, PE energy funds from the 2011 vintage were actually marked up on average to 1.1x multiple of money invested (MoM), while funds from the 2012 vintage were marked at 1.0x MoM and 2013 vintage funds were marked at 0.8x MoM. PE energy funds almost universally claimed to have dramatically outperformed the public equity market, not even recognizing half of the losses exhibited in public markets.
From a common sense perspective, there is little case for private equity investments being effective diversifiers for publicly listed equities. At its core, PE is simply a levered investment in small to mid-cap companies. If stocks experience a ten-year bear market (which many have forgotten but is most assuredly possible), you’re dreaming in technicolor if PE investments didn’t also experience significant losses and fail to act as portfolio diversifiers.
Whether the difference in volatility between private and public holdings is due to the irrationality of public markets, aggressive price “smoothing” by private equity funds, or some combination of both is not the subject of this missive. We are merely stating that the private equity industry’s benefits of lower volatility and portfolio diversification are at the very least far less than perceived, and at worst non-existent. If private equity provides neither higher returns nor significant diversification, does this mean that those who invest in the asset class are imprudent? The answer is not necessarily.
The accurate information, timely feedback, and associated short-term volatility that comes with liquid investments can make investors worse off if they use that liquidity to panic and redeem at the worst times. In contrast, illiquid holdings that are valued less frequently and accurately can allow people to be better investors because their artificially low volatility and relatively modest paper losses allow owners to ignore them and stay the course through challenging times. In this scenario, “ignore” means sticking with illiquid holdings through tough times when you might sell if you were presented with the full losses and had the opportunity to do so.
Could it be that the same investors who find private equity easy to stick with also have difficulty standing pat with a publicly traded portfolio of small cap even though the two are economically similar investments? Although such a proposition would be unthinkable for an utterly unemotional, purely rational Vulcan with Spock-like logic, it is entirely possible for humans. Although we have focused explicitly on PE, the idea applies to all illiquid assets which exhibit smooth returns due to the fact that they are not subject to the same, brutal judgment of public investments.
Political writer and satirist Karl Ludwig Borne wrote that “losing an illusion makes one wiser than finding a truth”. There can be little doubt that hedge funds and PE firms are not portfolio panaceas. Clearly, there are many top quintile or decile firms that have added significant value. However, it is difficult to know in advance which ones will be in this club. Mean reversion, to quote Scottish poet Robert Burns, can cause “the best-laid plans of mice and men to go awry.” There is considerable evidence which demonstrates that funds which were in the top quartile for a given period have no greater probability of being top performers in subsequent periods than their poorer-performing peers.
We believe that our Global Tactical Asset Allocation (GTAA) mandate offers a reasonable alternative for a portion of investors’ hedge fund allocations. The fund has a target annualized return of 5%-7% over an investment cycle and is designed to avoid large losses in bear markets. Since its inception in May of 2017, the fund has delivered higher returns than the HFRX Index of hedge funds while exhibiting a lower correlation to stocks.
On the long equity side, investors might consider our Canadian equity income strategy for a portion of their allocations to private equity. The fund has outperformed the TSX Composite Index by 2.7% on an annualized basis and by 13.4% cumulatively since its inception in October 2018. Importantly, both funds offer comparatively attractive terms of low management fees, no performance fees, and weekly liquidity.