There has been a propensity during the past 20 years for both institutional and individual investors to aggressively diversify 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 and venture capital to real estate.
The hedge-fund and private-equity industries have been particularly large beneficiaries of this shift. Notwithstanding that there has been a tremendous difference in performance between individual firms and investments, these funds in general have failed to produce their intended objectives.
The emperor has no clothes
Hedge fund assets under management grew to US$4.8 trillion from US$370 billion over the 20 years ending Dec. 31, 2021, according to BarclayHedge Ltd.
Given this explosive growth, many people would be surprised by the hedge-fund industry’s average performance. As the accompanying table shows, an average hedge fund has neither produced attractive returns nor provided effective diversification from public equities.
Over the 20 years ending July 31, 2022, the HFRX Global Hedge Fund Index had an annualized rate of return of 1.8 per cent, compared to 8.5 per cent by the MSCI All Country World Stock Index. Moreover, the HFRX index lagged the 3.3-per-cent 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 per cent while the correlation of global bonds to global equities has been only 22.9 per cent. In other words, bonds have provided both higher returns and better diversification than the average hedge fund over the past 20 years.
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 (PE) industry. Investors are told PE funds produce superior returns while providing portfolio diversification.
PE funds are far less liquid than public securities, with lockup periods of invested capital generally ranging from five to seven years. Illiquidity is a bad thing, and, all else being equal, you should receive a premium return for bearing it.
Like hedge funds, PE firms have been hard-pressed to deliver their stated objectives. “The big picture is that (PE firms are) 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.” Ludovic Phalippou, a professor at the University of Oxford’s Saïd Business School, said in a 2020 research paper.
This begs a question: Why has capital been flooding into PE funds?
Those who invest in PE may do so because they perceive it has a low correlation to stocks and provides diversification. However, this perceived benefit is often illusory. At its core, PE is simply a levered investment in small- and mid-cap companies. If stocks experience a 10-year bear market (which many have forgotten, but is most assuredly possible), you’re dreaming in technicolour if you believe PE investments won’t experience significant losses or act as portfolio diversifiers.
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. They are valued far less frequently, are less subject to the fickle vagaries of stock-market participants and may be subject to rosy valuations and artificial smoothing.
For instance, energy prices in 2014 and 2015 crashed by more than 50 per cent. The S&P 600 Energy Index of small caps dropped 52 per cent from Dec. 31, 2012, to Sept. 30, 2015. Yet on that last day, PE energy funds from the 2011 vintage were marked up on average to 1.1x of money invested, while funds from the 2012 vintage were marked at 1x and 2013 vintage funds were marked at 0.8x. Yet PE energy funds almost universally claimed to have dramatically outperformed the public-equity market, not even recognizing half the losses exhibited in public markets.
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Experts, rather than markets, determine the prices of PE-owned companies, and those experts are PE firm 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 happens to be employed by the PE fund. In a recorded public presentation, the chief investment officer of the Public Employee Retirement System of Idaho called this the “phony happiness” of private equity.
Clearly, there are many firms in the top quintile or decile that have added significant value. However, it is difficult to know in advance which ones will be in this club. There is considerable evidence demonstrating that funds in the top quartile for a given period have no greater probability of being top performers in subsequent periods than their poorer-performing peers.
Political writer and satirist Karl Ludwig Borne wrote that “losing an illusion makes one wiser than finding a truth.” Investors who believe that alternative investments are a portfolio panacea would be well-served to heed his words.
Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.