Image Credit: Christophe Vorlet
By Jason Zweig | Sept. 15, 2017 12:53 pm ET
You probably can’t get a Ferrari at the price of a Ford Fiesta, but some people can’t resist trying to find a bargain.
That’s the idea behind the latest attempt by exchange-traded funds to enable just about anybody to buy investments only the wealthiest could traditionally afford. This past week, a market-index firm and an ETF issuer moved to launch a benchmark and a fund that aim to produce returns similar to those of private-equity buyout funds.
Such portfolios have generally been available only to multi-millionaires and pension funds and university endowments. With billions in capital committed for years on end, buyout funds take entire companies off the public market, clean them up and ultimately resell them. They crank up their returns with borrowed money.
Over the ten years through March, private-equity funds returned an average of 9.9% annually, net of all fees, according to the American Investment Council, a trade group for the industry. That’s well above the 7.5% return on U.S. stocks, including dividends.
Skeptics have long argued that you could come close to the performance of private-equity funds by using borrowed money to buy an index fund that invests in stocks that are cheaper and smaller than average.
While such a homemade buyout fund lacks the analytical skill, financial acumen and operational expertise that the world’s greatest dealmakers wield, it sure is cheap.
Buyout funds often charge up to 2% of assets in management fees and 20% of profits, along with other expenses. All told, the cost of ownership in these funds can run roughly 3.5% annually.
Addressing pension-fund executives this past week, Laurence Fink, chief executive of BlackRock, the world’s largest investment firm, said that good private-equity managers deserve to be paid well. But if future returns are lower, he said, “I do believe fees should be lower.”
Had you used 50% borrowed money to buy Vanguard Mid-Cap Value Index Fund ten years ago in March, and kept your borrowing level constant each year, you would have earned an average of 8.4% annually, reckons William Bernstein of Efficient Frontier Advisors in Eastford, Conn.
That fund, like other index funds and ETFs that buy cheap, mid-sized stocks, was a significant holder of office-equipment supplier Staples, which went private this last week in a buyout led by private-equity firm Sycamore Partners. In earlier years such index funds held numerous energy and technology companies that ended up being acquired by dealmakers.
Presumably, undervalued companies cluster in areas of the economy that go out of favor with investors. Think of energy stocks in 2014 and 2015, or retailing stocks in 2017; buyout funds specifically targeted both those industries. Sector exposure appears to account for about half the long-term extra return of private equity, says David Turkington, head of portfolio and risk research at State Street Global Exchange.
In principle, an investor could use a benchmark such as State Street’s Private Equity Index, which tracks investments by more than 2,700 buyout funds, to shadow them. Mark Kritzman of Windham Capital Management in Boston and his colleagues have estimated that an investor using industry-sector ETFs to mimic those deal-making patterns could have outperformed the overall stock market by more than three percentage points annually from 2002 through 2014.
This past week, SummerHaven Index Management, a research firm based in Stamford, Conn., introduced a market measure that will attempt to produce returns similar to those of private-equity funds. At the same time, USCF Advisers registered with the Securities and Exchange Commission to launch an ETF based on SummerHaven’s index.
Based on research by Harvard Business School finance professor Erik Stafford, SummerHaven argues that the returns of buyout funds can be approximated with a basket of smaller companies that haven’t been issuing large numbers of shares recently, are modestly profitable and are selling at low ratios of total capitalization to cash flow.
The proposed ETF hasn’t yet stated its fees, but a commodity fund from SummerHaven and UCSF charges total expenses of 1.11% annually.
Andrew Lo, a finance professor at Massachusetts Institute of Technology who has helped design portfolios that replicate the returns of hedge funds, points out that no one would be interested in mimicking private equity if it hadn’t had such torrid returns in recent years.
Such performance won’t last forever. What’s more, any rise in interest rates could hit returns hard.
Is it worth paying opulent expenses to masters of the universe once you can mimic them for peanuts? Price competition is finally coming to the palaces of the fee kings.
Source: The Wall Street Journal, http://on.wsj.com/2foG8oW
For further reading:
Definitions of INDEX FUND, LEVERAGE, LIQUIDITY, PRIVATE-EQUITY FUND, SMART MONEY, SOPHISTICATED INVESTOR in The Devil’s Financial Dictionary
Andrew Lo, Adaptive Markets: Financial Evolution at the Speed of Thought
Robert S. Harris et al., “Private Equity Performance: What Do We Know?”
Will Kinlaw et al., “The Components of Private Equity Performance”
Erik Stafford, “Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting”
Gregory W. Brown et al., “What Do Different Commercial Data Sets Tell Us About Private Equity Performance?”