Thursday, May 6, 2010

Alternatives: Private Equity, Venture Capital, Hedge Funds, International Small - Which is Best?

The poor performance of public equity markets in recent times has lead investors to emphasize closer examination of alternative investments. The benefits would include high expected returns, low volatility, and low correlation with public equity markets - an investor's dream!

Often times investors are lured by high-flying returns produced by hedge funds, private equity, and venture capital. Itching to get their fair share of these juicy returns, investors tend to glance over what it really takes to be part of the "parade". Of all of the alternative investment managers claiming they can add value for you, how are you going to pick which managers which will outperform the others? Will it be past performance? Academic studies show, with great confidence, that past performance has no predictive validity. Maybe, you will go to the one with the highest education or most enticing models? Probably not a good idea either, seeing as literally a monkey throwing darts at a financial newspaper can outperform the professionals. Now you're stuck...let's look at the numbers to give us a better idea as to whether these flashy funds are with it.

Venture Capital
A paper by Chicago finance professor John Cochrane examined the results of 7,765 venture capital projects (not venture funds) between January 1987 and June 2000. By surveying the entire range of venture capital projects—not just the winners—the study avoided selection bias. The June 2000 termination date of the survey excludes the subsequent poor performance of many venture projects. Cochrane finds that venture projects have option-like characteristics; a small number have the chance of a huge payoff. Among successful projects—those with a new financing round, IPO, or acquisition—the arithmetic average return to IPO or acquisition is 698%, but with enormous standard deviation of 3,282%! Compound return is 108%. Accounting for selection bias by examining all projects (not just winners) lowers these numbers dramatically to a mean return of 57% and a compound return of 15%.

A second study shows similar results. A study by Peng Chen, Gary Baierl and Paul Kaplan examined the record of pooled venture capital funds from the Venture Economics database over the January 1960-June 1999 period. The absence of a liquid market for VC investments means there is no return history to analyze, so the authors restrict their study to 148 funds (among over 900) that have been liquidated. Chen et al. also report very high mean returns for venture capital fund investments over the 1960-1999 period: 45%. By comparison, mean return was 13.3% for the S&P 500 and 17.2% for US small company stocks over this period. The variance in VC returns was so high (standard deviation of 116%) that the compound return shrank to 13.4%, 120 basis points higher than the S&P 500 over this period but 90 basis points per year below US small company stocks.

Investors in venture capital do not necessarily capture the behavior of the entire asset class. Moving on...

Private Equity
A forthcoming study by Moskowitz and Vissing-Jorgensen examines the results over 5 million private businesses (proprietorships, partnerships, S corporations and C corporations), with estimated value of $6 trillion, using data from the Federal Reserve, Internal Revenue Service, Securities Data Corp., and the Center for Research in Securities Prices. Based on Federal Reserve survey data (whose results are not available to the IRS), the authors report the annual compound return of all private equity over the 1990-1998 period to be 13.9% vs. 17.9% for the S&P 500. Using Federal Reserve Flow of Funds data for the 1963-1999 period, the authors report compound return to book value of 13.2% for all private equity vs. 15.6% for public equities.

The results show that private equity does not offer a reliable improvement to a portfolio of public equities. Next.

Hedge Funds
Hedge fund manager Clifford Asness et al. studied the CFSB/Tremont database of hedge funds over the January 1994-September 2000 period. Funds were limited to those with assets over $10 million, audited financial statements, and those that met CFSB/Tremont reporting requirements. There were 656 funds as of November 15, 2000. Initial results suggested the average fund did well relative to a market model: beta was 0.37 and annualized alpha was 2.6% (net of fees). But hedge funds often hold securities that trade infrequently or are difficult to value, such as over-the-counter convertible bonds. If managers are slow to re-value securities, the presence of stale prices can artificially reduce reported volatility and create the illusion of low correlation with traditional benchmarks. Against a lagged market model, hedge fund results looked much less appealing: beta rose from 0.37 to 0.84 and annualized alpha went from 2.6% to -4.5%.

As we can see, all three alternatives require do not exactly fit our intended goal. Fortunately, there is an asset class which has shown to provide exactly what our portfolio of public equity needs - international small stocks.

International Small Stocks

With high expected returns and low correlation with US large cap stocks, international small stocks can play a useful role as diversifiers.

Annualized data 1970-2002
Compound Return / Standard Deviation
International Small 15.0 / 30.1
MSCI EAFE (net div.) 9.3 / 22.5
S&P500 10.8 / 17.5

Correlation of international small stocks with:

S&P 500 0.29
US Small 0.28

Although the volatility of international small stocks was appreciably greater than the S&P 500 Index (30.1 vs. 17.5), the low correlation suggests significant diversifying power. Using the same time period, a 100%S&P 500 portfolio could be revised to 70% S&P 500 and 30% international small with no increase in overall volatility, but a 200 basis point enhancement in realized return.

Low correlation with US large cap stocks and superior liquidity relative to venture capital, private equity, or hedge funds makes international small stocks an appealing choice for investors seeking alternative investments.

Thanks to Rex Sinquefield for compiling this research and introducing the topic.

No comments:

Post a Comment