Swedroe: Nails In The Hedge Fund Coffin

August 25, 2014

  • Companies in the S&P 500 are typically among the largest and strongest companies, while venture capital typically invests in smaller and early-stage companies with far less financial strength.
  • Investors in private equity forgo the benefits of liquidity, transparency, broad diversification, daily pricing and, for individuals, the ability to harvest losses for tax purposes.
  • The median return of private equity is much lower than the mean, or the arithmetic average, return. Their relatively high average return reflects the small possibility of a truly outstanding return, combined with the much larger probability of a more modest or negative return. In effect, private equity investments are like options (or lottery tickets). They provide a small chance of a huge payout, but a much larger chance of a below average return. While CalPERS can diversify this risk—it had almost 400 private equity managers as of September 2013—it’s difficult for individual investors to do the same.
  • The standard deviation of private equity is in excess of 100 percent. Compare that with the standard deviations of about 20 percent for the S&P 500 and about 35 percent for small value stocks.

While private equity or venture capital investing is high in risk and high in expected return, the returns investors have actually realized don’t appear to have compensated them fully for the strategy’s incremental risks.

For example, the returns should reflect, at least to a significant degree, a premium for the extreme illiquidity of private equity investments. Highlighting the lack of liquidity is the finding from one paper—“The Cash Flow, Return and Risk Characteristics of Private Equity”—that the internal rate of return for the average venture capital fund did not turn positive until the eighth year.

Given the above evidence, it seems appropriate that the hurdle for investing in private equity should be a premium that isn’t just above the return of an index such as the S&P 500, but above that of more similarly risky, publicly available small value stocks.

From 1926 through June 2014, the Fama-French index of U.S. small value stocks (excluding utilities) had outperformed the S&P by 3.66 percentage points a year (13.84 percent versus 10.18 percent). And since private equity is clearly riskier than public small value stocks (accounting for the higher standard deviation of returns, the high skewness in returns, and the lack of transparency and liquidity), there should be a significant premium over that of small value stocks.

What’s really unfortunate is that the poor realized performance in nonpublicly traded securities could have been avoided if pension plans had simply reviewed the historical evidence on such investments. The picture, as presented in my book, “The Quest for Alpha,” isn’t a pretty one.

Clearly, the two nonpublicly traded securities discussed here—private equity and hedge funds—merit examination beyond their relation to pension plans.

Later this week, we’ll take a look at some words of wisdom from a cross section of heavyweights in the investing world about hedge funds. Hopefully, what they say will provide some insight for the individual investor.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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