Market Views: can exchange-traded assets replicate private equity returns?
Many institutional investors in Asia are ramping up their alternative investments, particularly in private equity, but illiquidity and high fees are driving them to look to other asset classes such as exchange-traded assets.
Asset owners have been turning to private equity as they seek to enhance their returns in today's low-interest rate environment. FWD's Hong Kong chief investment officer Jethro Goodchild said in March the life insurer is turning to private equity to both improve portfolio diversification and investment yield, while a Goldman Sachs Asset Management survey released earlier this month shows that Asian insurers are pivoting to the asset class.
Canada’s Ontario Teachers’ Pension Plan (OTPP), Shanghai-based China Pacific Insurance Company (CPIC) and Alaska’s sovereign wealth fund are also keen to build their exposure to China private equity.
However, as with other alternatives, private equity has many drawbacks such as illiquidity, high fee rates and lengthy lock-up periods. As a result, investors have been looking to replicate private equity’s performance or returns by using a portfolio of exchange-traded assets.
Japan's Government Pension Investment Fund (GPIF), for example, has been looking to replicate private equity’s performance or returns by using a portfolio of exchange-traded assets, as published in a research report conducted by Nomura Research Institute.
In the report, Nomura explained that the replication can be done through two ways: company-level replication and index-weight replication. In the former, replication is attained by constructing a portfolio of single-name stocks with attributes similar to those of private equity-investee companies in the index being replicated. The attributes can be region, size, liquidity, fundamentals.
With index-weight replication, public equity indices are re-weighted to mimic private equity market indices' attributes.
One benefit of replication is it allows investors to rapidly scale up exposure without having to worry about the illiquidity of private equity investments.
However, the report also noted that alternative replication is not commonly used for two main reasons: inconsistent performance and a dearth of replicable return components.
In view of this, AsianInvestor asked four market experts for their views on whether exchange-traded assets can succeed in replicating private equity returns.
Their contributions have been edited for clarity and brevity.
Richard Tan, alternative investment director for Asia
Mercer
Reproducing private equity-like returns through replication approaches may be possible but not easily accomplished without significant skill and knowledge. Even then, investors are unlikely to benefit from the full potential private equity offers.
Even if private equity replication is deemed to be feasible, the investable product universe utilising private equity replication approaches is extremely small and is likely impracticable for most investors to pursue. Hence, it is improbable that asset owners will widely adopt this approach at this relatively nascent stage.
Not necessarily a like-for-like comparison, but institutional investors interested in establishing an investment nexus with private equity may wish to consider investing in publicly traded private equity firms. These stocks provide shareholders the opportunity to gain exposure in the operational management of private equity firms and this approach potentially has fewer execution challenges.
Richard Surrency, head of alternative sales for Asia
Franklin Templeton
A Harvard Business School research piece suggested that a trifecta of value investing, leverage, and hold-to-maturity accounting "represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds". We find this view simplistic in nature and does not represent the true nature of the investment allocation decisions to private equity that institutional investors undertake.
The proposal - that the selection of small firms with low Ebitda multiples, levered, can produce similar returns with the optionality of liquidity - negates the valuable active-management approach of private equity that can often solve for multiple scenario outcomes that benefit investors.
The value-add of private equity includes deal sourcing, often in non-public markets, due diligence and valuation, the introduction of board and management oversight, the implementation of operational and competitive efficiencies, and eventual sale or listing. The commitment of these resources overtime, while outperforming public market returns consistently over decades, suggests a higher confidence level than simply levering small listed, low Ebitda stocks ad applying hold-to-maturity accounting of net asset values.
Lulu Wang, portfolio strategist for private markets solutions
Aberdeen Standard Investments
The recent challenging economic conditions have further enhanced the role of private markets as a potentially higher returns generator and a significant risk diversifier.
We have seen a few private equity indices, in both buyout and venture capital, using a portfolio of large-cap equity stock, to replicate private equity’s performance/returns. While the simulated private equity indices “track” well relative to the equity performance in a buoyant market, they struggle to provide the stability when market conditions are under stress as witnessed in the first quarter in 2020.
It also fails to recognise the substantial differentials among private equity between the top-quartile managers and the market median. Furthermore, fees charged by those private equity replicates tend to be substantially higher than the standard ETFs, which made the option less appealing.
More importantly, we strongly believe that an active approach in the private market provides an opportunity for investors to focus on environmental, social and governance (ESG) factors, such as a company’s environmental footprint, diversity and social aspects.
Paul Sandhu, head of multi-asset quant solutions for Asia Pacific
BNP Paribas Asset Management
The IPO market has been operating like a high-powered machine, which has effectively shortened the cycle of funding for startups in the tech disruption and energy-transition sectors. This has resulted in very high returns in a very short period of time for PE and venture capital investors.
Because of this change in dynamic in private equity investments, replicating returns using publicly traded assets becomes very difficult. In fact, because of the shortened funding cycle in the private sector, what often happens is that much of the investment return of the company once it goes public has been sucked out in the private markets already.
However, another risk arises from the private equity markets recently - dispersion. The range of returns and volatility that can be achieved in private markets has never been so wide and so may create a situation where the return spectrum becomes almost binary and option-like.
My recommendation to investors is that private equity is a good diversifier for portfolios that are heavily exposed to public markets. But just like public markets it is important to hedge downside risk. In the case of private equity, hedging can be achieved but at a high cost and can never be 100% hedged, so the asset class should be added carefully.