Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
MIT and State Street debunk private equity ‘myth’
The prestigious MIT Sloan School of Management, with the assistance of State Street, has produced a paper which questions long-held assumptions about the true volatility of private equity investments. It is particularly relevant right now when some big investors are under attack from conservative politicians.
As reported in last week’s Investor Strategy News, Australian Liberal senator Andrew Bragg, an accountant and former policy advisor at the Financial Services Council, has been critical about the level of unlisted assets – private equity, private credit, direct property and infrastructure assets – held by industry funds.
But, as the Treasurer, Josh Frydenberg, said, the estimated $27 billion which could be withdrawn by members under the emergency scheme instituted by the Government to ease the financial pain of COVID-19, is less than 1 per cent of the total assets in the super system. As we reported, undeterred by this, Bragg sent an email to constituents advising them of the Government’s early withdrawal scheme. Senator Bragg does not have a Government portfolio.
The MIT/State Street paper, ‘Private Equity and the Leverage Myth’ examines the issue of private equity volatility being unrealistically low because the returns are based on historical appraisal valuations. An alternative of basing private equity being estimated as leverage public equity investments has been suggested, but this ends up with unrealistically high volatility for private equity.
The researchers from the two Bostonian institutions, found that private equity volatility, adjusted for smoothing, is roughly the same as public equity volatility despite the much greater leverage in the private equity investments.
They say: “We assert that the volatility we estimate from longer-interval private equity returns (to offset the effect of valuation smoothing) is the correct approximation of private equity volatility because it approximates the actual distribution of outcomes realized by private equity investors over longer horizons. When applied to the data, this approach yields the stubborn conclusion that private equity volatility is similar to public equity volatility despite its higher leverage. Why is this the case? It could be that buyout fund managers prefer to invest in companies whose underlying business activities are inherently less risky and can therefore bear higher leverage, which increases profits. Whatever the reason, our findings debunk the widespread misconception that private equity has higher volatility than public equity volatility as a result of its higher leverage.”
The paper was written by Mark Kritzman, from MIT, and Megan Czasonis, William Kinlaw and David Turkington, all from State Street.
– G.B.
