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Monday, November 26, 2007

About Those Alternative Asset Classes...

Various experts (almost invariably connected to firms that market or manage these investments) tout the importance of having exposure to hedge funds and private equity in one’s portfolio in order to create returns in excess of the overall stock market.
Being the skeptic I am about such matters I was hardly surprised to find this article in the Financial Times

Private equity underperforms market

By Martin Arnold, Private Equity Correspondent
Published: November 22 2007 16:48 | Last updated: November 22 2007 16:48

Private equity has on average underperformed the stock market in the last decade, according to a detailed survey of the buy-out industry submitted to the European Parliament on Thursday…..The research – based on data from 6,000 private equity deals and about 1,000 buy-out funds – shows that average private equity returns have underperformed the benchmark S&P 500 share index by 3 per cent, after fees charged to investors.“This does not correspond with the stereotype of the industry making its investors extremely rich,” Mr. Gottschlag told the Financial Times. “Investors have not had much fun in this asset class, even though they have all been obsessed with gaining access to the best-performing funds.”
And talk about crude math, how about this:
Excluding fees and carried interest (a widely used profit sharing scheme), returns from private equity outperformed the S&P 500 by 3 per cent.
“So private equity is generating value somewhere, but its fee structure means the general partners capture double the out-performance they generate,” said Mr Gottschlag, who is also head of research at Peracs, an advisor to buy-out investors

So yes, private equity is a profitable asset class…..for those that manage the private equity funds

Mr Gottschlag admitted that some private equity firms were consistently outperforming the stock market. But he was sceptical about the number of buy-out funds that say they are “top-quartile” in performance rankings.

And private equity seems like Lake Wobegeon where everyone is above average the Professor states:
“I have never met a general partner who was not top-quartile. So I wonder where three-quarters of the industry is hiding,” he said.And remember the data used came before the current period of tight credit where private equity firms have had to walk away from deals due to limited or expensive financing.

Friday, November 2, 2007

More Strange Advice on Investing

An article on safer alternatives to stock market investing in the Oct 28 NYT entitled:

Shedding Stock-Market Vertigo (but Still Making Some Money)

starts out logically enough ,mentioning some sensible alternatives including CDs and Treasury Inflation Protected Bonds.

Then the article veers off into the strange recommendation of actively managed bond funds. As we have noted before there is nothing particularly safe about these funds. The investor is simply giving his money to a bond “guru” who takes bets across the entire spectrum of fixed income investments. Much as with an actively managed stock fund, you never now what you own and what risks are lurking in the portfolio, particularly in the currently unstable bond market.
The article cites the recommendations of a Morningstar analyst (my bolds):

he has identified two — Metropolitan West Total Return and Pimco Total Return — as likely to benefit from credit market fears.
“They both have a history of opportunistic buying,” he explained. “Great managers love volatility.”

They may love volatility but is that what an investor really wants when he flees from “stock market vertigo”?

Mr. Peterson of Schwab likes Pimco Total Return and the Loomis Sayles Bond fund, which has international exposure, along with high-yield holdings intended to enhance performance.

Translation: they load up on credit, currency and sovereign risk to squeeze out higher returns .

Daniel J. Fuss, the Loomis fund manager, has excelled at finding the optimal mix of investment-grade and junk bond holdings, Mr. Peterson said. “Loomis is more of a credit analysis play,” he said. “They shift between investment grade and high-yield.”

This manager puts the conservative part of your portfolio in the riskiest types of bonds “high yield (junk) bonds. And with many forecasting a recession this is precisely what you do not want to own.

In all, his fund holds 22 percent in below-investment-grade holdings, along with roughly 17 percent in nondollar credits, chiefly in the Brazil real, the New Zealand dollar and the Mexican peso. These issues provide higher yield than dollar-denominated debt and would benefit from a continued decline in the dollar. This year through Thursday, the fund has produced a total return of 9.2 percent and has outperformed its multisector bond category average in each of the last five years.

Junk Bonds, Brazilian Real Bonds and Mexican Peso Bonds....Does that look like a portfolio designed to prevent market vertigo ? It looks to me like an accident ready to happen.

Once again it bears repeating. The only reliable way to reduce the risk of a portfolio is to increase the holdings of short term treasury bonds, treasury inflation protected bonds or investment grade bonds. Anything else is some kind of a bet on the direction of interest rates, credit spreads, currency risk, or sovereign risk. In fact a strong case could be made that even the investment grade bonds should be excluded from the list. Certainly a terrible choice would be an actively managed bond fund where you have no idea what risks the manager is taking.