Alternative investment industry fails to live up to expectations as hedge funds and venture capital operations are unable to impress in bear market conditions
Q: What kind of return would you expect on a private-equity fund?
A: About 20%.
Q: What kind of return would you expect on a hedge fund?
A: About 20%
Q: Should those types of investments consistently beat mainstream, big-cap stocks?
A: Of course, that's why they were created.
It may be time to think again.
In the past decade, two big alternatives to investing in traditional, mainstream equity and bond markets have emerged: private-equity funds, including both venture capital and leveraged-buyout operations, and hedge funds. Both have created huge industries, based on a simple, easy-to-understand promise: we beat all the other markets.
As a marketing line, it has been supremely effective. For every smart young financier, launching a private-equity fund or a hedge fund has been the quickest and easiest way to amass a fortune. Yet, as a description of reality it leaves much to be desired. The claims made for alternative investments are turning out to be wildly exaggerated.
Two recent pieces of evidence suggest that private-equity funds only just managed to match the returns on US big-cap stocks, and underperformed small-cap stocks. And hedge funds have been having a terrible year. Only one big equity hedge fund made money in the first two months of this year ” the aptly named Maverick Capital, which managed a 3.3% gain. Stock hedge funds fell by an average of 1.58%, according to the CSFB/Tremont Hedge Fund Index.
The idea that certain classes of investment can consistently outperform other types of investment is turning out to be a myth, a useful myth for the people selling the investments but a dangerous myth for those buying them.
This will have two important consequences. One is that the explosive growth in the hedge-fund and private-equity industries may be about to end. The other is that portfolio managers may have to permanently ratchet down their expectations of the returns that can be made from the markets.
Reliable figures for returns made by private-equity funds are notoriously difficult to pin down: like it says on the label, these funds are private and don't report figures in the same way as publicly traded stocks. Most figures are heavily massaged, to trumpet the successes, while the failures are tucked away in the circular filing cabinet underneath the desk.
New research in the usually dry pages of the Journal of Portfolio Management blows away some of the cobwebs that have collected on ancient venture-capital funds. Authors Peng Chen, Gary Baierl and Paul Kaplan are research directors at, respectively, Ibbotson Associates, Causeway Capital Management and Morningstar. They examined the venture capital raised and liquidated in the US since 1960 and calculated the returns made by those funds. While there have been some spectacular returns made by individual funds in individual years, there have also been wild fluctuations in performance, both between years and between funds. They found that, over 40 years, venture-capital funds returned a compound 13.4%. That is one percentage point better than the S&P 500 index and one percentage point less than American small-cap stocks.
The research excluded the past two years, which would probably have made the returns look a lot worse (think of all the venture capital that was sunk into dog-biscuit portals and devices to download the complete works of Mahler and Ibsen onto your mobile phone). The few published numbers available suggest the private-equity and venture-capital industries have been going through a rough time. UBS recently announced a 24% drop in fourth-quarter profit, as net income was dragged down by private-equity losses. Likewise, JP Morgan Partners, the private-equity division of JP Morgan Chase reported in January a loss of $1.2bn for 2001, dragging down the performance of the whole bank.
The hedge-fund industry, still the hottest investment sector, is looking little better. The promise to investors was that hedge funds could deliver generous returns in all markets.
It made no difference to them whether the bulls or bears were strolling through the fields, they could still harvest the hay. It was a seductive line, which helped to pull $31bn of fresh money into the sector in the past year. It turned out that in a bear market, hedge funds aren't very different from any other kind of fund. With one or two honourable exceptions, most of them lost money.
For the past few years, investors have poured money into alternative investments such as private equity and hedge funds because they reasoned that even though there might be higher risks, there should also be higher rewards. Those investments might account for only 10% or 20% of their portfolio, but that was the part that was meant to shine and dazzle. They were looking for brilliance, not mediocrity. If mediocrity is what they are mostly getting, it will not be long before they notice.
Two things follow. One, it is going to be a lot harder to justify the fees that have made those industries so rich. Private equity and hedge funds might not have high performance but they certainly have high fees. That can be justified if you are paying for clever people to do the research to find outstanding opportunities. But to match the S&P 500? Forget it.
Two, investors are going to have to throw out the notion that any class of assets can produce exceptional returns. Brilliant investors can, occasionally, and so can a few excellent companies. But seldom a whole industry.
They may even have to scale back their ambitions for the kind of returns that can be earned on their capital. If alternative investments cannot produce the 20% a year or more returns they promised, it is unlikely that anything can.
Bloomberg London newsroom
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