I had coffee with an old friend the other day. Midway through our conversation, the topic turned to exchange traded funds (ETFs). Diversified bond and equity ETFs are something I’ve mentioned quite a bit in my recent blogs.
My friend is financially savvy and didn’t want another exchange on standard ETFs like those that track the S&P 500 or the STI. He wanted to talk about something sexier: ETFs that offer investors exposure to private equity (PE).
PE comprises venture capital (VC) funds that invest in start-ups and buyout funds that take public companies off the exchange. It conjures images of wealthy investors, secretive deals and mind-boggling returns. This image is true to some extent because VC and buyout funds are closed to all but wealthy investors. My friend wanted to know whether there are ETF that mimic the portfolio of private equity.
His question got me off-guard. A PE ETF? Never occurred to me that index-trackers would stray into the space of alternative assets (read assets that are neither as liquid or transparent in terms of regulations compared to exchanged traded asset classes). But his question piqued my curiosity and sent me digging for the facts. The result is this blog.
My research led me to a fund with the moniker, PowerShares Global Listed Private Equity Portfolio. This entity is traded on NYSE-Arca, has the ticker symbol PSP and is structured as an open-ended exchange traded fund. That means investors can buy or sell the ETF just like any other traded stock. PSP is managed by Invesco, an investment management company based in the U.S. Invesco charges an annual expense ratio of 2.22% for PSP.
First things first. PSP is not the only PE ETFs, but is currently the largest and most liquid of a handful of such ETFs. Hence, I will mostly talk about PSP in this blog.
Second, PSP is not what a purist would call a true PE fund. A true PE fund provides venture capital financing to startups or take public companies private with the aim of an eventual relisting when they are in better operational and financial shape. In other words, true PE funds are private and their assets are illiquid. That’s something that can never be ETF-ised.
What PSP does is that it offer investors indirect PE exposure by investing in the shares of publicly traded PE firms. These include business development companies (BDCs), master limited partnerships (MLPs) and other vehicles whose principal business is to invest in, lend capital to or provide services to privately held companies.
Here is a graphic summary of PSP’s portfolio as of December 8, 2017 (source: http://www.etf.com)
PEs certainly sound sexier than bonds and stocks. But as noted, the firms that PE funds buy are young, small, inexperienced, high risk, hard to value, and illiquid. Not exactly the characteristics that most investors love.
So, are PE ETFs worth the trouble?
Academic research sheds some light on this question. An early study by Cambridge Associates found that U.S. buyout funds earned 12.4% between 1986 and 2009 while VC funds earned 14.5%. Both types of PE funds outperformed the 9% average return of public equities. However, the very high returns of the 1980s and 1990s have faded in recent years when large dollar amounts were at work. The changing fortunes of the PE industry can be seen in the following charts based on a 2014 Journal of Finance study.
Now let me turn to PSP’s performance. This ETF was introduced to the market in October 2006. In view of the above trends, one should not have high hopes that PSP’s performance is an inspiring one. This is confirmed by the following chart.
The above graph shows the cumulative total returns of one dollar invested in PSP and three comparison assets between November 2006 and November 2017: the S&P 500 index, the S&P High Beta Index and the ishares Russell mid-cap value ETF.
The first of these needs no introduction. The S&P High Beta Index summarizes the returns of 100 stocks in the S&P 500 list which are most sensitive to the market’s returns. I use this as a comparison index because PSP itself is a high-beta portfolio. Since PE firms tend to be small firms with low valuations that are nevertheless attractive as likely targets for private equity takeovers, I also use the ishares Russell midcap value ETF as another comparison asset.
As you can see from the chart, PSP trailed all three comparison assets. The performance gap with the two S&P indices is especially stark. A dollar invested in the plain old S&P 500 grew to $2.32 by end-November 2017. A dollar invested in PSP ended at $0.95.
A more sophisticated way to assess PSP’s performance is to calculate its alpha by running a regression of PSP’s returns against risk factors. The alpha captures PSP’s risk-adjusted returns.
I used three risk factors to account for PSP’s exposure to three sources of risk: (1) market risk (2) small-firm risk and (3) distressed risk. The risk factors to mirror these risk types are firstly the returns on the S&P 500 index, secondly, the returns of small firms minus the returns of big firms (SMB) and thirdly, the returns of stocks with low price-to-book ratios (value stocks) minus the returns of firms with high price-to-book ratios (growth stocks). I use monthly data to run my regression.
PSP’s alpha between 2006 and 2017 was negative 9.24% a year! In other words, after adjusting for risk, an investor in PSP would have lost over 9% a year on average during the eleven year period.
I wasted no time to email my friend to declare my undying love for plain vanilla ETFs 🙂
USCF Advisers in California has just rolled out two ETFs that try to mimic private equity portfolios. They are the USCF SummerHaven SHPEI Index ETF and USCF SummerHaven STIPEN Index Fund. The respective tickers are “BUY” and “BUYN”. Both ETFs will buy companies that are “cheap” compared to the market and believed to be likely PE takeover targets. BUY will focus on small to mid-cap US firms across different industries, while BUYN will invest exclusively in natural resource firms. For more information, visit www.uscfinvestments.com. Author’s note: would be interesting in future to see whether these ETFs really add value or are just more expensive ways to buy small and mid-cap stocks.