‘Asset class alpha’, and sector ETFs

A large percentage of the outperformance of private equity can be replicated by using sector exchange traded funds, according to new research.

The research empirically unbundles the sources of private equity return, differentiating between alpha, due to manager skill and illiquidity, and the return that comes from “asset class alpha”.

This “asset class alpha” – referred to as “liquid private equity” – can be captured by using sector ETFs, and has portfolio construction uses for investors wanting to capture outperformance of private equity without the liquidity constraints.

In a paper, ‘The components of private equity performance: implications for portfolio choice’ published in The Journal of Alternative Investments, the authors show that the sector weights of private equity funds predict the subsequent performance pf public equity sectors within large and small-cap universes.

One of the authors, Will Kinlaw, head of State Street Associates and a senior managing director of State Street Global Exchange, says a significant portion of the excess return of private equity over public markets can be captured by sector bets.

“Whether this is alpha or beta is a tricky philosophical question. From a public markets point of view this is alpha,” Kinlaw says.

“This is not a substitute for private equity. Private equity managers have clearly shown they can deliver company selection and capture an illiquidity premium.”

However the research, which is the first of its kind to look at the role of sector bets in private equity returns, shows that private equity exposures are predictive of public equity performance.

The research uses the State Street Private Equity Index, updated quarterly based on the cashflows of institutional investors (LPs), to evaluate the performance of actively managed private equity funds.

The research “conjectures” that the private equity managers collectively produce an asset class alpha because they anticipate the relative performance of economic sectors.

The authors point out that many private equity funds, such as venture capital funds, focus on emerging segments of the economy in which innovation is likely to be concentrated. Other funds, such as buyout funds, focus on underperforming segments of the economy.

“It may, therefore, be the case that private equity managers anticipate outperformance, whereas public investors respond to outperformance.”

Kinlaw says there has been a lot of research on the impact of size, value, leverage, and the liquidity premium with regard to private equity performance, but little on the role of sectors.

“So we set out to understand the role of sector bets, and used a regression technique to look for just the statistically significant exposures to sectors,” he says.

This “asset class alpha” can then be captured by using sector ETFs.

“We also looked at the shelf life of this information. Private equity managers are locked up for a period of time so there is decent information for two to three years in those bets.”

The authors – which include Kinlaw’s long-time collaborator, Mark Kritzman, chief executive of Windham Capital Management and a senior lecturer at MIT’s Sloan School of Management, and Jason Mao, vice president of State Street Associates – show that the decomposition of private equity excess return into an asset class alpha and an illiquidity premium affects the optimal composition of a portfolio.

“Private equity is less appealing than liquid private equity because liquid private equity delivers asset class alpha without subjecting the investor to illiquidity. Public equity becomes less attractive than liquid private equity because it does not offer an asset class alpha. Finally, private equity becomes less attractive than all liquid asset classes because it is seen to offer a smaller premium to compensate for its illiquidity.”