Are alternative investments all they’re cracked up to be? A recent paper by renowned U.S. institutional investment analyst Richard M. Ennis, titled “The Demise of Alts,” raises the question—and answers with a firm “no.” In the paper, Ennis, whom Canadian Family Offices featured in a July 10 article, argues that the heyday for alternatives has long passed, that they are too expensive, and that their return profile has been exaggerated. While his argument focuses on institutional investors, Ennis told Canadian Family Offices: “I don’t believe individual investors are advantaged in any way when it comes to alternative investments.”
Clearly, not everyone agrees with Ennis about alternatives and their failings. To get some context, we asked one of the panelists who appeared in our July online discussion on alts—Dale Powell, Head of Investments, Citibank Canada Investment Funds Limited, and a veteran portfolio manager—for his thoughts on the alleged “Demise of alts.”
Here is Powell’s counterargument:
I read with interest the recent paper by Richard Ennis, titled “The Demise of Alts,” because the world of alternative investment is large and diverse and merits frequent examination and, sometimes, vigorous debate. In that spirit, I have a few thoughts about, or rather counterarguments to, Mr. Ennis’s thesis, and I’d like to share them here.
While much of what the paper says could apply as well to family offices, the Ennis analysis revolves around pensions and endowments. It focuses largely on the returns they have realized through alternatives as compared to publicly traded securities. I would question the apparent underlying assumption here that a pension or endowment is a total return vehicle whose purpose is to maximize returns. Simply put, it is not. Rather, a pension or endowment is a vehicle intended to achieve a payout/cash flow sufficient to pay both current and future liabilities. Comparing returns for private equity or real estate funds that are by definition illiquid with publicly traded (liquid) markets is at best misleading. Public markets are valued in real time; alternatives are not.
The paper also pays significant attention to the costs associated with hedge funds (which it essentially characterizes as excessive). While I wouldn’t particularly quibble with the expense ratio given for hedge funds, I do have some reservations about relying on an index of hedge funds as a baseline. That approach has several problems—which, to be fair, Mr. Ennis does note—and not least of those is that there are many different kinds of hedge funds. For example, a credit hedge fund should not be expected to perform the same as a concentrated, activist long-only fund, yet they are both considered “hedge funds.”
To evaluate a private equity fund correctly, one should look at both the IRR and the multiple of invested capital …. IRR by itself is not illustrative of performance.
On the subject of costs, the author claims an “expense ratio” of something like six per cent in some cases, and I think he does that by comparing net and gross internal rate of return (IRR). That approach, however, is only applicable at the conclusion of a fund life, and our experience is that net and gross IRR tend to converge and be quite close after an expected 10-year tenure. Many private equity funds, including all the ones we offer to our clients, are not entitled to a carried interest until investors have earned a preferred return, or hurdle rate, and recouped all the management fees paid as well. Hedge funds we offer all have a “high-water mark,” meaning the manager cannot take carry until the fund has fully recovered any drawdown, and most of the ones we offer also require a preferred return.
I would also note that IRR as a calculation is exceptionally sensitive to small changes in short periods of time. To evaluate a private equity fund correctly, one should look at both the IRR and the multiple of invested capital, or MOIC, which measures the total value of an investment against the initial investment amount. IRR by itself is not illustrative of performance.
Mr. Ennis also uses buyout funds as a proxy for all private equity, but this approach is questionable given the diversity of private equity funds. I would suggest that a $300 million biotech fund is not the same as a $15 billion buyout fund, the latter of which may suffer from the well-known “size effect,” meaning the bigger the fund, the more difficult it is to generate outsized returns.
I agree with the author that actuarial return requirements may be a fantasy, and that is for several reasons. I think public markets have become much more concentrated and thus less diversified by only rewarding growth stocks, which has, to my mind, resulted in indices such as the S&P 500 no longer being a reasonable proxy for the market. Persistent very low interest rates have pushed institutions into higher-yielding or potential investments such as private equity and, in some cases, hedge funds. That is a result of monetary policy decisions, not necessarily a conscious choice made by consultants.
Finally, the paper makes the now-familiar argument that passive management of public market securities offers a better return profile than active management. Yet that argument underplays the increasing importance of risk mitigation. In my opinion, passive investing is inadequate from a risk perspective. Anyone involved with public markets will tell you that equity markets have become increasingly dominated by the Magnificent Seven, and a global index has largely become an excuse for U.S.-only investing. (Seventy per cent of the MSCI World Index is now in U.S. equities.) As a new order for global trade and business seems to be emerging, the world will see how well that works out in the long run. My guess is that passive investors might not like it very much.
Dale Powell, MBA, CFA®, FCSI, is Head of Investments – Canada at Citibank Canada Investment Funds Limited.
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