Updated February 2021
ALTERNATIVE ASSET CLASSES
Abstract: Alternative asset classes and investment vehicles are sometimes added to diversify equity and fixed income portfolios. This article examines gold, commodities, and currencies and entitities which frequently hold alternative assets in a variety of categories, hedge funds, private equity, and venture capital. Historical returns suggest that gold and commodities, both uncorrelated with equities and fixed income, provide portfolio diversification and may augment returns. Hedge funds, private equity and venture capital produce returns that do not appear to outperform conventional equity portfolios.
The majority of advisors, the financial media, and most investors focus primarily on two major asset categories, stocks and bonds. Most current financial industry analyses combine these two categories of assets in portfolios and then estimate forward portfolio returns based upon historical returns and standard deviations. Central to those practicing modern portfolio theory and particularly for passive and index strategies is the premise that diversified portfolios do better when assets are included that have moderate or minimal inter-correlations with each other. Another way of putting it would be to say that the ideal portfolio offers better long-term returns when one asset class rises if another languishes or falls. This smoothes and boosts compounding returns. Long-term, asset class diversification augments returns and reduces volatility. This article examines portfolio holdings which are sometimes used to augment returns in equity and fixed income portfolios.
GOLD: For over five thousand years gold has been considered a unit of account, store of value and medium of exchange, the definition of money. It is simply a counter or number which can be attached to all other goods and services and investments. Anything can be priced in gold. Gold is difficult to debase and is very rare, compact, and nearly indestructible. In the last decade skepticism is again growing regarding the trustworthiness of government paper and digital money often termed "fiat" currency. Fiat means by the dictate of governments. Historically, all paper money, without exception, has ended up worthless while gold has endured for millenia. Since World War II the average life span of a currency has been 42 years and the longest a fiat currency has survived so far is about 135 years, that's the US dollar. As I write this in February 2021 the US dollar index, DXY, has declined almost 11% versus a basket of foreign currencies. The developed world was on the gold standard from 1800 through 1932, including the United States, and though prices in gold varied somewhat due to variations in gold supply and the great gold rushes of the 1800's, prices of goods and services in gold differed little between 1800 and 1930. In 1913 the Federal Reserve was created to deal with price variations and booms and busts, an economic problem in part produced by variations in gold supply and demand. Its defined mandate was to maintain stable prices. The Fed has failed greatly in this regard. Since the Federal Reserve was established with that mandate the US dollar has lost about 98% of its purchasing power according to the government's CPI inflation index and 99% if we price it against gold. Gold clearly preserves long term purchasing power.
The primary argument for the ownership of gold is that over long time frames it tracks inflation closely and protects against the erosion of purchasing power fiat money and inflation always produce. In terms of portfolio design it also offers an asset uncorrelated with equity and fixed investments. From 1802 through 1997, gold turned in a virtually identical number to inflation. Its returns, like all asset classes, can veer upwards or downwards for long periods of time. From 1972 through 1982 gold returned an inflation adjusted 11.4% per year, more than 10% per year above all other asset classes. From 1982 through 2000 gold prices varied up and down between about $250 and $400 an ounce and gold price essentially went nowhere. From 2000 through 2015, gold gained 378.5%, far outdistancing all other asset classes even though the official inflation rate for that period was only 2.4% annually and 40.1% for the total period. As of 2021 several strong drivers for higher future gold prices are in place including massive expansion of fiat currency by global central banks and the US Fed and Treasury, very high and rapidly rising government debt funded by borrowing from the future, negative real interest rates, increasingly unstable and speculative currency markets, and a weak global recovery from the 2008 financial crisis. Infrequentlly mentioned in the financial press is that the US GDP has only grown about 20% in inflation adjusted terms from 2009 and 2018, about the same as its growth from the equity market peak in 1929 through 1939. In 2020 Us GDP growth was subpar and about 1% below long-term medians. In addition, rapidly declining discoveries of new gold reserves and increased costs of production continually add to gold prices.
A WSJ article by Jeff Opdyke on August 21, 2010 also argued that gold is a currency and not a commodity. Conventional wisdom sometimes holds that low inflation isn't good for gold. Opdyke asked Ibbotson, a well-respected research organization and source of extensive asset class data, to determine how closely inflation and gold-price movements track each other. The data, going back to 1978 and capturing an inflationary spike show a correlation of, at most, 0.08%. However, "back to 1973-a period that defines the modern non-gold-backed dollar-the greenbacks movements closely track gold's direction." Over the past 30 years, the correlation between the US dollar and gold is minus 0.65; a weakening dollar significantly drives gold price up in US dollars. Opdyke concludes that "gold is a currency" and "a gauge of the market's concern about the potential diminishment of the purchasing power of the dollar...." Another study found a very high correlation of 0.93 between gold and total US government debt for 1982 through 2010. Unless politicians suddenly raise taxes and cut spending, an unlikely development, government debt and gold should continue to rise together. Debt, always called stimulus by governments, is funded in fiat currency and as of 2020 US debt is rising at about ten times the rate of US GDP growth. Trouble?
Ibbotson conducted a study of the benefits of precious metals diversification covering the 1971 through 2004 period (Idzorek, CFA, Ibbotson Associates, 2005). Of particular note is their finding that precious metals tend to do best when traditional asset classes like equities and fixed income have negative returns. Ibbotson recommends the following allocations to gold: 7.1% for conservative portfolios, 12.5% for moderate portfolios, and 15.7% for aggressive portfolios. This is similar to what we at EAM recommend. A World Gold Council study published in Forbes in August 2007 found a -.03 correlation, neglible, for gold with other asset classes including equities, fixed income, commodities, and REIT's for 2000 through 2010 and "no stable positive correlation between gold and oil prices." Dimson et al (Credit Suisse Global Investment Returns Yearbook, 2012) anlyzed gold returns from 1900 through 2011 across 19 countries and found that gold was the only asset class with a positive correlation to inflation, 0.20%, while all asset classes had negative correlations including -.52 for equities and -.74 for bonds.
A common financial industry narrative is that gold price is likely to fall because there is no inflation and the Federal Reserve will soon increase rates from very low levels that have prevailed existed since late 2008. Since 1971 there have been seven periods of significant interest rate hikes. In three of them gold price rose, once by 8x, in three it went sideways, and in two it declined. The two periods in which gold declined occurred when interest rates were very high, not very low and well below inflation as they are in early 2021. After the dotcom bubble burst in 2000 the Fed cut rates to 1% then from 2004 through 2007 it increased short term interest rates to over 5%. Gold rose about 250%. The mainstream financial press continues to promote the idea that higher interest rates kill the demand for gold. During the 1970's and early 2000's this was decidely not the case. The mainstream financial press almost never has anything positive to say about gold. It rarely mentions that the daily price of gold in US dollars is set on the US Comex futures exchange via paper contracts that are minimally backed by physical gold, prices often mysteriously swoon for no apparent reason on no news, massive amounts of gold are sold short by one unidentified major player at times the market is most illiquid and has the fewest buyers, something real sellers of gold would not do, and physical gold is infrequently delivered between parties when futures and options contracts which dominate the market settle.
Gold's relentless rise over the 2001 through 2011 period and the appearance of gold ETF's like GLD in 2005 have given rise to several myths about gold ETF's promulgated mainly by gold bullion dealers who sell physical gold and "gold bugs" and compete with exchange traded public gold funds. An article (Exchange-Traded Funds Report, November, 2010) addresses these claims in detail. Gold dealers often call GLD and other ETF's "paper gold" since investors can't take delivery of the physical gold or they claim that gold ETF's don't own gold and lease it or own it but lease it out. These claims are false unless we assume that HSBC, State Street and other major multi-trillion dollar global investment banks are engaged in Bernie Madoff like scams.
Gold ETF's are different from ETF's in stocks and bonds where fund shares are based upon a basket of underlying securities pledged by authorized parties but not directly owned by the ETF. Paper shares in gold ETF's aren't created unless there is real physical gold to back them 100.0%. ETF's backed by gold, GLD, PHYS, and IAU would be examples. Gold ETF's are completely different from US Comex gold futures where the price of gold in US dollars is set in contracts that are largely not backed by gold. Comex gold futures are minimally backed by gold and are truly "paper gold". Briefly in Spring 2016 and again in 2019 over 500 ounces of gold futures were sold forward in the future for each ounce of gold which backed them. Gold price sank. The price of gold futures in US dollars has been systematically suppressed by strategically timed massive sales of naked gold futures shorts not backed by gold from Fall of 2011 through early 2021. This gold has been sold over brief time frames, sometimes in minutes at times the market is most illiquid with the fewest bidders for gold. This is gold price suppression.
An often repeated myth about gold ETF's is that investors can't be sure the gold is really there. ETFR states, "This is 100% false". The gold is audited twice a year and GLD's gold bar inventory is updated daily. When baskets of gold are created for GLD they are sometimes temporarily held by sub-custodians before being transferred to HSBC's bullion vault. In some respects GLD is actually more trustworthy than that found in coin shops or dealers because GLD creates a paper trail for the gold it holds while the sources and quality of most physical gold from retail dealers is often more difficult to confirm. George Soros, John Paulson and other superstar hedge fund managers have held billion dollar plus positions in GLD for many years. Other myths are that foreign gold storage is safer, gold ETF's move the market and buying gold ETF's is cheaper than physical gold. In several discussions with GLD's management EAM has been assured that GLD does not lease gold it puts in its vaults nor does it lease out its gold to others. Shares are fully backed by gold at the end of each trading day.
Wall Street, academia, and the mainstream financial press are generally critical of gold as an investment or part of portfolio allocations. As gold rose strongly over the last decade, countless articles appeared in the Wall Street Journal and elsewhere warning investors about the risks in gold, a bubble in gold, and the lack of intrinsic value in gold. Gold is a lump of metal and doesn't produce interest, dividends, or profit growth and thus its value is subjective and only what investors accord to it. The problem with this argument is that "fiat" paper currencies or digital money are also intrinsicially worthless. Fiat currencies are only worth what investors accord to them if they are not linked to something of value that cannot be created at will by central banks and governments...like gold. It is obvious that money in the form of pieces of paper or computer entries with "0"s and "1"s underlying them can be created infinitely while gold cannot. Fiat currencies trade up to $6 trillion daily on the foreign currency exchanges and are continuously changing value in relationship to each other 24 hours a day. Gold exists in the real physical world. For over 5000 years gold has been considered desirable, valuable, money and an asset that has been associated with real wealth and power. Gold was even highly valued in China, the MidEast, Europe, and Central and South America for thousands of years before there was any contact between these geographic regions and cultures.
Unlike central bank money creation or government borrowing and debt, both of which can be increased at will and in unlimited quantities, gold can only be created when it is mined and refined. A WSJ article (5-19-14) reported that global gold mines are depleting and extraction costs are rising rapidly. In 1995 22 gold deposits were discovered with at least two million ounces of gold in each while in 2010 there were six such discoveries, in 2011 one, and in 2012 there were no new large discoveries. Global gold production in 2013 was equal to 5.1% of estimated available reserves and according to the US Geological Survey it will take 19.5 years to exhaust supply. Goldman's estimate of available gold before exhaustion of reserves is nearly identical. More reserves might be available but they will be of much lower quality and require far higher capital investment to mine. The article concludes, "There ain't much gold left."
During Spring of 2012, both Warren Buffet and Bill Gates strongly criticized gold more or less calling it ridiculous. This is to be expected from two of the wealthiest people on the planet whose wealth has been generated primarily in paper equity assets priced in a generously created fiat currency. Statistical critics of gold often point to the 20 year bear market in gold from 1980 through 2001 or select time periods where gold has not done as well as other asset classes. While accurate it is statistically misleading to remove or select periods of time from time samples and then make comparisons of different asset classes. Stocks, bonds, and real estate have all had periods of time where they gave breakeven returns or worse for 20 years or longer. US stocks for example gave no return after deflation and inflation are adjusted from 1929 through 1954.
Gold dropped a stunning 22.9% in Q213, its worst decline in 93 years (Bloomberg). One might assume that this dramatic decline occurred because supply grew strongly and demand collapsed. They would be wrong. There was no significant news or change in the physical gold markets that drove the decline. It was entirely the consequence of massive short sales of largely unbacked gold futures contracts on the US Comex gold futures market, carefully timed to suppress gold prices, price manipulation. The eventual result was that the real physical gold market saw record manic buying later in 2013. Futures prices can be used to suppress cash prices in financial instruments, commodities, or gold short-term. A most dramatic example of this occurred in 1987 when short S&P 500 futures contracts, down over 29%, forced down the S&P 500 cash price over 20% in just one day.
As the decline in gold price developed in April 2013, the mainstream financial press carried near daily articles warning investors about owning gold, urging them to sell it and calling an end to a supposed gold bubble. Four key narratives were repeated constantly. There was no need to hold gold anymore since a rise in interest rates will occur and that hurts gold price, inflation was low, the US dollar was strong, and the Federal Reserve Bank would engineer a full recovery. Missing from these narratives was accuracy and reality. Since the gold bull market began in 2002 there has been no reliable statistical relationship between gold price, up about 400% through early 2021, and rising interest rates or rising or declining inflation.
Gold is the only asset which is no ones liability and has no counterparty promising to pay the holder of gold. Stock and bond prices are denominated in fiat currency and their true value is subjective since fiat currencies are used to value them and currencies are easily debased. This is why stocks and bonds are sometimes called paper assets in that they are promises of value written on paper or in computers. An article elsewhere on our website, "Key Returns: 2000-2018", compares compounded returns across major asset classes. Unadjusted for inflation, the Dow returned 218.2% including dividends, the S&P 500 returned 146.8%, the Nasdaq returned 91.9%, and gold rose 458.0%. Inflation as measured by the CPI-U ran a cumulative 45.8%. During this 19 year period gold prices rose and declined in a normal manner, corrected up to 25 to 30% for up to 18 months, then hit new highs again. This is typical price behavior for a healthy bull market, not a bubble market, and it is very clear which asset class has done the best since 2000, gold.
Why is gold infrequently mentioned or criticized in the mainstream financial press? Wall Street makes very little money from gold unlike the revenues it can generate from IPO's, M&A, 1% and higher management fees from equity portfolios, private equity LBO's, "2 and 20" hedge funds, derivatives creation and trading, CDS insurance and other financial products. Thus, it is not surprising that the financial press doesn't promote gold investment and gold ownership in the U.S. Ownership of gold by US individuals and institutions has beem well below historical averages in the recent past. It should also be noted that it is unlikely gold can be profitably timed and traded. Mark Hulbert (CBSMarketWatch, 6-3-13) states that only 15% of gold traders and timers tracked by his firm beat a buy-and-hold gold ownership strategy for five years and no traders beat buy-and-hold for gold for 10 or 15 years. This is similar to the underperformance of active managers in equities and bonds when they are compared to passive and index portfolios.
COMMODITIES: Several commodities indexes exist, the Goldman Sachs Commodities Index, GSCI, and the Dow Jones Commodities Index, DJ-UBS (formerly DJ-AIG), are probably the best known. Indexes vary in the number and weightings of commodities with some heavier in oil and gas and others spread out across energy, precious metals, base metals, and various agricultural products. Mutual funds that aim to track commodities prices typically use some form of futures contracts and deleverage them by placing most investor money in fixed income. Investors can also hire a commodity trading advisor and trade commodities directly or use managed futures pools however this involves high management costs, high leverage, and the risk of margin calls. Commodities tend to rise during inflationary times and are part of what constitutes inflation. Commodities are things that exist in reality like gold but their prices are set short-term in futures markets. In Q42020 commodity prices rose over 10%.
One risk with commodities is that weak or recessionary economic conditions may decrease demand and commodity prices. And, commodities prices can vary greatly regardless of the demand for physical commodities. Speculation in futures contracts, "corners", and hoarding can drive prices to extremes. Commodities index funds available to investors use futures contracts plus cash to simulate cash or "spot" prices and the two can diverge hugely. In 2001 the GSCI declined 31% and failed to diversify portfolios in a year in which almost all major US and global equity indexes also declined substantially. Commodities did very well in the inflationary economy and equity bear markets of 1972 and 1973, gaining 21.71% and 57.73% respectively. In 2002 commodity index prices rose about 30% in the face of a weak recessionary economy. In 2008 commodities rose to record highs due to futures speculation and hoarding then quickly collapsed. For 1973 through 2007, the GSCI returned 10.9% versus 11.0% for the S&P but with a much higher standard deviation, 24.5% versus 17.2%. Their correlation with the S&P over that period was -0.30. Commodity futures prices can be very volatile and disconnected from the prices of physical commodities.
In 2006, Ibbotson (Idzorek, CFA) published an analysis of the role of commodities as a portfolio diversifier for 1970 through 2004. They focused on a fully collateralized total return commodity index run with monthly rebalancing. According to Ibbotson, "Our historical analysis supports the claims that commodities have low correlations to traditional stocks and bonds, produce high returns, hedge against inflation, and provide diversification through superior returns when they are needed most…we found that including commodities in the opportunity set resulted in a superior historical efficient frontier…" They note, "over the common standard deviation range, the average improvement in historical return at each of the risk levels was approximately 133 basis points…and improved the risk return characteristics…we believe commodities offer an inherent or natural return that is not conditional on skill." Ibbotson recommends an overall portfolio allocation between 9% and 29% to commodities with a high 22% for a 60/40 equity/fixed ratio.
Gorton and Rouwenhorst, Wharton and Yale academics, constructed an equal weighted monthly index of commodity future returns for July 1959 through December 2004. They found that fully collateralized commodity futures have historically offered the same return and Sharp ratio (risk/return) as equities. The risk premium for commodity futures was 5.23% annually vs. 5.65% for equities, they had about the same Sharp ratio, 0.43 vs. 0.38, but commodities offered a lower standard deviation, 12.1% versus 14.85% for equities for the period studied. In addition, commodity futures returns were negatively correlated with equity and bond returns, offering further diversification.
CURRENCIES: Individual currencies do not really constitute an asset class but rather the continually varying rates of currency exchange between countries. A currency is a medium of exchange, a convenience in a sense that it bypasses direct bartering. Currencies trade on the FX exchanges and are the world's largest daily market sometimes trading up to $7 trillion a day. FX currency markets often involve extreme leverage, sometimes 100x or more. Investors can also gain exposure to currencies from owning unhedged foreign equities and unhedged foreign fixed income. As noted in the section on gold above all fiat currencies are paper assets and fiat currencies have a reliable history of ending up worthless. FX markets are simply a daily method of determining which currencies are seen as more valuable and which are seen as less valuable for the moment. In 2006 Deutsche Bank, however, published a study indicating that currency diversification across securities in portfolios is an important part of asset allocation.
From 1968 through 1992, a period which includes the abandonment of the gold standard in 1971 and high inflation through 1982, the dollar depreciated at an average annual rate of 1.1% per year against the dollar index, a basket of currencies from the G-10 countries and Switzerland. The yen gained 3.58% annually against the dollar and the Swiss Franc gained 3.67% annually. The dollar lost an additional 25% against the index from 2000 through 2009 though the index by that time held the Euro, a significant change in index composition. From 2012 to late 2016 the dollar enjoyed a spirited rally which took it to multi-year highs. Exchange rates are always changing.
DFA (May 2015) has explored the impact of currency movements on global equity and fixed income returns. From 1974 through 2014 currency returns swung from positive to negative repeatedly and developed market currencies gained against the US dollar by over 10% in 11 out of 41 years with an annualized average return versus the US dollar of 1.01%. Currency returns were positive 22 out of 41 years, indicating that unhedged international equity and fixed portfolios benefitted from avoiding the US dollar. Higher volatility was the price for this additional return. Unhedged international equity returns for 1985 through 2014 had a higher standard deviation, 15.61% versus hedged returns of 14.11% but the unhedged index returned 12.5% annually versus 10.3% for the hedged index. For the same period, the Citigroup World Government Bond Index Ex-USA, a 1 to 5 year index, produced a standard deviation of 9.11% when unhedged versus 1.77% when hedged but in return offered a higher return of 6.99% versus 5.63% for hedged bonds. DFA also plotted developed market currency returns versus the US dollar in a given year against returns over the previous year and found no correlation or discernable relationship. This suggests currency movements are hard to predict or profit from.
As of 2020 there is much discussion in financial circles that China, Russia, India, Australia, and many other countries are actively establishing alternatives to US dollar based banking and international trade. The US dollar's future has become less certain since the US is running large and growing trade deficits along with rapidly growing budget deficits funded by fiat currency issuance. It is also expanding its aggregate monetary base at many multiples of GDP, a form of currency debasement that presents a false image of economic growth. China moved to bypassing the US dollar in its trading with Japan in Spring 2012 and new countries are joining China to trade outside the US dollar regularly. As of early 2021 the world is rapidly pivoting away from the use of the US dollar in international trade and banking. Currency indexes are available from Rydex, Wisdom Tree and others for specific countries or baskets of currencies in countries and EAM recommends them if clients want direct foreign currency exposure. About 60 to 65% of global equities and fixed income are not priced in US dollars.
HEDGE FUNDS: As DFA puts it "hedge funds aren't an asset class but a compensation structure". There are countless asset classes and types of trading and investment strategies pursued by hedge funds including equity long/short strategies, global macro, merger arbitration, distressed debt, relative value, fixed income arbitrage, and funds of hedge funds. As of 2021 many hedge funds are involved in high frequency algorithmic trading and speculating in equities, options and futures with very high leverage. These funds manage an estimated $2 trillion and most holdings are not visible to the investment public. What distinguishes them from other investments is that they are minimally regulated, secretive about their holdings, and charge very high fees, typically a 2% annual management fee and 20% of their profits.
The marketing line for hedge funds is that they offer superior performance, protect investors in bear markets, are the preference of sophisticated investors, and are minimally correlated with other types of investments. Research on hedge fund performance doesn't offer much support for these assertions. Ibbotson and Chen looked at hedge fund performance from January 1995 through March 2006 and found that the average hedge fund had returned 8.98% per year, lagging the S&P 500 by 2.6% per year. CBS Marketwatch (August 2017) reported that, based on Federal Reserve data, the average investor household obtained an annual average return of 4.5% from 2003 through early 2017 versus a return of just 1.6% annually in a diversified hedge fund index. Numerous studies support these findings as well as anecdotal examples of spectacular hedge fund failures like Long Term Capital Management in 1998 (see Roger Lowenstein,"When Genius Failed", 2000). It produced 30%+ returns for three years then due to excessive leverage and the error in its mathematical models constructed by three Nobel laureates and twelve Ph.D.'s required a Federal Reserve orchestrated bailout by major banks in order to avert a collapse in the global credit markets.
A Reuter's article (1-3-11) reported that hedge funds returned 4.52% in 2010, soundly trailing the Dow which rose 11% in 2010. They note that the number one reason hedge funds became popular as an alternative investment was that they do not depend on the broader market. Yet, in 2010 nearly every hedge fund strategy tended to move in synchrony with the markets according to Lipper. A Goldman Sachs study covering January 2012 through October 2012 found that only 13% of hedge funds outperformed the S&P 500 while the average hedge fund returned 8% less than the S&P for that period. An article in the Economist (12-22-2012) reported that the S&P500 had outperformed an index of hedge fund industry returns, HFRX, for ten straight years, a return over 90% versus 17% after fees for hedge funds. An article in the Journal of Financial Economics (January 2011) reviewed claims for market outperformance by hedge funds from 1980 through 2008 and found that in dollar-weighted returns what real investors in the funds actually received was 3% to 7% annually less than the reported long term returns in equity funds and only marginally higher than the risk-free rate of return. There is little reason to expect that this has changed in 2021.
A Marketwatch article on 10-26-11 reported two studies of hedge fund performance. One examined "funds of hedge funds", a frequently marketed strategy for diversifying hedge funds. In a broad sample of 1300 funds from 1994 through 2009 the study found that after fees only 5.7% of the funds outperformed the risk-adjusted returns of the average single hedge fund. They also compared professionally designed funds of funds with groups of randomly selected hedge funds. The differences were minimal. They conclude that there is little evidence suggesting that hedge fund picking skills exceed chance guessing. Another study looked at 30 years of hedge fund performance and found that overall they did worse than a stock-market index fund and not much better than a simple basket of Treasury bonds.
There is a serious statisitical problem with hedge funds. That problem is survivorship bias. Aggregate performance data is biased upwards if funds that fail do not have their performance data included in pooled data for funds currently operating. An S&P study of hedge fund survival found that only 25% of funds that were reporting data in 1996 were still doing so in 2003. Presumably, the 75% of the funds that disappeared went out of business during that eight year period though some merged with other funds. Several studies have come up with similar estimates of survivorship bias in hedge fund data, some in periods as short as four years. There is also a problem with backfill bias. Because hedge fund reporting is voluntary many managers start a fund with seed money and begin reporting their track record at a later date only if the retrospective numbers look good and will attract capital. One study found that returns for backfilled funds are more than 5% higher annually than non-backfilled funds.
In addition to likely underperformance, hedge fund investors rarely have liquidity on a daily basis. Funds typical allow exit once a quarter or once a year. Investors usually cannot know or understand the risks managers are taking nor how a hedge fund fits into their other investments since portfolio holdings are often not public. Hedge fund managers are to some degree incentivized to take risks since they receive 20% of profits. Many funds don't receive that 20% profit bonus until they reach the prior high water mark for the fund, and if well below that mark find it more profitable to close up shop and start a new fund where they can share in the 20% gains immediately if things go well rather than make up past underperformance.
A successful hedge fund is a great business. Some of the biggest fortunes in history have been made by hedge fund managers. Just to make it into the elite group of the top 25 highest paid hedge fund managers in 2009 required a minimum annual income of $350 million. And, their incomes are typically taxed as "carried interest" at 15%, the average tax rate for couples making about $60,000 per year. Calculating hedge fund returns is more art than science and a good story can always be told. Hedge fund managers can choose whether or not to report their returns or stop reporting returns during a string of bad results. Poor returns won't attract clients. There's also evidence to suggest that when a hedge fund is performing poorly and fails the last few terrible months are unlikely to be reported. In a sense hedge funds can claim returns they fabricate and sell their expensive services more attractively.
Hedge funds routinely report returns based on the value of $1 invested at inception (time weighted returns) rather than by internal returns or IRR (asset weighted returns), what investors actually receive for the time they spend invested in the fund. EAM reports time weighted portfolio returns to our clients. From 1998 through 2010 the HFRX hedge fund index had an annual return of 7.3% on a time weighted basis and was ahead of the S&P 500 at 5.9% with dividends reinvested. But on an asset weighted basis the HFRX showed a return of 2.1% and that's what real investors receive. The hedge fund industry lost more money during the 2008 crisis than all the profits it had generated in the prior 10 years. This also makes it abundantly clear that hedge funds didn't hedge anything during the 2008 financial crisis.
The Financial Times, typically a promoter of the financial industry, published a piece in early August 2012 by Andrew Baker reporting the conclusions of the Alternative Investment Management Association, a group promoting hedge funds and other alternative investments. Their rebuttal to all the evidence against hedge funds was entitled, "Methodological, mathematical, and factual errors in 'The Hedge Fund Mirage'". It is worth noting that according to Simon Lack, a critic of the industry and author of the book, "The Hedge Fund Mirage", found that from 1998 through 2010 hedge funds gathered over $1.6 trillion in assets while producing $9 billion in profits for investors and $440 billion in fees for themselves. In an stunning example of regulatory capture the SEC decided in August 2012 to allow hedge funds to sell directly to the public, something they were not allowed to do for more than 70 years (Jaffe, Sept. 2, 2012, CBS MarketWatch). That didn't stop CalPers, the nation's largest public pension plan with about $300 billion, from exiting its hedge fund postions in September 2014. It did so stating that management fees were too expensive and the funds too complex to make such holdings worthwhile.
PRIVATE EQUITY: The term "private equity" generally applies to venture capital and leveraged buyouts (LBO's). Private equity LBO firms raise capital from institutions and wealthy individuals and use the money to purchase a public company, then take it private and restructure it by adding debt and leverage, often funded by junk bonds, reduce head count, skimp on capital expenditures for growth, outsource production and then sell the company back to the public again in an IPO. Turnaround times average about ten years. In the 1980's companies like Kohlberg, Kravis Roberts & Company and Forstmann Little and Co. pioneered private equity LBO's, then called leveraged buyouts because of the borrowed money and leverage involved. After junk bonds collapsed in the late 1980's equity LBO's have generally been referred to as private equity. Private equity has been particularly popular with institutions and educational endowments. In 2006 Newsweek reported that private equity deals were attracting $200 billion per year in the US and Europe, meaning that about $1 trillion a year was going into LBO's due to the high leverage involved. Their sales pitch is that private equity performs a service by reforming weak companies. Hostile takeovers in the 1980's and the collapse of the junk bond market gave them a bad name until David Swenson of the Yale endowment demonstrated how well Yale had done in such deals (David Swensen, "Pioneering Portfolio Management, 2009").
Private equity firms are designed to create minimal risk for the general partner and the private equity firm and transfer the risk on to investors. Their objective is to enhance shareholder value which in practice means extracting as much equity as possible for the private equity firm and its investors as possible regardless of the consequences for the company involved. The general partners typically fund 1% to 2% of the total buyout with their own money with the rest coming from pension funds, endowments, and wealthy individuals, the limited partners. The general partners typically take 20% of any profits after exceeding an 8 per cent return "hurdle". Any losses are born by investors so the general partners do not lose much personally if the deal fails. It is nearly impossible to get any data on private equity failure rates but David Stockman, a private equity investor with over 25 years experience, notes that four of hedge fund Bain capital's ten "home runs" eventually went bankrupt. Bain is one of the nation's largest private equity firms.
How well have private equity managers actually performed for investors? One study examined LBO deals between 1987 and 1998 and found that net returns averaged 36% per year, far above the 17% per year an investment in the S&P 500 would have produced. However, had leverage been applied at the level a typical LBO employs the S&P would have returned 86% per year. In other words, the risk adjusted return of LBO's is terrible. A study by Cambridge Associates compared the twenty year performance of LBO's ending in June 2003 with the S&P 500 for the same period. LBO's averaged 11.5% while the S&P averaged 12.2%. And, LBO's took far more risk. Applebaum and Batt (Private Equity at Work, 2014) present a detailed analysis of private equity and how private equity funds perform. They note that only the top 10% to 25% of funds outperformed the S&P 500, most of them are not available to the public, and that the methodology of computing private equity returns is debatable when using the internal rate rate of return to compute yield spreads between private equity and stock indexes. Mark Hulbert (Marketwatch 7-5-13) reported on an academic study examining the performance of private equity from over 300 firms taken private by private equity between 1995 and 2007. The researchers concluded that such companies didn't perform any better on average than they were doing before being taken private and didn't outperform companies that remained public.
Private equity firms collect enormous fees and have made some general partners extremely rich. The firms not only charge an annual management fee of 2% and pay themselves 20% of any gains but take little or none of the losses. They also collect deal fees for structuring the deals, often take incentive or consulting fees for partners or company management, and sometimes collect special "dividends" from junk bond issuances. They also charge management fees to the company they have LBO'd and when then finally sell the company back to the public they make a further profit from the IPO. In 2010 private equity nearly shut down due to difficulty in raising capital through debt. Low interest rates and easy liquidity drove private equity returns from 2009 through 2016. From 2011 through 2013 private equity was booming and raised $1.17 trillion. Josh Koshman ("The Buyout of America", Penguin Portfolio, 2009) examines private equity in detail and considers it economically destructive and dangerous to companies and credit market stability. Burrough's and Helyer, "Barbarians at the Gate" and Bruck, "The Predator's Ball" examine the 1980's LBO and junk bond booms, arguing that most were destructive and subtracted value. Applebaum and Batt (Private Equity at Work, 2014) reach the same conclusions in their thorough and detailed analysis of the private equity industry.
VENTURE CAPITAL: Though usually lumped together under the vague term "private equity" venture capitalists typically charge similar fees to private equity managers but invest in start-up companies that can be taken public within five years or so. Contrary to popular investor perception venture capitalists usually do not invest or risk their own money but gather it from high net worth investors or institutions. Venture capital firms usually fund companies which have customers and sales but require capital to grow to the point where they can be taken public. Speculation is rife in private equity and in 2018 about 80% of private equity IPO's were in companies with no profits and in 2020 this percentage remained high. Companies which have no customers or sales are usually funded by owners or "angel" investors. Early stage venture companies fall roughly into the microcap equity asset class.
As is the case with private equity, venture capital's past performance numbers are not impressive. One study examined venture capital returns from 1960 through 1999 and found that over 40 years venture capital funds returned 13.4% annually, one percentage point better than the S&P 500 but one percentage point less than small cap growth stocks, a similar equity asset class. A 2005 study examined over 16000 financing rounds for over 7700 companies covering 1987 through 2000 and concluded that risk and returns for venture capital were similar to those for the smallest NASDAQ growth and value stocks but that illiquidity risk, extreme volatility in returns, and high price volatility made them much more risky than their publically traded counterparts. Worse still, survivorship bias is a serious problem in the data with various studies finding somewhere between 25% and 40% of venture capital firms survive for ten years and others finding that about one-quarter of funds had negative returns.
Returns distributions for venture capital are similar to those from lottery tickets. A few win and many lose. Kleiner Perkins et al., the Palo Alto venture firm, has made its owners billionaires. Bloomberg (5-7-13) notes that it delivered "staggering" returns during the dot.com boom but that its venture funds did poorly up until 2013. According to data compiled by Cambridge Associates for the National Venture Capital Association venture funds returned 35.7% annually for the decade ending in 2000 but lost 1.9% annually for the next decade ending in 2010. This clearly illustrates the volatility and unpredictability of venture capital returns. The Kauffman Foundation has invested in venture capital for over 20 years in over 100 such funds and issued a report in 2012. Over the previous 20 year period Kauffman had been paid out, on average, 1.31 times the amount it invested in any given fund. The average venture capital fund returned less money to Kauffman than they had invested in the first place along with a few big winners. The really high rates of return came exclusively from funds with less than $500 million committed, something which was rare amongst top tier venture capital funds in 2012. Venture funds typically target a five year turnaround time but often investors are locked in for longer periods. Kauffman held 23 funds more than 10 years old and eight funds more than 15 years old. Liquidity can be a problem.
CONCLUSIONS: Investors are continually presented with new investment ideas, terms, theories, data, and products. The financial services industry wants to sell something and "new" sells better whether it's soap or a financial instrument. Yet, there are really only four basic asset class categories and they've been around a long time; equities, fixed income, real estate, and commodities, including the special case commodity of gold. All can produce good returns or very poor returns. EAM has concluded that investors are best off avoiding currency trading, hedge funds, and venture capital funds.