Whether or not “alpha” actually exists was one of the subjects broached by a panel of influential institutional investors Monday at the Milken Institute Global Conference in Los Angeles.
“I told Harold Bradley today, [the CIO] from the Kauffman Foundation, that the biggest mistake I probably made in my career was not taking what I did, levering it up and putting it in limited partnerships and calling it alpha,” quipped Scott Minerd, chief executive and chief investment officer for Guggenheim Partners Asset Management. “You get paid a lot more money for it that way.”
A fund considered to be “alpha”, one of five statistical measurements used in modern portfolio theory, means its returns exceeded its risk and the investment outperformed benchmarks, while beta refers to performance relative to the broader market.
I don't know how we make our return objectives without investing in illiquid assets.
Most of what the world has assumed to be alpha over the past 10 to 20 years, has “has really been nothing more than levered up beta”, Minerd said, noting that it can be very difficult for small investment staffs to discern the difference, particularly if they are new entrants to an asset class.
“For instance, in real estate, what is the appropriate amount of leverage? If you don't have a real estate group internally and you're allocating to real estate managers, leverage is part of the game in real estate,” Minerd continued. “So when do you know that someone is generating alpha through their real estate portfolio through management of property or good selection and they're just not getting it from over-levering the portfolio?”
He added that he has no doubt alpha actually does exist, but not in the abundance fund managers would have one assume.
Joseph Dear, chief investment officer at the California Public Employees' Retirement System, noted later during the panel that private equity GPs are “like the worst of the parents of Lake Wobegon: every child is above average”.
It's simply not possible for them all to be top-quartile as claimed, he said. “But for those firms that demonstrate that ability to generate those returns, there's a place in the capital markets for them and for those investors who can find those managers and develop and keep relationships with them there's a place in the portfolio for that.”
Private equity remains a “really important tool and asset in our portfolio”, Dear added. Last year, CalPERS bumped up its private equity allocation to 14 percent from 10 percent, largely due to the denominator effect. It's unclear whether CalPERS will keep that allocation as the pension is undergoing a massive strategic asset allocation review this year that may see it cast aside traditional portfolio silos divided by securities and geographies. But, Dear stressed, “I don't know how we make our return objectives without investing in illiquid assets, so it's certainly not going to disappear.”
Minerd agreed that “it would be foolish to be out of private equity as an asset class”, calling it an essential piece of the portfolio for long-term investors.
But that may not be the case for LPs who only began investing in the asset class in recent years, said Janet Cowell, the treasurer of North Carolina. “We were later to the game, we have vintage year exposure that's not great. I did not go to the legislature to ask for more private equity during my first year in office because, frankly, I didn't think we'd get it; we're not going to have stellar [returns], we're not [invested with] the Lake Wobegon folks and the fees are [high]. So … I don't think it's going to be as much the answer for us.”
Exposure to 2005, 2006, and 2007 vintage years remain a concern for LPs given portfolio company debt that will need refinancing in the next few years.
“About half the money ever invested in private equity was invested in in '05, '06 and '07,” said Dear. “If those capital structures fail, then the consequences for investors in private equity are going to be catastrophic and presumably will have a lasting long term impact on private equity going forward.”
If the companies are able to refinance, in many cases, the returns may not be “spectacular” but should be adequate to beat LPs' targets, he said, noting CalPERS expects its private equity programme to outperform public markets by 3 percent.
The need for GPs to reduce fees and the allure of investing directly were also among the topics discussed by the panellists, which also included Erol Uzumeri, the outgoing head of Teachers' Private Capital, and Robin Claessens, the chief executive of UK pension Invensys Pension Scheme.
Watch a video of the panel here.