ETF investors can tap into the private-equity space by looking to an ETF strategy that attempts to replicate the long-term return characteristics of diversified private equity allocations.
On the recent webcast (available On Demand for CE Credit), Accessing Private Equity-Like Returns on a Budget, Erik Stafford, John A. Paulson Professor of Business Administration at Harvard Business School, explained that investors have typically honed in on private equity because the investment strategy’s returns have been high relative to public market benchmarks with low drawdowns.
Specifically, private equity funds try to improve operations; advise, monitor and incentivize management; allow management to focus on long-term value; and secure preferred access to financing. These private equity strategies also exhibit several passive components, including the ability to buy firms with specific characteristics, hold positions for long periods, double the leverage and conservatively mark a portfolio.
As part of the selection process, Professor Stafford explained that financial buyers typically select components based on reliable predictors, such as small firm size, low EBITDA multiples, negative net share issuance and low profit margins conditional on positive profits.
Professor Stafford’s proprietary PE Replicating Index reveals that publicly traded equities with characteristics similar to those selected for leveraged buyouts have historically exhibited high risk-adjusted returns after controlling for common factors associated with value stocks.
Alternatively, hold-to-maturity accounting of net asset value, combined with multi-year holding periods, eliminates the majority of measured risk.
Stafford found that portfolios of similarly selected public equities with similar leverage, long holding periods and hold-to-maturity accounting produce unconditional returns that are highly consistent with those of the pre-fee aggregate PE index, which suggests that the contribution of the active components of PE investment process beyond the investment selection process is not a net positive.
Consequently, Stafford argued that an investor could isolate the attractive component of private equity funds, or the investment selection methodology, and manage this efficiently at low cost with improved liquidity to produce a similar effect to traditional private equity funds. For example, the selection methodology may be translated into a rules-based indexing methodology for an index-based ETF. Investors would skip the leverage, smoothing and high fees associated with traditional private equity funds.
As a way to help investors gain exposure to a private equity-esque strategy in a cheap and easy-to-use ETF wrapper, investors can look to something like the USCF SummerHaven SHPEI Index Fund (NYSEArca: BUY) and the USCF SummerHaven SHPEN Index Fund (NYSEArca: BUYN).
John Love, President and Chief Executive Officer of USCF, argued that BUY and BUYN could provide the opportunity to access returns comparable to an asset class that has traditionally only been available through private markets. Specifically, Love lists a number of benefits, including diversification, liquidity, transparency, no lockups, no vintage risks, no investment minimums, no takeover premiums, substantially lower fees and exposure to equities that PE firms are likely to acquire.
The ETFs’ underlying indices are similar to private equity funds in that they screen for investment criterias, include similar average sector allocations and show similar returns. However, the ETFs are unleveraged, transparent and are able to measure actual performance rather than estimate it.
Financial advisors who are interested in learning more about private equity allocations can watch the webcast here on demand.