We've talked about private equity companies being sources of alpha quite a few times. I'm not saying they are proxies for private equity investing, they are companies that operate private equity funds and they clearly benefit from the space without being proxies. Some of them anyway.
There are a couple of ETFs that track the space. One of the oldest ones is the Invesco Listed Private Equity Fund (PSP). Here's an article I wrote about it at theStreet.com when it first listed in late 2006. I was not a fan out of the gate on this one. I questioned whether blending the various companies together would wash out the effect of owning just one or two individual names. I thought it would be a source of volatility but maybe add some yield.
Most of that was correct but I'm shocked at how poorly it's done. ETFs are not the answer for every exposure as is the case here. That's not really the point of this post though, I just stumbled into the poor performance of PSP as I started to prepare to write this post.
We've talked around this point at the margin but some of the public equity stocks look like high octane proxies for the broad stock market. Taking a page from Taleb's idea of barbelling the portfolio to get most of the return out of a smaller slice of the assets and how that corresponds to capital efficiency and return stacking, I wanted to build out theoretical portfolios that use smaller allocations to private equity manager stocks to provide the same return contribution from a normal allocation to the S&P 500.
There's some statistical context. The returns from year to year are very lumpy but the long term results across all three stocks in terms of growth and volatility has been pretty uniform. The correlation of all three to the S&P 500 is in the range of 0.70. Equaling the S&P 500 looks like this.
So return weighted, not volatility weighted but it's close on the volatility. Below, modeling out a 60/40 comparison, 28.2% into BX would equal 60% into the S&P 500 and 29.4% and 27% into KKR and APO respectively equal 60% into the S&P 500. Using ReturnStacked ETFs' investment process that leaves roughly 30% of the portfolio to stack alternatives on top.
We'll use 40% the iShares Aggregate Bond ETF (AGG) to hopefully better assess the benefit or lack thereof for using the private equity stocks this way and the alternative stacking. First though is the private equity stocks, AGG and the rest in T-bills (no alts).
The return weighted private equity versions are all in the ballpark versus plain vanilla 60/40. Next, we'll build in some alt exposure to see if any aspect the results improve. We'll put 10% each into managed futures, merger arbitrage and global macro-ish.
The other two have the amounts of BX and KKR I mentioned above. MERIX is a client and personal holding.
All three benefitted from this with their respective CAGRs. There was not much help with standard deviation but the Sharpe Ratios are lower and the correlation of all three is close to 0.70. They all did better in 2022.
There are plenty of flaws to this including the weighting to just one stock and how lumpy the returns have been. There is a prompt to wondering whether the effect could be recreated with any sort of broad based ETF. Based on the following sample, I don't think so but if you play around with this and come up with any, please comment on this post.
There's something to all of this, it supports the idea of barbelling even if we haven't found a practical way to implement yet. In the real world, 30% into one stock seems insane to me. But someone could build a basket of names with similar volatility profiles as the private equity stocks to get a similar effect.
The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.
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