Passive Alternative Investments, An Oxymoron?
A growing share of investment products are managed passively, each tracking a benchmark that represents a selected investment universe. Index funds and their ETF counterparts now account for nearly 40 percent of stock investments in the U.S. Even in the world of alternative investments, passive approaches seem to be gaining some ground.
Alternative investments are traditionally managed in a highly active fashion in order to extract alpha and dynamically adjust beta exposures to various financial and non-financial markets. For certain alternative investments, such as private equity, the idea of a passive approach seems to be an oxymoron. In the paragraphs below, we will discuss whether a passive or an indexed approach to investing in alternatives makes sense and, if so, under what circumstances.
CAPM and Passive Products
William F. Sharpe is known for developing the theoretical foundation for index funds. He is also credited with creating the Capital Asset Pricing Model (CAPM), which states that only “systematic” (or “market”) risk is rewarded in equity markets, and that idiosyncratic risks should be diversified away. Sharpe’s model points out that investing in the stock market as a whole is most efficient from a risk/return perspective, and that active inclusion or exclusion of stocks does not add value. A passive style of investing takes this proposition to heart and limits its risk exposure to systematic risk. But this is only as good as the underlying passive methodology.
To operate index funds as originally envisioned by Sharpe and others, stocks and their weights were originally selected so that a portfolio could replicate the performance of a capitalisation-weighted index. Thus, index products based on different weighting schemes such as equal weight have evolved and are now broadly accepted. Moreover, this passive investment principle has been applied to other asset classes including credit.
In yet another development, more nuanced index products, such as ETFs that track unique benchmarks, have been introduced into the markets. If a benchmark exists, one should be able to construct a fund to track said benchmark. Here, while portfolio management is conducted in a passive fashion, defining a benchmark, its constituents and determining the appropriate weights and/or factors, done with a specific objective in mind is anything but passive. Smart beta products are recent examples of this type of “passive” investing.
Private Equity versus Public Equity
Private equity (PE) investments, by definition, deal with private securities which are not traded on a stock exchange. Due to the private nature of these portfolio companies, information tends to be scarce, and there is no organized or liquid market for these securities.
A general partner of a PE fund is extremely “active” in identifying target companies, negotiating ownership of companies, structuring each deal including financing, making strategic decisions for portfolio companies, as well as being intimately involved in the management of these companies. The degree of general partners’ engagement goes far beyond that of “active investment management or security selection.”
However, private companies are exposed to the same economic factors that drive the value (and valuation) of publicly traded companies. These include, general economic conditions, technological developments, shifts in consumer preferences, technological disruption and other factors that affect any business, whether publicly listed or not. To a certain degree, two companies in the same business sector, one being public and the other private, are influenced by the same factors. In other words, there is an intuitive reason to believe that an index for private securities should act similarly to its public market peers. This presents the possibility of utilizing public equities to replicate the performance of private equities.
Passively Managed PE Funds
Table 1 compares the annualized returns for Cambridge Associates US Private Equity Index, S&P 500, Dow Jones US Small Cap, and Russel 2000, as of September 30, 2017. The returns are shown across various periods.
Cambridge Associates’ US Private Equity Index represents the returns realized by limited partners (investors) net of fees, expenses and carried interest. The highest return among different indices for each investment period is shown in blue. From the table, it is clear that in the long run investors have been better off investing with private equity managers as the Cambridge index outperformed other public indices over longer time periods.
Table 1: Various US Equity Index Returns, as of September 30, 2017.
Source: Cambridge Associates, “US Private Equity Index and Various Benchmark Statistics,” September 30, 2017.
Another observation is that for all indices in the table the recent one-year period has delivered high returns while the 10-year period has delivered the lowest annualised return for each index over these time periods. This table reflects that the performance pattern of private equity and public equities are correlated but private equities have delivered higher absolute returns in the long run.
Not All Passive PE Funds are Made Equal
While investing in PE funds has rewarded patient providers of capital, this type of investing generally requires limited partners to:
1: meet large investment minimums;
2: make a long-term (10 year) commitment;
3: understand capital calls and the “J” Curve;
4: wait many years before seeing realisations; and
5: accept stringent privacy, withdrawal and termination restrictions.
From an investor’s perspective, the investment outcome is more important than the theoretical foundation of a product. If there was a way to create an investment product that tracked the performance of a private equity index, without the requirements listed above, it would clearly be compelling for many investors. In fact, a number of funds have emerged with the goal of simulating the returns of private equity investments.
Unlike public equity index funds, a more liquid private equity product may not be able to capture, with high correlation, private equity index beta. Hence, they are not truly “passive” in the way defined by the CAPM. In this sense, passive private equity products are an oxymoron. Private equities simply do not have sufficient liquidity to make these markets as efficient as the public markets are. There is also less transparency to take advantage of the equity markets’ price discovery process. On the other hand, if “passive” refers to managing investments so that a portfolio will track a certain benchmark without active judgements, passive private equity products would not be an oxymoron. In fact, this could provide a convenient means for many investors to replicate the private equity market.
More innovative products, with better characteristics, are being made available in the public markets these days. As with any alternative investment product, investors need to choose carefully. The devil is always in the details.
George Lucaci is Partner and Senior Advisor at Mercury Capital Partners
 The New York Times, “One Cause of Market Turbulence: Computer-Driven Index Funds,” February 9, 2018.
 Sharpe helped Wells Fargo & Co. to develop one of the first index funds in 1973. See Bloomberg View, “William Sharpe on Pricing and Risk,” June 5, 2017.
 See William F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk,” The Journal of Finance, September 1962, pages 425-442.
 The 10 year returns for all these indices were strongly influenced by severe market losses around the time of the last global financial crisis.
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