For most asset classes, returns over the 12 months ending December 2011 barely beat inflation. South African listed property was the best performing asset class, producing a return of 8,93%, followed by bonds at 8,80%, cash 5,71% and equities 2,57%.
However, to generate ‘real’ returns any asset class must at least beat inflation of 5% over the same period. This means equities produced no real return, cash barely so, while listed property and bonds only marginally outpaced inflation, says Koos du Toit, CEO of P3 Investment Group.
The next challenge is that individual investors rarely make exactly what the market achieves. A research paper out of the US covering 163 US equity managers using 10-year figures demonstrated that whereas the US investment industry returned 12% a year during the decade, the average investor returned only 5%.
The gap, says Trevor Garvin, head of Nedgroup Investments’ multi-management division, is attributable to investors switching out of temporarily poor performing funds and therefore being out of the market (in cash) at critical moments.
The reason for this is that during that 10-year period 44% of US managers were in the bottom 10% for three years or more, 77% were in the bottom quartile and fully 97% experienced at least a three-year period in the bottom half of their performance-tracking table.
Private equity beats the market
One means of tapping into superior performance – and being locked into it – has long been private equity. High net worth individuals (HNWIs) have a close affiliation with private equity, typically because their own businesses started in this manner. Indeed, in many cases the bulk of their assets are still locked up in their own or other small private businesses.
One entrepreneur, Allon Raiz, CEO of Raizcorp, says he does not invest at all. “Why would I hand my money over to someone else to manage when I can invest it in my own business?” He may not consider it as such, but he’s invested in private equity.
Research performed by Momentum’s International Private Equity investment on an aggregate of 11 South African private equity funds found them to have produced a return premium of 12% a year (18% before costs) relative to the FTSE/JSE Africa All Share Index. International research has likewise found that private equity produces returns roughly double those of listed equity markets.
One family office, Stonehage, confirms that out of sheer necessity it spends much of its time advising family clients on private equity as it is such an important aspect of their portfolios. It is because of this affiliation that many HNWIs wish to take it a step further and invest in private equity within their portfolios. However, the question is how, because there are important challenges relating to the investment vehicle, the liquidity constraints and the need for diversification. This is an asset class that has not been historically accessible to the private investor, even wealthy ones.
The challenge of private equity is that like hedge funds, each has a different investment strategy which follows quite individual investment cycles. Much depends on the nature of the underlying investments, and for this reason many private equity firms are beginning to specialise. To remove cyclicality from the portfolio (which might be at odds with the client’s liquidity needs) requires diversification.
A further requirement is to select only top quartile managers, because the gap between top and median managers is more extreme than is the case with equity managers. Private equity has a five to ten year investment cycle, but there are models for the retail market whereby the fund manager makes a market for those wishing to exit earlier, at a cost. Almost all investment houses today offer retail private equity funds of funds (which therefore offer diversification), with the best known being run by Old Mutual, Momentum, Sasfin and Coronation.
Another important aspect is to personally study the underlying investments, as success or failure depends entirely on this factor. To make money in private equity, the fund has to be invested in top quality companies. A final challenge is that many of these investments when offered to the retail market are opaque and often layered with fees.
A good indicator is if the private equity manager itself has put significant amounts of capital into the fund. Beyond this it is essential to research the manager’s experience and track record and whether the company has solid succession planning in place.
Hedge funds fail the test
As to the role of hedge funds in a HNWI portfolio, financial adviser Bryan Hirsch says he no longer recommends these to clients as appetite has dried up.
“Hedge funds were supposed to protect one from the downside, with the idea they make most of their money by going short. In fact, most hedge funds turned out to be invested long and failed dismally to deliver in the 2008 crash. I’d rather have clients in property and equities than hedge funds.”
In fact, most private investors are more involved in hedge funds than they know: private client managers will ‘take protection’ when they believe the market is over-heating, and that implies hedging.