Morningstar Advisor - Winter 2008 - (Page 26) Gray Matters Another Block in Building a Portfolio By Tom Idzorek It’s now possible to prove that private equity has a place in a diversified collection of assets. New research from Ibbotson Associates is shining light on the role private equity should play in portfolios. The extraordinary performance of leading asset allocators, like the Yale Endowment, coupled with a lower perceived risk premium for traditional equities, has created considerable interest in alternative asset classes. Over the past few years, Ibbotson has completed a series of studies that demonstrate that adding asset classes to a typical allocation can improve investors’ risk and return trade-off. The free lunch of diversification remains the easiest and most cost-effective method of improving a portfolio’s risk/return trade-off. To that end, Ibbotson encourages all investors to look at the all-inclusive Sharpe-ratio-maximizing market portfolio of modern portfolio theory’s capital asset pricing model (CAPM) and consider expanding their opportunity sets to include what some investors might view as alternative asset classes. All else being equal, investors who expand their opportunity set and allocate to each of the available asset classes will likely improve their risk/return trade-off. One key alternative asset class is private equity1. A new Ibbotson study examined the roles of U.S. and non-U.S. private equity in a strategic asset allocation and found that— similar to other asset classes that Ibbotson has studied—private equity improved the risk/ return characteristics of a model asset allocation. Until our study, the role of private equity in a well-diversified portfolio had not been clearly understood. While defining the private equity asset class was straightforward, there wasn’t a widely-agreed-upon time series of data representing the beta of the asset class. The illiquid nature of the private asset class created performance measurement issues and significantly reduced individual investors’ access to the asset class. The lack of widely accepted benchmarks prevented investors from understanding the risk, return, and correlation characteristics of private equity, and hence, the role of private equity in a diversified portfolio. The few private equity indexes that existed had the standard problem of how to measure the performance of private assets. The inability to determine a true market price for private assets forced investors to use appraisal-based prices that typically led to artificial smoothing of returns. Smoothed returns result in lower estimates of volatility, lower correlations with most other asset classes, and artificially high risk and return relationships, all of which can lead to a dramatic over-allocation in a traditional mean-variance optimization setting that attempts to maximize return per unit of risk. A new way of gaining access to the private equity asset class is emerging, however. It is accessible by all investors, it is easy to maintain a target strategic asset allocation, and it results in a mark-to-market time series that does not suffer from return smoothing. The equities of publicly traded firms whose businesses are similar to those of traditional private equity firms are being bundled together, and these bundles can serve as proxies for the private equity asset class. These firms— whose revenue stream comes mostly from investing in or lending or providing services to privately held companies—trade on public exchanges, so performance measurement is straightforward and investors can easily purchase the individual assets or products that are built around this new type of private equity index. Securitization is changing the private equity asset class, and over time, what was once an alpha, skill-based strategy will become a traditional beta asset class. In our study, we used two new indexes composed of publicly traded companies as proxies of the private equity asset class: the Red Rocks Listed Private Equity Index for U.S. private equity and the Red Rocks International Listed Private Equity Index for non-U.S. private equity. (The research for this article was prepared for Red Rocks Capital Partners.) 26 Morningstar Advisor Winter 2008
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