Morningstar Advisor - Winter 2008 - (Page 27) In a series of historical optimizations, we found that including U.S. private equity in the opportunity set would have dramatically improved the risk and return characteristics over the past 10-year period. From the beginning of 1997 to the end of 2006, U.S. private equity and non-U.S. private equity were the best-performing asset classes in the opportunity set, although the performance of the private equity proxies appears to be highly sensitive to the weighting scheme of the proxies. This sensitivity highlights that all private equity investments still contain a high level of specific risk. Over time, we think securitization will reduce the amount of specific risk associated with private equity portfolios. For the study, we created two historical efficient frontiers. Including U.S. private equity and non-U.S. private equity—based on both Red Rocks private equity indexes using backfilled histories—dramatically improved the risk/return characteristics of the efficient frontier. Over the common standard deviation range from approximately 0.67% to 34.1%, the average improvement in returns from including the two private equity asset classes in the optimization is an impressive 633 basis points. We also created a forward-looking optimization using a set of returns based on a global implementation of the CAPM. In a finding that is qualitatively similar to that of Ennis and Sebastian2, the benefit of including private equity is most significant for higher-risk, equity-centric asset allocations. The benefits are most pronounced in asset allocations with a standard deviation above 19%, which in our analysis corresponds to asset allocations with approximately 85% or more in equities. In both historical and future-looking optimizations, including U.S. private equity and non-U.S. private equity in the opportunity set improved the available risk/return characteristics of the asset allocations. The portion of the private equity asset class that is available for purchase represents approximately 2.6% of the worldwide investable universe. A range around this 2.6% market-neutral allocation—varying from 0% to 10%—seems appropriate for most investors, according to the optimizations. For investors with average risk tolerances, an allocation below 2.6% could be regarded as underweight in private equity. Allocations to private equity above 10% should be entered into with great caution and are only appropriate for very aggressive, knowledgeable investors with access to top-quartile managers. Institutional investors with access to topquartile managers should use traditional MorningstarAdvisor.com 27 http://MorningstarAdvisor.com
For optimal viewing of this digital publication, please enable JavaScript and then refresh the page. If you would like to try to load the digital publication without using Flash Player detection, please click here.