The Markets January 23, 2008

Custom Performance Demands Could Mean Lost Revenues

Demand from institutional investors for precise and often-custom made indexes to allow them to meet socially responsible investment (SRI) constraints could represent a significant revenue loss problem for money managers, a new report concludes.
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A TABB Group news release about its research said instead of comparing a manager’s returns against a broader market index or ranking similar funds’ performance against one another, the benchmark process has become granular and precise. TABB notes that institutional players “have been at the heart of the change within the benchmarking space,” and observes that much of the trend has been driven by political bodies that have ordered the pension plans to tailor their investments to specific social, moral, and political beliefs.

Those SRI mandates, according to TABB, have “blossomed into a new industry of research and indexing….” The appetite for index-based funds is nearly insatiable, with index-based assets under management (AUM) increasing by 2,610% since 1993, TABB said.

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With nearly $1 trillion invested in the U.S. in index-based products such as exchange-traded funds (ETFs), active managers stand to lose approximately $12 billion a year in potential management fees, TABB contends, labeling the situation “a serious danger to the active management community.”

According to TABB research director and study author Adam Sussman, by 2009 nearly 70% of all pension plans representing $40 trillion AUM will be using customized benchmarks. That, in turn, “will create more sophisticated investments as pension plans are exploring different views on asset allocation and portfolio construction, examining risk-adjusted returns, complex correlations and liability matching,’ Sussman asserted.

He noted that the added emphasis on more precisely measured performance is prompting institutional investors to trade exchange-traded and over-the-counter (OTC) derivatives that attempt to capture beta less expensively, hedge against interest-rate risk, and buy alpha. The researcher contends that hedge fund replication strategies could easily cost active asset investment managers billions more a year in lost management and performance fees.

The 37-page report with 27 exhibits was based on in-depth interviews with 38 pension plans and investment managers in the U.S., the UK, and across the European Union that are responsible for or actively managing investments worth $2.32 trillion.

The report is available to TABB clients at https://www.tabbgroup.com/Login.aspx.

The Markets January 23, 2008

Private Equity Becoming a Beta Asset Class

A new study of the private equity market finds that securitization - bundled funds of publicly traded private equity firms - is changing the private equity asset class.
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An Ibbotson Associates news release about its research said that over time, what was once an alpha, skill-based strategy is becoming a traditional beta asset class.

According to the announcement, Ibbotson Associates relied on two new indexes of publicly traded private equity firms to represent 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. Researchers found that weighting scheme plays a big role when it comes to performance.

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The domestic private equity compound annual return ranged from 4.5% to 24.9% from 1997 – 2006 depending on weighting scheme of the index, and the compound annual return for the international private equity ranged from 10.8% – 21.5%, compared to 8.6% for the S&P 500 over the same period.

When it comes to historical optimizations, the research found that adding even the most pessimistic historical domestic and international private equity Indexes to the opportunity set increased the risk/return tradeoff in the portfolio with optimal allocations ranging from 0 – 7% and an average improved return of 46 basis points. At the optimistic end, an unconstrained optimization with domestic and international private equity improved average returns by 633 basis points, the Ibbotson researchers found.

The study said traditionally, investors would allocate to a skill-based strategy in either leveraged buyouts or venture capital. The fragmented structure of the private equity market was such that private equity investors could not fully diversify away from private company specific risk. So, all private equity investments were a mixture of systematic risk exposure to the private equity asset class and to private company specific risk, the study said.

The study was conducted by Thomas Idzorek, vice president and director of research and product development for Ibbotson. The report is available here.

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