By: Tim Price, UBP London
Published: September 11, 2006  

(Private) equity funds are now giving hedge funds a run for their money as the pariahs of international corporate governance wrote David Skeel, a professor of law at the University of Pennsylvania, in the Financial Times last week. He went on:

The reason we hear so much about (private) equity funds and hedge funds is that they are the ghosts of the market’s future. As money that might once have gone to mutual funds pours into (private) equity funds and hedge funds, these funds will play a central role in international corporate governance. Even more momentously, they may increasingly assume many functions traditionally handled by banks. With the array of financial instruments now available to hedge the kinds of risks traditionally borne by banks, there is nothing to stop hedge and (private) equity funds from serving as lender as well as acquirer.. we are unlikely to look back on the (private) equity funds’ new buy-and-borrow trick as evidence of a crisis in corporate finance. Instead, it will look like another signpost on the way to a new financial order that we can barely even recognise right now.

Notwithstanding the fierce invective against this new financial engineering (by private equity locusts according to SPD chairman Franz Muntefering last year; by hedge fund highwaymen of the global economy according to Malaysian prime minister Mahathir Mohamad in 1997), these so-called alternative investments have in truth already joined the mainstream. Anyone who argues differently is in denial. In financial markets, as in every other aspect of life, change is part of the natural order of things. Those who seek to maintain the status quo and the balance of financial power in markets are arguing for the ossification of culture, and not least seeking untenable control over an otherwise Darwinian process. In looking for the rationale behind the flood of capital into alternative investments, the answer, quite understandably, lies in the palpable failure of what went before.

Before Niagaras of capital cascaded into hedge funds and private equity vehicles, those waterfalls of money were being poured into mutual funds. As ever in finance, the lexicon was deficient. A mutual fund implies co-ownership. Most mutual funds were and are anything but. In any case, at some point in the 1990s, and perhaps before, we got to the ludicrous state of affairs whereby there were more equity mutual funds listed on the New York Stock Exchange than there were stocks on that exchange. The market started to eat itself. Unsurprisingly, popularity and disappointment went hand in hand. It could hardly have been otherwise. As Yale’s David Swensen reminds us, active managers as a group must underperform the market by a margin equal to the cost of trading (market impact and commissions) and the cost of fees. Swensen cites a study conducted by Robert Arnott, Andrew Berkin and Jia Ye examining mutual fund returns over the two decades ending in 1998. During those twenty years, the average mutual fund underperformed the market (more specifically, the Vanguard 500 Index Fund) by 2.1% a year. Over fifteen years, the deficit was 4.2% per year. Over ten years, the underperformance amounted to 3.5% per year. As Swensen suggests,

the Arnott team’s work provides a prima facie case for avoiding active mutual fund management.

The differential in fees between most mutual funds and Vanguard (whose fee was less than 0.2% per annum) accounted for more than half the shortfall. The balance stemmed from a combination of poor security selection, costs associated with the mindless trading conducted by managers in futile attempts to best the market, and various forms of chicanery visited upon the hapless mutual fund investor.

So the Arnott study pretty much drives the nail into the coffin of active management. Or more specifically, it crushes the intellectual justification for funds that endeavour to beat the market. (Whether the market as defined by a popular equity index is an appropriate benchmark for any unconstrained investor is, of course, another matter entirely. Suffice to say that wholesale adoption of the cult of equity left a lot of followers impoverished as the bull market of the 1990s evolved into a house of cards.)

So mutual funds, in general, have failed and continue to fail investors. Meanwhile, the most popular alternatives, hedge funds and private equity funds, are excoriated by the long-only crowd as little more than expensive confidence tricks. If hedge fund and private equity managers reported their returns on a gross basis, this argument might hold water, but they don’t, and it doesn’t. In financial markets as in life, you get what you pay for.

Skeel is surely right. While the invulnerability of mega cap companies to (private equity or hedge fund) takeovers is now open to question, and the financial air is ripe with uncertainty, the sense of crisis slowly embracing the listed markets – and poor-performing corporate executives – is consistent with a recognition that the game has changed, possibly quite profoundly. The co-ownership (boutique ?) structure of private equity and hedge funds is surely a template for successful businesses of the future to follow. The invariably hierarchical and often unbalanced ownership structure of the listed company is fraught with conflicts of interest and agency risks. A partnership is a partnership. While the costs of these new vehicles may seem prohibitively expensive, given that they require additional due diligence, a nominally cheaper mainstream offering (government bond fund; long-only equity fund; insert faddish product du jour here) may be destined for underperformance, not to say outright obsolescence.

Tim Price, CIO UBP Global Strategies,
Union Bancaire Privée,
London, 11th September 2006.