Private Equity and the Systematic Endowment Portfolio
China continues to grow solidly, in the US both ISM indices are lower than recent extreme highs, and the Non-Farm payroll disappointed elevated expectations. Taking out the noise from such data, as advised by Kahneman in "Lunch with the FT" this weekend, the business cycle components of the algorithms point to a continued supercharged recovery in the US. With the Fed decisively on hold, fixed income markets have remained calm, and we have seen further gains in global equity markets. Along with a strong momentum of growth in earnings these are all factors which lend support to our equities and high yield bond positions. We remain fully invested (overweight risk) with significant exposure to US equities and high yield bonds. This has delivered returns of 5-12%+ YTD and 20-40%+ YoY depending on portfolio risk levels.
The most remarkable new information over the past month has been the S&P 500 earnings season. As of Friday the 7th of May, 437 companies have reported their Q1 2021 earnings. The growth rate is about 50% and the actual earnings number is more than 20% higher than expected when the earnings season started. With S&P 500 at an all-time high at the time of writing, it is worth considering that recent earnings growth has been so strong that the S&P 500 now trades at 31 times trailing 12-month earnings but 22.4 times 2021 earnings. This is not cheap in a historical context, but markets seldom correct to trade cheaply during boom years. Having followed and reported on these earning numbers for 20+ years, we have experienced how consensus in lacking reality just as bad in a recovery as it does in a downturn, and we expect this year to be nothing different.
In this edition we introduce the Systematic Endowment portfolio, our concept for multi-asset investing that combines liquid and private market investing and which is the optimal set up for investors with a multi-generational investment horizon. We introduced its predecessor, the Endowment Style Portfolio, in 2015, as part of the new offering of our previous employer, where it is used across the world as a guide for UHNW and Global Family Office clients "wishing to invest like an Endowment". An important source of inspiration is the Yale Endowment and its asset allocation, shown in Figure 1 and famously set up by the late and great David Swensen.
Figure 1: Asset Allocation of the Yale Endowment portfolio as published in the Yale Endowment report
The key insight of this framework is that for investors who seek high returns in line with "growth" or "equity" portfolios, there is an advantage in combining private and public markets and, thereby, harvesting the higher long term expected return in private markets, while giving up some but not all liquidity. In the case of the Yale Endowment portfolio, shown in figure 1, the sub asset classes add up to 38.4% in Private Equity & Venture capital, which along with 12.5% in Real Estate and Natural Resources gives a total of close to 51% in illiquid private markets. The remainder is split between the more or less liquid categories: Fixed Income and Cash, Foreign Equity, Domestic Equity, and Absolute Return, leading to a broadly speaking, 50% vs. 50% split between private and public market investments. The Yale Endowment returns have been great over the longer term but less impressive in the past decade. We trust and hope this will reverse, but nevertheless think the relative performance supports the notion that a significant additional liquid equity market exposure is a good idea, especially now that there seems to be a rush into private market which could easily be followed be less extraordinary returns in the coming years (funds/vintages). Liquid market allocations are also appropriate for those who are in the portfolio build-up phase, a period that should ideally last a business cycle, at least for the less liquid components of private markets. Before we continue to explore the benefits of the Systematic Endowment Portfolio (SEP), we offer a brief update on our performance and positioning.
In our Systematic Equity Allocation strategy, we maintain a 100% equity allocation (a 40% overweight for those thinking in relative terms). Our main exposure is US large cap equities that are expected to perform well through the various sector rotation events of the coming quarters. As of the end of April, this strategy and the aligned fund were up 12% year to date and 44% year on year.
In our multi-asset mandates and funds, we have a full allocation to equities (50%-70% depending on restrictions) and an enhanced 30% allocation to high yield bonds with duration of around 3 years. These portfolios are up 5-8%+ year to date and 25% year on year.
In our Global Fixed Income Opportunities strategies and funds, we maintain our high yield bond positions and a significant weighting in short duration assets, since we expect government bond yields to move up again as and when the fixed income market starts pricing that inflation is increasing as disposable incomes and risk appetite return along with investment demand. These portfolios remain in positive territory for the year and are up 10% year on year.
Private Equity and the Systematic Endowment Portfolio Concept
Private market investments, like Private Equity, Venture Capital and Real Estate have for generations been popular with wealthy families, Endowments and Foundations. Over recent decades, they have become core building blocks in institutional portfolios and in the ultra-high net worth and global family office segment and are now spreading to the affluent segments. In 2014, we developed the Endowment Style Portfolio concept to serve as a guide on how best to combine liquid market investment with private market investments for the many UHNW and Global Family office clients we worked with. Using our new generation of Dynamic Allocation Strategies, we have now developed this concept into the Systematic Endowment Portfolio (SEP), offering enhanced liquidity and risk management. Before we look closer at the benefits of such systematic management of liquid assets when these are combined with private market holdings, it is useful to look at both the financial and behavioural reasons for holding private equity and other private market assets.
From a top-down perspective, the key attraction of private market is the perceived higher return potential driven by the following factors:
High historical return driven by the benefit of improved operational efficiency and well managed leverage has led to a reasonable expectation that these will be solid return also in the future.
Alignment of interests between investment managers (GPs) and investors (LPs) drives both expected dedication, performance, and a feeling of fairness as the managers have "skin in the game".
The tangible management skills and proven track record of many private equity teams and companies both in terms of return on investment and in retaining and motivating key staff.
The recent drive down in yields and the resulting hunt for yields in a low, zero and negative yield environment. A very strong force, particularly in Europe, where the long terms growth outlook is poor after decades of lost reform potential and increasing populism among national governments.
These are all factors that help explain the growing interest in private market investments, but they don’t fully explain why interest has been increasing while returns have been moving closer to those of liquid assets. Here less rational and more emotional factors are at play as well, including:
Herd behaviour in implementation do to slow adaptation of new investment ideas and methods turning from a drag to a feeling of needing to move when everyone else does so.
The more psychological herd behaviour and fascination as the discreet millionaires of the private investment world have become less discreet billionaires publishing books and appearing on TV shows.
The feel-good factor of "proximity to the real economy" and to real assets (something you can touch and understand).
The relief from the stress of living with daily price movements of liquid assets. A factor which can lead to better investment decision if it actually lowers stress levels and lead to more time to think constructively about investment decisions.
As with all booms, some will also burn their finger in private markets, where many SPACS are already struggling to justify their appearance as public listed companies as their "public" share prices are significantly down. However, for the truly multi-decade and inter-generational investor, time should even this out as private equities and other private market investments deliver solid returns which also in coming decades are likely to be higher than those offered by liquid markets. Assuming this optimistic scenario plays out, the question is how best to combine illiquid and liquid assets (which are also not trading cheaply). In our view, a good starting point is to explore where liquid market holdings best supplement private market investments:
Liquidity: An obvious area is liquidity, as private market investments never really offer liquidity. In times of crisis, particularly, this can become a problem and periods like 2002-03 and 2008-09 has shown the benefit of liquidity to mitigate risk, drawdowns and panic.
From a more "active" point of view, periods of persistent market stress also provide great opportunities to deploy capital in private market assets, both it requires that such capital be available and liquid.
Diversification in capturing value creation: Most investors struggle to obtain full global diversification in private market investments. A broad equity index can solve this problem. Moreover, it is not possible for everyone to be part of all early-stage successes. Companies like Apple, Amazon, Microsoft, Alibaba etc. have created more USD returns after their listing than before. In this way, diversification can help to ensure participation in tomorrow's successes.
Diversification from asset class returns: There are not many private market assets which go up in value during persistent recession, but US government bonds do, especially the longer segment such as 10-year, so it makes sense to include such bonds in calm periods.
Taking the above factors into consideration, an optimal solution for multi-decade investors who want to create a long-term return stream in the spirit, if not in the exact form, of the Yale Endowment, is to combine a large allocation to markets, especially Private Equity and Real Estate with, significant allocation to liquid markets. Such
portfolio, in stylised form, is shown in the pie chart to the left in Figure 2.
Figure 2: The Systematic Endowment Portfolios & The dynamic movement portfolios asset allocation
The pie chart to the left is made up of 50% public market investments (with our Systematic Equity Allocation strategy (SEA) as place holder) and 50% private market. On option is to let the public market part of the portfolio consist of a fixed weight of bonds and equities. This was indeed the case in the 2015 edition of our Endowment Style Portfolio. This however leaves additional return potential, as well as risk management benefits to be explored by including a Systematic Equity Allocation strategy (SEA strategy) for the liquid market part of the portfolio. The reason the SEA strategy helps optimise return and risk management, is that dynamic asset allocation process assures that the weight of government bonds increases when the algorithms show an increased probability of financial market stress, recessions, and drawdowns in Private Market. The algorithms can obviously be wrong in case of smaller fluctuations in the business cycle and market risk, but for lasting persistent recessions they will assure allocations shifts and risk reductions.
To the right Figure 2, we show an example of how this would be implemented combining Private Equity, Real Estate, and our SEA strategy. When the outlook is negative, we hold the "Defensive" portfolio in the SEA strategy and the steady and unchanged weight in private markets. The "Defensive" portfolio thus consists of 50% government bonds, 40% Private Equity and 10% Real Estate. When we have a positive view of markets the SEA strategy and the associated ACCI SA fund hold 100% equities (as is currently the case). This means that the "Positive" portfolio shown in the column to the right in Figure 2 holds 50% liquid market equities, 40% Private Equity and 10% Real Estate in the positive state. Seen over a longer period, this means holding more bonds when financial markets are volatile and vulnerable, and risk is high (and opportunities for the liquid investor plentiful) and more equities in periods of relatively low volatility.
In figure 3 below we break up the endowment portfolio into its main components. The blue line is the SEA strategy as expressed in the Systematic Equity Allocation strategy (SEA). The back line shows the return of a static portfolio with 60% global equities and 40% US government bonds. The grey line shows the return of Cambridge Associates US Private Equity funds index. Figure 4 shows the drawdown of each of these three components.
Figure 3: The SEA strategy, the Static 60% Equity 40% bonds benchmark strategy and the CA US PE Index
Both the Endowment Style Portfolio and the Systematic Endowment portfolio offer the liquidity benefit compared to private market investments. The diversification benefits and the risk management benefits are much larger for the systematic portfolio.
Figure 4: The SEA strategy, the Static 60% Equity 40% bonds benchmark strategy and the CA US PE Index
In Figure 5 below, we show the stylized simulation of the return over the last two decades. The private market side is a simulation based on the Cambridge Associated indices for Private Equity and Real Estate investments. The liquid market part is a simulation two decades back using our Systematic Equity Allocation strategy for the 50% part of the portfolio held in liquid markets, where we move between zero and 100% equities, with the balance in US Government bonds with medium duration (the strategy also used in the ACCI SA fund). As this is a low frequency strategy this includes approximately 4 allocation changes in the liquid portfolio every year. The private market portfolio is held constant.
The grey line in the figure depicts the total return of S&P 500 since the beginning of 2000. The black line is the static Endowment Style Portfolio consisting of the fixed weights of 40% Private Equity, 10% Private Real Estate (both simulated with the respective Cambridge Associates indices) and 50% invested in a static mix of 60% equities and 40% bonds (S&P 500 and US treasuries 7-10 years). As is seen in Figure 5, this stylized Endowment Style portfolio has delivered a return of more than 500%, significantly outperforming the S&P 500 index, which has delivered a respectable 337% total return since the first of January 2000.The Blue line in the chart shows the total return of a Systematic Endowment Portfolio. Just like the Static Endowment Style Portfolio, the Systematic Endowment Portfolio has a 40% allocation to Private equity and 10% allocation to Private Real Estate. The remaining 50% follows the dynamic process of our Systematic Equity Allocation Strategy moving between 100% and Zero equities (S&P 500 iShares), with the balance invested in US Treasuries (7–10-year iShares).
Figure 5: The Systematic Endowment Portfolio vs. the benchmark Static Endowment Portfolio and S&P 500
As shown in the table above figure 5, the annual return of the Systematic Endowment Portfolio has been well above 10% (after trading costs and management fees). This is 3% per annum more than the Static Endowment portfolio. A difference which over the 20-year period leads to an additional 300% return. Even allowing for some scepticism regarding the historical simulation, there seem to be good reason to consider this strategy. There are also a number of more qualitative and intuitive advantages of the Systematic Equity Allocation Process. The most important advantages are that:
The Systematic Equity Allocation Strategy is fully liquid both as a mandate and as a fund solutions and can be built with ETF`s, Actively managed asset class funds or derivatives. (we offer them with daily liquidity in UCITS form).
From both a quantitative and qualitative point of view, the probability that the systematic strategy will deliver the desired return characteristics increases with severity of crises meaning that the longer lasting and the more severe any future crisis is, the more likely it is that Systematic Equity Allocation strategy will work, as the algorithms will get out of risk and stay out of risk in lasting recessions.
This is illustrated well in the simulated drawdowns shown in Figure 6, showing drawdowns over the last 20-years and thereby through three global recessions.
Figure 6: Drawdown of the Systematic Endowment Portfolio, The static Endowment portfolio and S&P 500
As seen in figure 5, diversification also helps increasing positive portfolio characteristics expressed in the "Sharpe" and "Sortino" ratio". More important from a conceptual point of view, when losses occur, they are smaller and recovery is faster. From a practical, hands-on point of view, the Systematic allocation portfolio also has the advantage of being liquid. The longer lasting and the deeper the crisis is, the more likely that the liquid part of the portfolio is in bonds. This is not only beneficial for returns but also offers liquidity for deployment in private markets when these are most attractive during or after severe recessions.
A final advantage of the Systematic Allocation Portfolio is that it offers a conceptual segregation of the portfolio which allows for a gradual and differentiated implementation of ESR, SRI, Social Impact Investing and other Sustainability characteristics. By clearly separating the various components of different asset classes of a portfolio, according to both asset class and liquidity, the transition process becomes easier. A topic will return to in future editions of this publication.
Mads N. S. Pedersen, Managing Partner and CIO