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Rekenthaler Report

Christmas Clubs and Private Equity Returns

Freedom is just another word for an emotion left to lose.

Enforced Savings
Back in the day, points out economist Richard Thaler, there were Christmas Clubs. Before credit cards were widespread, how to be certain that money would be available to buy Christmas presents? Join a Christmas Club! Send the Club weekly checks, and in return it will send that money back, sans interest, when the holiday season arrives. Problem solved.

On the surface, Christmas Clubs were bad choices. The Club extracted the time value of money, leaving the saver with nothing more than what he put into the scheme. He could have fared just as well by stuffing those bills (or coins) underneath his mattress, or earned interest in a bank savings account.

Except that the mattress and savings account could be easily raided, and the Christmas Club could not. The Club didn't take money for doing nothing; it provided a service to members, by preventing them from succumbing to temptation. Mathematically, joining the Club was suboptimal. Practically, it often proved sensible. Also, asks Thaler, who is to say today's shoppers are better off? Charging gifts to credit cards that aren't immediately repaid is costlier than joining a Christmas Club. 

The Bucket List
In short, what looks foolish to computers may be smart for humans. Such is the idea behind Morningstar columnist Christine Benz's "buckets." In theory, the soundest investment approach is to create a single portfolio allocation to address multiple goals, rather than to build this bucket for that goal. That is how optimization routines work. But computers need not interpret their counsel. People do. If they don't understand the decisions' logic, they are less likely to stay the course.

(In another life, I confronted this problem. I was responsible for an investment-advice program that was technically sophisticated. It would consider the investor's complete holdings when conducting its calculations, and then, almost instantly, provide comprehensive instructions for all accounts. Black magic! Users recoiled. They preferred to see their answers come one step at a time.)

The Illiquidity Puzzle
Which brings us to private equity funds (bear with me). Private equity funds are sold at their launch with their new shareholders required to hold the funds for at least five years, and often substantially longer, before receiving a return on their investment. They cannot redeem their shares with the fund sponsor, and while a secondary market has developed, sales are neither easy nor cheap to execute.

This illiquidity is normally considered to be a bad thing. Indeed, per traditional thinking, it is the bad thing that makes private equity funds a good thing. The claim works like this: Being locked into a fund for several years, with an uncertain secondary market, is unappealing. To offset this disadvantage, private equity funds must logically possess an advantage that liquid equity funds do not. That advantage comes in the form of higher expected returns.

Such is the conventional wisdom: Private equity funds, to use the jargon, "harvest the illiquidity premia." However, there is a potential problem with this hypothesis, that being that private equity funds may not, in fact, have outgained the public stock market. Determining private equity performances is notoriously difficult; the database is rife with creation and survivorship bias, the former referring to successful but previously unknown funds announcing their presence, and the latter being when unsuccessful funds decide no longer to report their numbers. In addition, private equity accounting is not uniform, as with, say, mutual funds.

This has led several knowledgeable parties to doubt that private equity funds do, in fact, deliver higher returns. The Wall Street Journal wondered, "Does Private Equity Really Beat the Stock Market?" Its answer was, "Most likely yes, but it is really hard to measure and comes with big caveats"--not a ringing endorsement. Warren Buffett was more critical yet. "We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest."

A Contrarian View
If private equity returns have indeed been less than advertised--that debate remains unsettled--AQR founder Cliff Asness think that he knows why. Perhaps private equity's allegedly unattractive illiquidity is actually a benefit. If that were so, then private equity funds could be expected to return less than publicly traded stocks that carry equal business risk, not more. Writes Asness:

Liquid, accurately priced investments let you know precisely how volatile they are and then they smack you in the face with it. What if many investors actually realize that this accurate and timely information will make them worse investors as they'll use that liquidity to panic and redeem at the worst times? What if illiquid, very infrequently and inaccurately priced investments made them better investors as it essentially allows them to ignore such investments given low measured volatility and very modest paper drawdowns?

What if, in other words, private equity funds are the investment equivalent of Christmas Club memberships? People like private equity not because it is a more profitable investment but instead because it is emotionally satisfying.

Extending the Thesis
Well, it's a hypothesis, no more than that, and one that is difficult to test. But I confess to finding the Christmas Club argument intriguing, in part because it so obviously applies to home ownership. Houses, too, are assets that are not easily traded once purchased and that are only infrequently reprised. Such attributes can be considered drawbacks, but every homeowner knows that at least to some extent, the reverse is true. Houses seemingly never lose their value, so long as they are not sold. That is, without question, a pleasant attribute.

Continues Asness, "Could the same investor who finds private equity easy to stick with also find a levered publicly traded small-cap portfolio impossible to stick with even if they're economically very similar investments?"

Yes, that could be. If so, it implies that the leveraged small-company portfolio will likely post the higher total returns of the two investments. That would be an ironic outcome, considering that institutional funds have invested hundreds of billions of dollars into private equity, and almost nothing into leveraged portfolios of publicly traded small-company stocks.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.