How to Evaluate Semiliquid Fund Performance

As Morningstar begins formal coverage of semiliquid funds, nearly all of which focus on some segment of private markets, one nagging question is: How should investors gauge a fund’s performance?

When evaluating a fund, investors should consider its performance against an index and peer group, its risk profile, and if it offers any diversification benefits. While each of these three areas requires careful analysis, one overarching idea cannot be emphasized enough: Investors in semiliquid private market funds need to be compensated for tying up their capital.

In early September, our manager research team will launch its first set of Morningstar Medalist Ratings for semiliquid funds. Like mutual funds and exchange-traded funds, we evaluate them on key factors such as investment process, management, performance, and fees, but we adapt our established approach to the unique characteristics of semiliquid structures. In this article, we’ll explore performance. We also examine fees, investment process, management, and parent firms in related articles.

Why Public Benchmarks?

The foundation of performance assessment starts with benchmarking, and investors in semiliquid funds should demand a return that beats an easily accessible public benchmark. That is, we believe investors should not settle for less-than-public-market performance when they’re unable to access their money as readily—that is, daily—as they can owning a mutual fund or ETF. To underperform a public index gives rise to the simple question: What is the point of giving up any liquidity at all if there is no additional reward?

What then is an appropriate public benchmark? In Morningstar’s assessment of semiliquid fund performance, each Morningstar Category’s category index will serve as the public proxy for comparison. Equity categories use indexes composed of publicly listed companies, while fixed-income categories use the Morningstar LSTA US Leveraged Loan Index, an index composed of senior, broadly syndicated corporate loans that are priced daily.

Some funds will inevitably not fit neatly into a category, which will make benchmarking more art than science, but investors in those funds should still demand a return in excess of what could be had in a similar public-market-based strategy.

Why Not Private Benchmarks?

Some may argue that a more relevant index should include private assets. However, defining a benchmark is not as easy as it sounds. Should it be a representation of the opportunity set presented to a portfolio manager? Or, should it represent the opportunity cost faced by investors in the fund? Finally, how should it be weighted and reconstituted?

With private markets, these questions get complicated quickly. While one could theoretically put together a universe of private company equity securities, for instance, it may not actually represent the portfolio-manager’s opportunity set (that is, it is not “investable”). Buyout funds, for instance, take controlling stakes in entire companies, so there is a problem of mutual exclusivity. Two buyout funds (generally) cannot own securities in the same company, since one usually owns the whole thing. In public markets, one investor’s ownership of Microsoft MSFT shares does not exclude any other investor from owning it. The same mutual exclusivity problem can also exist in private credit. It can be argued that these funds compete with one another to win deals, and therefore an otherwise inaccessible company is still relevant within an opportunity set, as it does represent a security that the fund could have owned. But an index should comprise securities that are always available to all market participants.

Beyond universe definition and security selection, private index construction presents numerous challenges as well. Public equity market indexes are usually market-cap weighted, but private companies do not widely trade and, thus, do not have observable market caps. Asset managers and third parties provide valuations for private companies, but they are in the eye of the beholder. When there is a discrepancy among valuations—and there always is—whose opinion will be the final one for how a private company should be valued in the index? With no consensus values and limited transaction data, the index’s relevance fades fast, as its weightings (and returns) can be arbitrary, stale, or flat-out wrong.

What About Peer Groups?

Beating a public market index is the primary hurdle for a semiliquid fund, but peer analysis can help identify stronger contenders among the competition. Here, performance analysis keys in on category averages and peer rankings. Only after it’s clear that a semiliquid fund can compensate investors for its structural illiquidity by topping its Morningstar Category index should investors begin to consider whether it’s among the best available options in a given category.

To us, semiliquid funds that can’t beat public market indexes simply aren’t worth owning, even if they beat their category average. On top of beating an easily accessible public benchmark, we also want to see a fund top its competitor set (that is, its category average). The primary hurdle (a public market index) must be cleared first, though.

What About Risk?

Morningstar assesses mutual fund and ETF performance on a risk-adjusted basis. Risk, in that context, considers the traditional financial theory view that volatility is a good enough proxy for risk. The basic question we’ve traditionally sought to answer is: Does a fund compensate investors for the turbulence they have to endure?

With semiliquid funds, this framework gets thrown out the window. These funds have substantial control over their volatility levels, considering they are also the ones that determine the portfolio’s security-level valuations, which create (or mute) the volatility in the first place. Using any volatility-based measures for risk, therefore, would likely punish the better actors (that is, those that mark their positions more frequently or more realistically) in favor of those funds that are slow to move any valuation.

While risk-adjusted returns are thus not the primary way we think about results, risk is a large component of other pillar ratings. If, for instance, a private credit fund is particularly loose on risk and is willing to make underwriting concessions in exchange for yield, there must be adequate processes and people in place to manage that additional risk. If risk is not being managed properly, the fund’s People and Process ratings would reflect our doubts that the fund can add value over a public benchmark.

Fund-level leverage is another difference between these funds and most mutual funds and ETFs. A lot of semiliquid funds employ leverage to help boost returns. Leverage is a two-sided coin, though, and it can magnify losses on the downside. Semiliquid funds that employ leverage will be compared with unleveraged indexes, which, in calm markets, can make them look like strong performers. However, Morningstar Medalist Ratings are “through-the-cycle,” so the amount (and types) of leverage being used will likely affect other pillar ratings. Simply put, more leverage increases risk, particularly considering how a semiliquid fund may perform in a stressed environment.

What About Diversification?

One argument for accepting less-than-public-market returns would be if these products provided some diversification benefits. That is, investors may be willing to accept potentially lower returns in exchange for an uncorrelated, steadier return stream.

We do not buy this argument. Private companies operate in the same planet and economies as publicly traded companies and are subject to the same business cycle fluctuations as everyone else. Infrequent pricing of private assets creates the illusion of low correlation with public market securities, but isn’t it strange how, immediately after a company has an IPO, it all of a sudden becomes highly correlated with the public market?

Still, there are some semiliquid funds that do pursue truly diversified strategies by investing in assets that have uncorrelated payoff patterns (for example, reinsurance-focused strategies). These kinds of strategies require a lot more nuanced analysis of their value-add, but they will not be a focus of Morningstar’s ratings for now.

Is There a Standard Illiquidity Premium?

No, Morningstar does not have a specific illiquidity premium hurdle that needs to be cleared. As outlined above, though, everyone should demand something in return for giving up liquidity.