What are the main problems that advisors try to solve in a client’s portfolio?
To justify your own fees, performance that consistently outpaces the broader market indexes would be nice. However, you’re not willing to take on undue risk or volatility. Moreover, as an advisor you’re always focused on the cost of those investments, and an investment with high turnover goes against the long-term investing goal that most advisors have on behalf of their clients, not to mention the tax consequences of higher-frequency trading.
So perhaps you’re thinking that certain alternative investments would fit the bill. The problem with many alts, however, is that your clients may need to be part of the high-net-worth cohort. Burned by the 2008-2009 hypercorrelation and crash-and-burn of many private vehicles, you demand liquidity and transparency. Oh, you also can’t stomach the costs of 2-and-20 managers.
Enter Ben Warwick of QES Investments and a pairing of two investing vehicles — in ETF and mutual fund formats — that appears to go a long way toward meeting client needs for performance and diversification while assuaging advisors’ concerns about alternatives’ costs, transparency and liquidity.
Last month, an ETF was launched based on a QES private equity strategy on the London Stock Exchange, Source Nomura Modeled PERI ETF (PERI:LN). This past week, Hatteras Partners launched a mutual fund, Hatteras Private Equity Intelligence Fund (HPEIX). Both are built to deliver the benefits of private equity investing without the drawbacks of direct investing in listed or unlisted PE.
As CIO for the multi-office family office Sovereign Wealth Management, Warwick — a ThinkAdvisor and Investment Advisor contributor — and his team sought to use alternatives in performing asset allocation for larger portfolios. However, he found that there were “some negatives to what we were using,” the primary drawback being the “the delivery mechanism of the limited partnership.” Looking to deliver to his clients “access to risk premia that they wouldn’t have been able to access,” QES started by using futures, especially managed futures in portfolios as a strategic tilt away from the typical 60/40 portfolios.
Warwick realized that QES wanted to “build products that solve problems for advisors.” First up: the Aspen Managed Futures mutual fund (MFBTX), a low-cost index-based managed futures ’40 Act fund using both trend and countertrend strategies. He says the “low cost and the sensible structure of the index gave us some success with that product,” which has attracted $160 million in assets in just two years.
Around that time, however, “we started to see if we could make available the returns of private equity, specifically buyout funds.”
Why private equity? Simple, Warwick says. “Because the returns are better,” delivering 3% to 5% better returns than an unmanaged S&P 500 strategy. However, PE also requires that a HNW investor “tie up your money for a decade” more often than not.
So QES started conducting attribution analysis on PE returns to determine the source of those extra returns. While some observers would expect the returns come from “levered equity,” Warwick said, “that doesn’t explain why private equity investments show a bigger upside with lower drawdowns.”
It turns out that individual managers’ alpha isn’t the primary driver, either, though he admits “there’s some of that.” Instead, what QES’ research found was that the “surprising driver” of PE returns is timing — “when you get in and when you get out” — and sector selection.
“Private equity managers are like hedge fund managers,” argues Warwick, in that they exhibit “herd behavior; if you see one or two deals in utilities,” for example, “you’ll see all these private equity managers going into utilities.”
Since there’s a “momentum effect in capturing the money flows of PE, if you could capture that momentum effect and mirror the leverage, which changes with credit spreads, you could get close” to the returns of private equity funds. So QES needed to find the data on private equity funds to determine that momentum and timing.
Enter Preqin, which Warwick calls the “Morningstar of PE,” which has a “huge database” containing “30,000 transactions and 600 buyout funds.” Its data allowed QES to build portfolios that mimic the private equity buyout space.