Portfolios of Funds –
Homemade or Outsourced?
Investors in private assets need to be mindful about costs, extensive diversification, and manager proliferation. Hiring myriad managers does not ensure they will be winners collectively. To the contrary, the law of averages works against investors.
In our white paper Targeting Private Assets, we examine the performance of the endowment model. R. Ennis2 finds that, since the Global Financial Crisis, endowments have underperformed their risk-based benchmarks, a public fund composite, and a 70% equities / 30% bonds passive portfolio.
R.Ennis identifies two key performance drags:
- High costs and overdiversification. Overdiversification tends to reduce the overall specific business exposures that private equity managers seek. With such high diversification, endowments cannot overcome the impact of high active management fees.
- Manager proliferation. Large endowments have an average of over 100 asset managers and in excess of 1,000 active company bets that, unfortunately, end up cancelling one another out.
K. Polen makes three most sensible recommendations:
- Focus on the quality of the business approach in creating a strategic advantage,
- Assess the quality of the organization, and
- Give paramount importance to the alignment of interests.
Clearly, thus, investors in private assets need to be mindful about costs, extensive diversification, and manager proliferation. Hiring myriad managers does not ensure they will be winners collectively. To the contrary, the law of averages works against investors.
These insights and recommendations by both Ennis and Polen are most relevant to the question as to whether investors should create their very own portfolio of funds or outsource the manager selection and portfolio construction process through a fund of funds.
In its 2020 Private Equity and Venture Capital report, Preqin provides comparative data for the relative size and performance of funds of funds, including balanced funds diversified across growth stages:
Private Equity: Risk/Return by Fund Type (Vintages 2007-2016)
For the vintages 2007 – 2016, funds of funds delivered 3 a Sharpe ratio of 1.9x, clearly outperforming the average of buyout funds – Sharpe ratio of 1.2x – and balanced funds diversified by stage and approach – Sharpe ratio of 0.9x. Funds of funds do seem to be earning their fees through astute manager selection and robust portfolio construction and risk management.
Diversified portfolios of funds managed internally with the appropriate processes, teams, and experience could potentially achieve results similar to those achieved by funds of funds. The experience of the endowment funds, however, should serve as a warning about creating and indulging in excessive complexity.
Robert S. Harris recently published a paper in the journal of Financial Economics studying the performance of funds of funds. Very insightfully, Harris questions whether the large blue universe of single funds in the chart above is the appropriate benchmark for funds of funds in as much as investors “would find it difficult to invest in (single managers) directly”. So, the large blue dot may not even represent the actual opportunity set of investors.
To summarize, funds of funds outperform the single fund universe on a risk-adjusted basis. Furthermore, this universe may not be the appropriate benchmark as investors do not have access to all the managers in this universe.
1This is not an investment recommendation
2Richard M. Ennis: https://richardmennis.com/blog/endowment-performance
3Past performance is no guarantee of future returns.
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