Private Capital Beta: Theory Reloaded

In a recent Financial Analyst Journal article titled “Do (Some) University Endowments Earn Alpha?” the authors find that endowments mostly fail to deliver alpha and what looks as alpha can be almost totally explained by the inclusion of alternative investments in a static asset allocation. Digging further, the authors find that there is no strong statistical evidence of selection skill relating to the private equity and hedge fund portfolios.

“Our results fail to provide evidence that some combination of manager selection, market timing, and tactical asset allocation generates alpha for investors, which would appear as positive intercepts in our attribution models. This conclusion rests on the assumption that the benchmarks in our factor models do not deliver alpha.”

Independently from the fact that is unclear if alternative benchmarks intrinsically deliver alpha, what emerges from the article is that:

  1. Malkiel’s monkey, from his best-selling book “A Random Walk Down Wall Street”, seems to be at ease with private capital too;
  2. private capital beta delivers a premium over traditional beta.

These findings have important pricing, investment strategy and risk management implications.

Firstly, Malkiel’s recent reading of his efficient market hypothesis (EMH) theory seems applicable also to the private markets, at least in Lo’s adaptive version (AMH). Ex ante, price changes are random, cannot be predicted and, if they can, the prediction would relate to mean-reverting elements tied to overall market characteristics (i.e. indices’ serial correlation/momentum, dividend yield, price/earnings) and beta but no arbitrage without risk could exist:

“Suppose that stock prices are rationally determined as the discounted present value of all future cash flows. Future cash flows can only be estimated and are never known with certainty. There will always be errors in the forecasts of future sales and earnings. Moreover, equity risk premiums are unlikely to be stable over time. Prices are therefore likely to be “wrong” all the time.”

As a consequence, given that the above equally applies to the public and the private markets, diversification plays a crucial role for eliminating idiosyncratic / specific risk.

Secondly, the private capital premium that implicitly emerges from this “Malkiel’s monkey approach” unambiguously qualifies private capital fund investments as an asset class with unique and homogeneous risk-return characteristics (or a specific subset of the broader equity asset category).

Whatever disagreement between Burton G. Malkiel and Warren Buffett there may be, private capital investments seem to be a middle-ground where the monkey approach holds but, at the same time, value, unconstrained and concentrated portfolios can deliver superior returns versus the public market indices.

From a pricing perspective, a rational investor should not pay for the expectation of any alpha and prices should only reflect private capital beta eventually adjusted by French-Fama factors.

From an investment standpoint, superior selection skill claims are seriously challenged. Investors’ objectives should shift toward achieving a low-cost, efficiently diversified, allocation to private capital.

At the same time, from a risk management perspective, they should recognize that beta implies relative returns and that market (beta) volatility is the leading factor driving individual firm volatility in particular in down markets.

 

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