Opinion | Why individual investors should avoid alternative investment funds4 min read . Updated: 02 Oct 2019, 07:19 PM IST
You should invest in a PE, VC or hedge fund only if you can manage such a fund
Most institutional investors (large university endowments, pension funds etc.) across the world have tried to imitate the investment success of David Swensen, the chief investment officer of the Yale University endowment. Swensen’s success is because he invested in alternative investment funds (AIFs)—private equity (PE) funds, venture capital (VC) funds and hedge funds. But Swensen insists that individual investors should avoid AIFs. Let’s understand why.
The gospel according to Swensen
David Swensen’s book Pioneering Portfolio Management: An unconventional approach to institutional investment (published in 2000) is the Bible for institutional investors the world over, particularly about investing in AIFs. Swensen’s approach is based on the fact that the average active mutual fund does not beat the index.
Later in 2005, Swensen wrote a book for individual investors, called Unconventional Success: A fundamental approach to personal investment. He initially hoped that he could make minor changes to his book for institutional investors to create a book for individual investors. But as he did the research for the book for individual investors, he realized that the data was pointing him in the opposite direction. He realized that most institutional investors could not identify the best AIFs, and individual investors do not have the large and competent teams required to evaluate AIFs. So individual investors will most likely pick the worst AIFs. In summary, he recommends that individual investors should avoid AIFs and instead invest in index funds. Let’s use PE funds in India as an illustration to understand Swensen’s recommendation.
Private Equity in India
PE funds in India invest in mid-sized unlisted companies and are able to exit those investments only after five to 10 years. Simplistically, in exchange for bearing the pain of holding investments that are illiquid for five to 10 years, PE funds are hoping to earn, say, a 2% per annum higher risk-adjusted net-of-fees returns than the Nifty 50 index. Since unlisted companies do not have a share price that is quoted on any market, a PE fund manager runs the risk of paying twice or thrice as much as the fair price of the share. It is very difficult to avoid such mistakes, so a PE fund manager has to be exceptionally competent to achieve his objective.
Even if a PE firm has a successful track record of 10-15 years, that success may be because of only a handful of successful investments. So, it is difficult to know whether this handful of successful investments were due to skill or luck or some combination of the two. Hence, an individual investor has to look inside the PE fund manager’s mind and figure out whether a PE fund manager is exceptionally competent.
Individual investors investing in a PE fund should ideally read and understand around 2,000 pages of due-diligence material about a single PE firm. Most individual investors would not get access to this due-diligence information and even if they got access to it, they would not know what to look for in it. And this would be just a small fraction of what they would have to understand about a particular PE firm. They would also have to understand the soft aspects such as how the PE fund manager thinks, whether the entire team is competent and the PE firm’s strengths and weaknesses in its focus area. It is even more difficult to understand these soft factors. Further, they would have to understand all of this for at least 20 such PE firms before deciding to invest in one PE fund. So, individual investors have to read 40,000 pages of due-diligence material to understand just a small fraction of what they need to know.
This is a litmus test that I propose based on my experience as a PE fund manager for 12 years. You should invest in a PE fund only if you can successfully manage a PE fund yourself. Like Swensen, you may not be and may have never been a PE fund manager. But like Swensen, you should be capable of being a PE fund manager.
Further, it may be more difficult to identify a good PE fund than to successfully manage a PE fund. Hence this litmus test is a necessary but not sufficient condition. The same is true for investing in a VC or hedge Fund. The failure of most large institutional investors to replicate Swensen’s success and select the right funds is soft proof of this.
In summary, if you can successfully manage a PE , VC or hedge fund, then you have a tiny chance of being able to identify a suitable fund to invest in. Otherwise, you have no hope in hell of knowing which fund to invest in.
Since you do not have to be able to be a fund manager to select a suitable index fund, invest in an index fund such as the Nifty 50 index fund with the lowest fees.
Avinash Luthria is a Sebi-registered investment adviser and advice-only financial planner at Fiduciaries.in