Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. The more different you are from the person that defined a rule the less you should follow the rule. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.

The myth of better risk adjusted returns in industry super funds

“When you get to the wealth advisory business, you can hardly find another place in the world with so many high-IQ people doing so many dumb things.”

-          Charlie Munger

The Battle of Bosworth Field took place in August of 1485 in central England. It was the decisive and penultimate clash of the War of Roses and forever immortalised in Shakespeare’s Richard III. What does this have to do with private assets? I will get there. But act 5, scene 4, line 1 of Shakespeare’s work is the reason I think the conventional wisdom about private assets makes no sense.   

Last week I questioned the widely shared view that private assets automatically bestow higher returns on investors. I think the illiquidity premium has been competed away and suggested individual investors avoid private assets since we will not get access to the best investment managers while paying high fees.

The illiquidity premium is not the only benefit of private assets cited by industry cheerleaders. There is also the notion that Private Equity, Venture Capital, unlisted real-estate, private credit and countless other iterations of private assets offer higher risk adjusted returns than public markets.

The risk adjusted return refers to the idea that there is an efficient frontier that represents the maximum level of return given each level of risk. Underlying this notion of the efficient frontier is that risk and volatility are universally synonymous for all investors. I couldn’t disagree more. But let’s follow this logic.

The ideal investment in risk adjusted return land is one with a high return and low volatility. Enter private assets. Industry super funds and other backers of private assets love to talk about idiosyncratic risk and the overall low volatility of the assets.

The reference to idiosyncratic risk simply means that private asset returns are not impacted by anything else happening in markets. Low volatility means that prices don’t bounce around a lot.

For an example of this view I will quote Australian Retirement Trust (“ART”) Head of Investment Strategy Andrew Fisher from an interview with Investor Strategy News:

“When we think about alternative assets or unlisted assets, we think about those as forever assets – which doesn’t mean we’re going to hold them forever, but we don’t ever want to force the teams to sell. We think of them as idiosyncratic opportunities and so we effectively will put an illiquidity risk premium there and then it goes to an idiosyncratic exercise.”

What Andrew is saying is that the value of a private asset isn’t correlated with anything else going on in markets – “idiosyncratic” – but they earn an illiquidity premium over the returns of those very markets. And that is the magic. If you want a higher risk adjusted return this is the perfect asset. The return is higher than if the same asset was publicly traded thanks to the illiquidity premium. Plus the volatility of a portfolio holding private assets is lower because it isn’t correlated with anything else in the portfolio.

You may have guessed that I don’t agree with this at all. Before getting into my argument a quick review of public markets.

What is a public securities market?

A properly functioning securities exchange provides liquidity and price discovery. In other words, you can buy and sell whenever you want and always know the price.

The question is does the cost of a financial asset always equate to the value of that asset. The answer is yes if you believe in the efficient market hypothesis. Most people including me disagree. But if I need to sell something it doesn’t really matter. What I own is worth only what somebody will pay me for it at that time.   

In 1626 Dutch colonist Peter Minuit bought Manhattan for $24 worth of stuff from the Algonquin people. Did $24 represent the value of Manhattan at the time? I’m not sure. But on May 4th 1626 the price of Manhattan was $24 because that is the price that the Dutch and the Algonquins agreed upon.        

The beauty of a publicly traded market is that it isn’t just two parties that agree upon a price. It is lots of people coming together to agree. Some of these people are smart and informed. Some are ignorant. But ultimately it all evens out and the collective view is supposed to be a better representation of value than a one-off agreement. Not perfect. Just the best we have.  

Economist Friedrich Hayek’s body of work explored this topic. He postulated that markets were the most effective way to aggregate prices by bringing together information that is dispersed throughout society. This is the wisdom of crowds.

Yet we also talk about the madness of crowds. That is because as humans we have the tendency to judge historical events by things that happened subsequent to that event. We say the Algonquins got ripped off by the Dutch because we know what became of Manhattan. We say that the price of shares in the depths of the global financial crisis was madness because we know the economy recovered.

At the time the Algonquins probably thought they got a great deal. Or maybe they didn’t think about it at all. They got $24 dollars for a piece of land when they could just head over to what became Brooklyn and hang out there. The people selling shares in the global financial crisis thought there was a real risk that capitalism was on life support. They wanted whatever cash they could get. Things are clearer through the rear-view mirror than the windshield.

Public markets aren’t perfect. As Ben Graham said Mr Market has fits of euphoria and despair. But many people believe they are the best way to figure out the price of something at any given time. You can choose to buy and sell at the current price or you can sit things out. But the price is the price.

Who sets the price for private assets?

Private assets aren’t traded on an exchange. The value of a private asset is generally set by the holder of the asset or somebody they have hired. There are valuation models, valuation committees and independent parties ticking boxes. But ultimately this is a beauty in the eye of the beholder valuation approach. The valuation is reflective of the intent of the holder. Some of the things that ASIC has recently uncovered at industry super funds suggests this process can be significantly improved.  

This is where we start to run into a problem with the industry view of private assets. Because the assets aren’t idiosyncratic. There are publicly traded airports and privately held airports. Walk down any block in the CBD of Sydney and one building will be privately owned by a super fund and one will be owned by a publicly traded real estate investment trust. I could go on. But the point is that the assets are not idiosyncratic. Only the way they are valued is.

The AFR recently recounted the view of UniSuper Chief Investment Officer John Pearce:

“Mr Pearce, who oversees $136 billion of assets, said that public markets did not always provide more accurate valuations, citing the 43 per cent drop in Sydney Airport’s share price during the 2020 pandemic relative to the 11 per cent fall in Adelaide Airport, an unlisted asset.

‘It turns out Adelaide airport was actually closer to fair value than Sydney Airport. It’s not necessarily the case that just because you have price discovery on listed market, it must be right.’ “

Think about this quote. He is saying that public markets are not the best way to value an asset. As proof he is citing a historic valuation with the benefit of the hindsight while ignoring a century of economic theory about the power of markets. What is the best way to value an asset? It goes unsaid but presumably UniSuper’s valuation model.

Whatever valuation approach you think is better there is one thing that is clear. The argument that private assets offer better risk adjusted returns than publicly traded assets can’t possibly be true. In one case price is used to measure the return and volatility of public markets. In the other the price discovery of public markets is declared nonsense and ignored in private valuations of similar assets.

Why valuations matter for super funds

One of the reasons that Dave Swensen was a proponent of private assets is because the Yale endowment could hold an asset forever. Yale University and the endowment are designed to last in perpetuity. It is funded by philanthropic gifts and the endowment owns the funds. This is the definition of permanent capital.

An industry super fund is not permanent capital. Andew Fisher can talk about holding an asset forever, but the industry super fund doesn’t own the asset. The members of the fund do. Yale can periodically value assets and ignore volatility. An industry super fund should not be allowed to.

To understand why we can go back to the different ways to value a private and public airport. If the same quote from John Pearce at UniSuper came from the head of Yale’s endowment I wouldn’t think twice about it. But at a super fund it matters what a private investment is worth every single day.

It mattered what Adelaide Airport would have sold for in March of 2020. Maybe in all the uncertainty of COVID as central banks were desperately trying to keep liquidity in the system by buying every imaginable bond somebody would have paid UniSuper’s valuation for Adelaide Airport. I’m sceptical.

UniSuper's would probably say it never would have sold Adelaide Airport in March of 2020. This is the argument when we hear a holding period is 'forever'. The problem with this argument is that lots of people in March of 2020 bought and sold Adelaide Airport.

Every UniSuper member that withdrew money sold their portion of Adeliade Airport. Every UniSuper member that made a super contribution bought some of Adelaide Airport. The point is that UniSuper does not own Adeliade Airport. The members do. The members are buying and selling these assets every single day. The price has to be right or somebody is getting cheated.

Final thoughts

Sydney Airport has since been taken private. And somebody is likely pontificating on the risk adjusted returns of Sydney Airport right now. This is an insult to common sense. How can the same asset be “riskier” if it is publically owned vs. privately owned? How can the valuation of the same assets be so different?

More and more companies are being taken private. More lending is being done privately. More start-ups are staying private. This isn’t some new world order. It is greed. The fees charged on private assets are significantly higher than public assets.

I don’t think this is some far-reaching conspiracy. It is just easier to believe things when you financially benefit from them. And the same story is rolled out again and again. There is an illiquidity premium that is retained despite the flood of money in private assets. The volatility of private assets is lower because the owners of those assets design valuation methodologies that keep volatility low.

In act 5, scene 4, line 1 of his namesake play Richard III cried "A horse! a horse! My kingdom for a horse!" A dismounted and vulnerable Richard III couldn’t wish away the universal truth that the value of everything is situational. The private asset cheerleaders expect us to ignore this reality and keep paying their fees.

Please share any thoughts or topic suggestions with me at [email protected]  

Get Mark's insights in your inbox

Read more of Mark's articles

Read previous editions of Unconventional wisdom

What I've been eating

If there is a better restaurant in Australia than Fico in Hobart I haven’t been to it. Last weekend was my fourth trip to Fico and each time the meal has been close to perfect. Pictured is a reimagined pasta al pomodoro which was the dish of the day for me. The tortellini were filled with a fresh tomato sauce with garlic and basil placed on a bed of torched bechamel. Too good to describe.  

Fico