Study Suggests Private Equity Should be a Consideration in TDFs

Results of a study published by Neuberger Berman research partner the Defined Contribution Alternatives Association (DCALTA), in collaboration with the Institute for Private Capital (IPC), suggest that including private equity funds in defined contribution (DC) plan portfolios both improves performance and has diversification benefits that lower overall portfolio risk.

Researchers examined the impact of including private investment funds into diversified (e.g., balanced and target-date fund) portfolios that otherwise hold only public stocks and bonds. The analysis utilizes a comprehensive sample of 2,515 U.S. private equity funds to create simulated portfolios for 1987 to 2017 that invested part of their overall equity allocation in these funds.

They considered portfolios with just buyout funds, in which private equity firms buy companies using a little bit of their own money, and a lot of borrowed money; just venture capital (VC) funds, in which private equity firms usually invest in minority stakes in startup companies, often in high-growth sectors like Internet and consumer technology, bio-tech and healthcare technology, and energy; and a combination of buyout and venture capital funds by investing in 10 randomly sampled funds per vintage in each case. For the combination of buyout and VC the 10 funds are drawn randomly from the universe of funds in each vintage, so allocations vary (on average) with the mix of new funds.

The first portfolio is a base case benchmark comprised of only public market assets, i.e. stocks and bonds. The researchers consider two allocation rules: 4% per year, which leads to significant under-allocation, and an “over-allocation” that results in approximately a 20% target for private funds on average.

Results show buyout funds improve overall return (by 64bps to 86 bps per year) but yield a much higher risk-adjusted return. Specifically, the adjusted annual standard deviations fall from 10.39% in the base case to 9.47% and 9.22%, respectively, with the buyout fund allocations. These results suggest that diversification benefits may be as large as return benefits. Overall, the adjusted Sharpe ratios for the portfolios that include buyout funds are notably higher (0.67 and 0.72) than for the base case (0.55).

The researchers found that allocating to VC funds yields larger excess returns over the all-public benchmark (9.68% and 9.89%, respectively). However, the allocation to VC funds also results in less diversification benefit. Specifically, both the 4% allocation and the over-allocation portfolios with VC result in an increase in adjusted risk to 12.52% and 12.99%, respectively. Consequently, allocating to only VC results in more modest improvements in adjusted Sharpe ratios.

Results from including both buyout and VC funds in the diversified portfolio fall between those for buyout only and VC only. Returns are higher than the all-public benchmark and adjusted standard deviation is about the same as the all-public benchmark. The adjusted Sharpe ratios are higher than for the all-public benchmark, but inferior to the portfolios with only buyout funds. “These results suggest that on a risk-adjusted basis the largest benefits are obtained from the portfolios with just buyouts,” the research paper says.

Factoring in increased fees

The researchers note that the costs associated with managing alternative investments are often higher because of the need to build and manage relationships with fund managers and the additional burden of sourcing private investment opportunities. They estimate these effects by simulating additional costs incurred by the private fund portfolio. Specifically, they consider two cases: an additional 25 bps or 50 bps on the capital allocated to private funds. The results show that the diversified portfolio returns are dampened slightly by fees (as expected) but continue to outperform the all-public benchmark portfolio. The results for returns indicate that by introducing an additional fee of 25 bps, the overall mean portfolio return declines by 5 basis points. Given the fees represent roughly a constant shift down in returns, the standard deviation and other higher-order moments of the distributions hardly change.

Portfolio variations over time

The researchers sought to understand the properties of a portfolio strategy that provides an investor exposure to more private funds early in the investment lifecycle but then shifts to increasingly lower-risk and more liquid assets over time. In particular, they simulate the impact of including private market funds into target-date funds (TDFs) that typically have a defined change in asset allocation over several decades.

The analysis found average returns of the TDF portfolio are higher than for the all-public benchmark and the calibrated portfolio outperforms in 82% of the 1,000 simulations. The adjusted standard deviation falls considerably from 9.89% to 8.50%, suggesting that the diversification benefits from adding buyout funds remain substantial. This fall in risk drives the Sharpe ratio up for the calibrated portfolio so that in 100% of simulations, it is higher than for the all-public benchmark. “This is the first evidence we are aware of that an investor can invest their portfolios with private market funds and achieve substantial diversification benefits while at the same time manage dynamic allocation targets within reasonable bounds,” the paper says.

The research paper not only illustrates potential return characteristics and diversification benefits, but also offers allocation strategies to guide investment decision making. The paper, entitled “Why Defined Contribution Plans Need Private Investments,” is here.