Product and Strategy Notes: Lifecycle Funds, Private Equity Mutual Funds and Sector/Style Rotation Watch

Lifecycle Funds

Recent months have seen the introduction, particularly in the United States, of a large number of age-based funds. These have appeared in both the retirement and college savings markets, and include offerings by many big players (e.g., Vanguard, Fidelity, T. Rowe Price). In essence, the value proposition of these funds is "tell us the year you want to achieve your goal, and leave the asset allocation to us." In practice, they all operate the same way, moving from a higher risk/higher return asset allocation to a lower risk/lower return asset allocation as their target date approaches.

For example, if you invest in the Vanguard 2045 Target Retirement Fund (VTIVX), your investment will be allocated as follows: 72% to Vanguard's Total (U.S.) Stock Market Index Fund, 13% to its Europe Stock Market Index Fund, 5% to its Pacific Stock Market Index Fund (in other words, 18% to the EAFE index), and 10% to its Total (U.S.) Bond Market Index Fund. Over time, this allocation becomes more conservative. For example, if you invest in the 2015 Target Retirement Fund (VTXVX), 40% of your investment would be allocated to the Total (U.S.) Stock Market Index Fund, 7% to the Europe Index Fund, 3% to the Pacific Index Fund, and 50% to the Total (U.S.) Bond Market Index Fund.

A number of readers have written to ask what we think of these funds. Based on the principle that you should always say something nice first, we like the fact that the Vanguard products use low cost index funds to execute their strategy. However, we also have a few not-so-nice things to say about these products. First, from our perspective they use too few asset classes. In addition to the four they use (U.S. equity, U.S. investment grade bonds, foreign developed markets equity, and U.S. real return bonds in their 2005 fund), why not include foreign currency bonds, commercial property, commodities and emerging markets equity? Doing so would enable investors to achieve an even better risk/return trade-off.

Second, we believe the basic premise of these funds is flawed. As we have repeatedly tried to show in our writing, your asset allocation should be based on much more information than just the date by which you want to achieve a certain goal. The size of the goal, the amount of initial capital, the expected amount of future savings, and multiple risk parameters (e.g., trading off the probability of losing money versus the probability of achieving your goal) also contribute to the minimum required rate of return you need to earn, and therefore to the appropriate asset allocation strategy.

Third, the theory behind the funds implies that investors should place all their assets in them. Doing otherwise would result in the actual asset allocation in the investor's portfolio being different from the one in the fund. Yet the evidence suggests that very few investors have put all their assets in a lifecycle fund. Apparently, the "trust us" pitch isn't working too well.

Finally, because the asset allocation in these funds changes as a function of time (rather than as a function of a reassessment of the multiple factors noted above), it is unclear from their marketing materials what long term rate of return an investor should expect to earn on them. Being curious types, we ran some simulations to explore this issue. We assumed that we wanted to achieve our goal by 2025. We therefore assumed an investment in the Vanguard 2025 Fund. We further assumed that the asset allocation of this fund would change to that of the 2015 fund in year 11, and again change to the allocation used by the 2005 fund in year 18 (35% U.S. equity, 50% U.S. bonds, 15% U.S. real return bonds). For our asset class return assumptions, we used a weighted 67%/33% mix of our historical U.S. real returns (based on the 1/71 to 12/02 period) and 33% our forward looking assumptions (all of this is from our 2003 asset allocation review). Our correlation assumptions were based on the 1994-2003 period.

Based on 10,000 simulations (that is, 10,000 different possible outcomes for 20 years of individual asset class returns), here is what we found. Our investment in the 2025 fund had an expected compound annual real return of 5.1%. The probability that it would not lose any money -- that is, that we would at least get our initial investment back -- was greater than 99%. The probability that we would earn a compound annual real return greater than or equal to 3% was 86%; greater than 5% was 51%; and greater than 7% was 15%. So, to relate this to our model portfolios, what we have here is something that unfavorably compares to our 3% target real return portfolio.

So, does all this mean we are dead-set against lifecycle funds? Not necessarily. There is one circumstance where we strongly support them. Research has also shown the bulk of many investors' retirement savings is in their defined contribution plan (e.g., personal pensions, superannuation funds, 401k or 403b funds, etc., depending on the country where you live). Research has also shown that a large number of participants in defined contribution pension plans chose the default asset allocation option, which usually includes a high percentage of fixed income investments. We think that these investors would greatly benefit if (1) the default option was a lifecycle fund, (2) that used a broad mix of asset classes, and (3) implemented its strategy using index funds.

Private Equity Mutual Funds

Over the last two months, many private equity firms in the United States have announced plans to launch publicly available closed end mutual funds that will enable individual investors to invest in this asset class. What is one to make of these offerings by the likes of KKR, Blackstone, Gleacher, Apollo and Evercore and others?

Let's start with their basic business. The proposed public offerings are coming from leveraged buyout funds, which typically provide equity and large amounts of debt to purchase either private companies or divisions of public companies. These funds earn their profits when the companies they buy are either taken public (via an initial public equity offering) or sold to an operating company (known as a "trade sale"). The managers of these buyout funds typically charge investors annual fees equal to two percent of the assets under management, plus twenty percent of the profits they make.

So why are these funds -- which have historically been available only to wealthy investors and institutions -- all suddenly launching funds aimed at individual investors? Let me count the reasons. First, while the funds raised from wealthy individuals and institutions come with a time limit, the money made available via the closed end mutual funds will live forever (assuming it is not depleted by investment losses and fees paid to the managers). Second, the economics of the buyout business are changing, and not in a good way. While the profitability of the early deals done in the 1980s by the likes of KKR and Forstmann Little are legendary, in recent years the number of funds and the amount of money they manage has dramatically grown. To some extent, the downward pressure on fund returns created by this increase in supply was cushioned by falling interest rates, which expanded the universe of possible deals that could be done. However, with interest rates now rising, those days are over. So what can a good buyout fund manager with an apartment on Park Avenue and a house in the Hamptons do to keep the good times rolling? Lock in funds and lower the cost of equity to be used in buyout deals. And how to do that? By raising funds from individual investors, whose required rate of return is probably lower (due to lack of information and/or perceived scarcity value) than that demanded by more sophisticated wealthy and institutional investors. Voila: a rush of public offerings from previously exclusive private equity firms.

So what returns from an investment in one of these offerings might an individual investor reasonably expect to earn? Historically, a major problem in evaluating the relative attractiveness of private equity as an asset class has been the lack of available and reliable data on its risk and returns. The essence of the problem is that the actual return earned on an investment in a private equity fund isn't known with certainty until the fund is liquidated, usually after ten years. Before then, estimated returns are based on the valuation of the fund's investments (often by its own managers), which is at best a very uncertain science. Two of the most recent studies in this area have overcome this limitation. The results of the first study ("The Cash Flow, Return, and Risk Characteristics of Private Equity, by Ljungquist and Richardson) are based on the actual cash flow data for a sample of 54 buyout and 19 venture capital funds that were raised and liquidated between 1981 and 2001. The study contains a number of very interesting findings:

• The funds' investments were not well diversified. On average, they invested close to forty percent of their capital in a single industry.
  
  
• The average private equity fund generated annual returns above those on the domestic equity market (net of fees paid to the fund's managers) of between five and eight percent.
  
  
• However, the average return fails to tell the whole story. The returns on the sample of funds had significant negative skewness, with many funds underperforming the domestic equity benchmark, while just a few delivered returns well above it. In short, manager selection is a critical component of successful investing in the private equity asset class.
  
  
• The returns earned on most funds did not turn positive until the very end of a fund's life (most were liquidated, and their profits returned to investors, after ten years).
  
  
• In essence, the private equity returns earned above those on domestic equity reflected compensation for holding an illiquid investment for ten years, as well as the risk associated with picking a poor investment manager.
  
  
• In general, the more money that was raised by private equity funds in any given year (known as the "vintage year" of the fund), the lower the returns earned by private equity funds started that year.
  
  

The second study is "Private Equity Performance" by Kaplan and Schoar. It is based on results for a sample of 746 buyout and venture funds provided by Venture Economics, an industry magazine. The sample covers 1980 to 2001 and includes funds which were largely liquidated, and whose performance can therefore be more accurately calculated. Venture capital funds represent 78% of the sample, while buyout funds comprise 22%. It is important to note an important limitation of this data: fund reporting to Venture Economics is voluntary, and roughly half the funds raised do not provide results. However, the funds that report tend to be larger than average, and therefore represent more than half the capital committed to private equity funds. They find that both the average and the median buyout fund underperformed (on a size weighted basis) the S&P 500 during the period they analyzed on a net-returns to the fund investor basis. Moreover, these results are not adjusted for differences in risk. If the buyout funds were riskier than the S&P 500 Index, their relative underperformance would have been worse. A separate paper, "The Price of Diversifiable Risk in Venture Capital and Private Equity" by Jones and Rhodes-Kropf, find that indeed, this is the case: private equity funds have higher estimated returns volatility than the S&P 500. Finally, the Kaplan and Schoar paper notes the spread between the returns earned by the worst and best performing buyout funds is quite large: funds at the 25th percentile earned only 72% as much as the cumulative return on the S&P 500, while those at the 75th percentile earned 103% of its return.

Based all of these considerations, we are not at this time going to add private equity (or, more accurately, closed end mutual funds that invest in buyout deals) to our model portfolios. Instead, we will wait until more performance data becomes available (hopefully the existence of public funds will lead to the creation of a better index) before taking any action.

Sector and Style Rotation Watch

A while back we published a table which described a number of classic style and sector rotation strategies that attempt to generate above index returns by correctly forecasting turning points in the economy. The basic logic is that you earn high returns by investing today in the styles and sectors that will perform best in the next stage of the economic cycle. We published the table to make an important point: there is nothing unique about the various rotation strategies we described, which are widely known by many investors. Rather, whatever active management returns (also known as "alpha") they are able to generate is directly related to how accurately (and consistently) one can forecast the turning points in the economic cycle. Our larger point was, and is, that consistently getting this right is beyond the skills of most investors. In other words, most of us are better off getting our asset allocations right, and implementing them via index funds rather than trying to earn alpha by timing the ups and downs of different sub-segments of the U.S. equity and debt markets.

That being said, we continue to be surprised by the interest our table continues to generate (based on the number of emails we receive about it). For that reason, we have updated it by including the year-to-date returns for funds which correspond to the different styles and sectors:

| Global Aging and Asset Class Returns | Model Portfolio Update | This Month's Letter to the Editor: Tilts to Small Value Stocks in US - Which Funds? | Product and Strategy Notes: Lifecycle Funds, Private Equity Mutual Funds and Sector/Style Rotation Watch | Global Asset Class Returns | Equity Market Valuation Update |