[This article originally appeared on Forbes]
My friend and business partner, Joe, manages money for a living, so analyzes a lot of prospective investments during any week. As the CIO of a family office, Joe has virtually no constraints on his investment choices – he routinely analyzes everything from real estate to bonds to listed equities to private companies.
Joe asked me the other day what I thought about private equity investments: did the potential big win of a successful early-stage investment offset the risk of investing in a start-up?
Research last year from Bain & Company suggests that in the U.S. at least, returns on private equity firms eventually (over 10- and 20-year timeframes) exceed that of a basket of publicly-traded stocks, but can underperform listed equities, especially over shorter timeframes.
Bain’s finding did not come as a surprise to me because of what I’ve read about an effect known as the low-volatility anomaly. In short, while common wisdom holds that generating high levels of return requires that one has to accept more risk, in actual fact, the opposite is true. Holding a portfolio of low-volatility stocks actually generates higher returns than owning a portfolio of high-volatility ones.
Figure 1. These data come from the 1990-2009 time period, but expanding the time period back 80 years gives roughly the same results.
It’s hard to express just how revolutionary of a finding the low-volatility anomaly is. Thousands of pages have been published in modern finance about the relationship of risk and return, and in fact, all of it is hogwash.
The true relationship between investment risk and return boils down to the old saying from Aesop’s Fables: “Slow and steady wins the race.”
There are a lot of good reasons to believe that this apostasy might be true – billions of them, in fact. Several years ago, a research paper entitled Buffett’s Alpha explored the secret of the Oracle of Omaha’s amazing investing results from a scientific perspective. The conclusion was that Buffett’s success could be boiled down to a combination of two factors:
- Investment in low-volatility stocks, and
- The use of investment leverage
Buffett’s use of investment leverage stems from his ownership of insurance and reinsurance companies. Berkshire’s insurance clients send him premium payments and he “borrows” that money and uses it to invest until one of his clients files a claim. While Buffett calls the insurance premium he invests in the market “float” usually investing using borrowed money is called “leverage.”
When this paper made the rounds through the world of professional investment managers, the reaction was one of disappointment. “My fund can’t buy an entire insurance company, so it’s impossible for me to replicate Buffett’s numbers,” sighed hedge fund managers worldwide.
However, these managers threw in the towel too hastily simply because they were not acquainted with a simple, standard tool of modern finance – the option contract.
Options can be used in levered strategies and while they are not quite as attractive from a leverage perspective as owning your own captive insurance company, when an investor understands how to use them prudently, they are powerful and flexible tools.
So what did I tell to my friend Joe? Private equity can be a successful investment strategy if you undertake it patiently and methodically. For myself, though, I’d rather not be an investing hero and take risks that don’t need to be taken. Instead, I’ll stick to the strategy of using a moderate, prudent amount of investment leverage to buy boring, low-volatility public companies.
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