When asked why he robbed banks, Willie Sutton replied, “because that’s where the money is.”
Similarly, private funds are attractive to high net worth investors because they carry the potential for outsized returns – that’s where the money is. Several factors explain this potential. Among them: the inefficiency and the illiquidity of private markets.
But private funds also carry outsized risks. And, it’s not just the Madoffs of the world that bear watching; plain old incompetence can also bring down a private fund.
The most important reality about private funds is that, as a prospective investor, you are at a distinct disadvantage in being able to assess the risk. Not only does the fund manager have much more information than you about his own fund, but even the information they do disclosure is often insufficient.
Consider, for example, the Sharpe Ratio, a statistic intended to summarize a fund’s risk-return profile in one easy number. Hedge funds and other private funds universally cite this statistic in their marketing materials, with a high Sharpe suggesting that the fund delivers good performance relative to its risk. Sounds great. It turns out, though, that the Sharpe Ratio, despite its popularity, can be highly misleading.
Sophisticated investors understand this. David Swensen, for example, the manager of the Yale endowment, is on record saying that he doesn’t bother with Sharpe Ratios because it is apples-to-oranges to compare publicly-traded stocks to private funds holding illiquid investments, such as real estate, that aren’t priced every day. Illiquid investments have inherently lower price volatility simply because they are only re-appraised sporadically. This is neither good nor bad; it is simply a reality inherent in these types of investments that the Sharpe Ratio would be incapable of detecting.
Indeed, even the inventor of the Sharpe Ratio himself is skeptical of how it is used by clever marketers. In a 2005 interview, William Sharpe said that his ratio was being “misued” by hedge funds. “Hedge funds can manipulate the ratio to misrepresent their performance.” One reason, he said, was that “[p]ast average experience may be a terrible predictor of future performance.” Sharpe warned that, “I could think of a way to have an infinite Sharpe Ratio” and concluded by saying that “no number can” help investors fully understand a fund’s potential risk.
Integral Capital provides a case in point. In 2001 the venerable Art Institute of Chicago became smitten with the 32-year-old founder of this hedge fund and his impressive sales pitch. Integral funds, he claimed, had never had a losing month and had the highest Sharpe Ratio in the industry. The museum ultimately invested $43 million into two Integral funds. As Sharpe warned, however, the museum didn’t fully understand the funds’ risks, and their investments quickly turned into a disaster. After suffering losses of more than $20 million, the Art Institute sued, accusing Integral of improprieties in how it allocated fund assets. Tellingly, the fund’s attorney responded that the fund, “could have bet on the Super Bowl if he wanted” with clients’ money.” In other words, Integral may have lost money, but it didn’t technically do anything wrong. Cold comfort.
Alternative measures are no better. For example, Frank Sortino, the creator of the Sortino Ratio, a close cousin of the Sharpe, is also uneasy that his ratio is used by hedge funds for marketing purposes. “I think it’s used too much because it makes hedge funds look good,” says. “It’s misleading to say the least…I hate that they’re using my name.”
If you put money into a private fund, you need to recognize that it is, by definition a black box. The insiders will always understand it better than you. As a result, no matter how many years of terrific performance a fund may demonstrate, you cannot know whether any given fund will succumb to the fate of an Integral. To be sure, private funds offer tremendous potential, but an extra dose of due diligence never hurts.