THE History of GameStop income short sellers front page of the global financial press. The Reddit mob’s “Main Street takes revenge on Wall Street” narrative cast these short sellers as the villains of the financial markets. It also created enough consensus buying pressure to reduce their positions to margin calls and realized losses.
But my focus here isn’t GameStop’s story. Rather, it is about the need for both short positions and representative, investable benchmarks for private market investments.
Cash is king.
I confess that at the beginning of my career, I considered naked short positions to be a noisy and disturbing component of the market. But I was convinced that the market would discover the fair value and that fair value would become the transaction price.
Trained as a long-time investor, I had in mind the notions of quantitative fixed income, equilibrium economics and efficient pricing models, and when I was plunged head first into the fundamental analysis of stocks in corporate finance and public market investing, I was fascinated by stock stories and entrepreneurial narratives. At that time, I naively believed that pure speculative short positions, those that sought to profit from a company’s misfortunes, had some – yes, let’s face it – unethical components.
Later, the stock markets taught me how to invest in real life and I soon realized the important and courageous role that shorts play. Value is a target, an expectation, the result of the best possible judgment process. But the price you pay or receive in actual transactions is the only objective element that matters. Cash settled transaction is king. The rest is opinion.
Short sellers are a serious breed of investors. They borrow stocks and sell them out of conviction. In a reasonable time horizon, they believe that the price they have to pay to close their position will cover the costs and produce the targeted profit. Belief is the key. The ability to withstand the passage of time, to wait, is the critical execution variable. You don’t think something is a good investment on its own or in relative terms a good hedge against another investment – the long-short case – and can fund the trade, then you sell it. Full stop.
Talking is cheap.
What does short selling have to do with indices? If indices are investable, investors have the ability to buy and sell an asset class. This implies that the indices are representative of the asset class or the sub-allocation within it. This means that going long or short on an index creates a natural hedge to complement or create a well-diversified portfolio.
This, of course, applies not only to bullish or bearish macro long-short situations, but also to any tactical adjustments to existing asset allocations.
What makes an index investable and representative? According to accepted theory, a representative benchmark must meet seven requirements, including investment capacity. He must be :
- Specified in advance, before the start of the evaluation period.
- Appropriate, consistent with investors’ investment style.
- Measurable and easily calculated on a reasonably frequent basis.
- Unambiguous, so that the identities and weights of its constituents are clearly defined.
- Reflects current investment views.
- Belonging, in order to offer adequate accountability.
- Investable: in other words, it is possible to hold either the benchmark index or its constituents.
The practice of the financial markets and the regulations of the European Union (Reference regulation, EU 2016/1011) further state that the notion of financial benchmarks requires a specific regulatory regime for indices that are used to determine the amount to be paid or the value of a financial instrument, or to define an asset allocation or to measure performance fees.
Beyond these borders, the notion of benchmarking loses its gravity. All other products that are simplistically defined benchmarks should be reclassified as metrics for peer group comparisons because they lack the required formal elements of a valid benchmark definition. If an investor cannot consistently use the relative value indications of a benchmark, that index does not meet utility requirements and is merely a post-mortem exercise. Talking is cheap.
Private equity (PE) is the perfect example of an asset class for which all currently used benchmark definitions should be reclassified. These are metrics for peer group comparisons and relative value analysis ratios. There is no valid benchmark for the unlisted equity industry, none that provides an unambiguous performance assessment or provides adequate market risk management of investment portfolios.
For these reasons, PE feedback discussions are more like arguments between football fans than precise performance evaluation exercises. And I’m not just talking about future performance expectations, which are, by design, subjective and based on assumptions. I mean past and current returns, which should be ex post notions that leave no room for ambiguity or subjectivity. And yet they do.
Why is assessing the performance of an industry with trillions in assets under management (AUM) still so elusive? Industry metrics point to large margins of absolute return and outperformance, while academic studies produce conflicting evidence. None of the metrics currently in use accurately calculate average industry performance.
I propose an objective solution. Anyone discussing the outperformance or underperformance of the unlisted private equity asset class, or subsectors thereof, should align their financial interest with their judgment and eat their own cookies. Would they buy or sell their “benchmark” determinations? Would their benchmarks be tradable? Money talks, after all.
I advocate the construction of benchmarks that truly represent the physical allocation to unlisted private funds and that respect the underlying theory and comply with regulatory requirements. The only objective criterion that should guide such an exercise is the short trade challenge I propose. If an investor is long the physical constituents of the index – unlisted private equity funds – and short the index, the resulting net position should be zero or reasonably close to it, depending on the accuracy of the hedging position match and the costs associated with holding individual constituents of the index.
I don’t see such an instrument available on the market today. This is a gap that needs to be filled.
In whose interest?
The development trend of the industry is clear. It points to democratization. This involves the concept of product suitability.
It is in the interest of general partners and investors to anchor private equity return expectations on metrics that any class of investor can understand and verify. Benchmarks should provide this reference price in the market. These benchmarks have historically contributed to significant market growth in the asset class they are meant to represent.
They could do the same for private equity. That is why it is in everyone’s interest that they be created.
If you liked this article, don’t forget to subscribe to the Enterprising investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / primeimages
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and report professional learning (PL) credits earned, including content on Enterprising investor. Members can easily register credits using their HGV tracker online.