MATTHEW FEARGRIEVE: Vanguard- bringing Private Equity to the Masses?

Matthew Feargrieve

Readers of this blog will be aware that Vanguard, the USD5trillion-plus mutual fund operator, announced last week its JV with HarbourVest, the USD45billion private equity house. Both partners in this mega-venture are behemoths of the asset management industry, and the tie-up seems to herald a new era of innovation and disruption in the mutual fund sector, not just the closed-ended space hitherto occupied by traditional private equity funds.

We have been told that the joint offering will initially be made available to institutional investors, notably pension funds. But the real allure of the proposition being tabled by HarbourVest and Vanguard lies in the latter’s status not simply as the senior partner in the JV but as a mainstay of the passive investment world. So when @CityWire reports Vanguard’s CEO Tim Buckley as saying things like “private equity will complement our leading index and actively-managed funds, as we seek to broaden access to this asset class [for] individual investors“, we naturally sit up and listen.

It can be no coincidence that this venture comes at a time of record underperformance (should that “continuing” underperformance? Or “record continuing” underperformance?) for so-called “active” mutual funds. You know, the kind of funds that charge a minimum of 1%, excluding broker fees and transactional costs, ostensibly to outperform the market but that in reality are confined to using long-only techniques and are legally prohibited from using true leverage, and so ultimately track the index or, very often, under-perform it.

In this climate of diminishing returns for investors seeking alpha (or even just reasonable returns) in actively-managed, long-only funds, a great amount of pressure has come to bear on the managers of this type of retail product. Take Neil Woodford, who overcame the inhibitive effect of UCITS liquidity rules simply by ignoring them, making significant allocations to small-cap and unlisted companies that were well outside the received universe of stocks available to the conventional active manager, only to come to grief when two things came to pass: (1) institutional investors invoking the daily liquidity afforded (or supposed to be afforded) by UCITS funds, and (2) the wisdom of his unlisted investments proving to be fundamentally lacking, many of them turning out to be (at worse) a shot-to-nothing or (at best) a long-term bet that was hopelessly — and ruinously, for his investors — incompatible with the supposed daily liquidity of the UCITS regime.

And yet at the heart of the collapse of Woodford’s funds was arguably (very arguably, perhaps) his need to source investments outside the much-plundered universe routinely accessed by his peer group, a need driven and, who knows, encouraged by his institutional investors. True alpha has for some time been impossible to find in the long-only space, particularly during a sustained US bull market. Institutional and retail investors alike are questioning the sanity of paying upwards of 1% per year (excluding costs) to a so-called “active” manager who does nothing but place long-only bets in rising markets on mid- to large- cap stocks. Are investors in active, long-only funds getting enough bang for their buck?

Since the financial crisis of 2008, buy-and-hold has been a central part in the strategy of many hedge funds. Many were found to be invested in hopelessly illiquid positions, which had to be sidepocketed and managed as discrete investments requiring discrete investment strategies. The expertise of hedge fund managers in managing private equity-style investments has accordingly been built up for more than a decade. The “alternative” investment space of yesteryear has embraced buy-and-hold and has made a success of it.

Investors these days have in essence three investment choices: true alternative (hedge); private equity; and long-only (retail/mutual). Given its historic underperformance and the fees it charges, the “active” retail space is in sore need of disruption. This is the need that Vanguard has very successfully satisfied with its index funds. Now it seeks to expand its value proposition by moving into buy-and-hold mode.

In the aftermath of the closure of the Woodford funds, some commentators have asked whether the daily liquidity required by the UCITS model should be subjected to some sort of qualification. Our view is that a viable alternative to the inhibitions of the UCITS model and, looking ahead, the model of choice for Vanguard’s “retail private equity” offering may be found in the UK in the non-UCITS (NURs) regime. These illiquid or semi-liquid investment funds have traditionally mainly been used for real estate portfolios, but the regulatory framework is capable of revision and expansion to accommodate investors with the appetite and risk tolerance for some — deliberate — illiquidity in a fund’s portfolio, and who understands the liquidity profile of his shares, which may be redeemable monthly or quarterly, as opposed to daily.

Had the NURs model been sufficiently evolved in this regard from the version that was available to Neil Woodford at the time when he had his illiquid investments in mind, the fund product duly structured and sold to investors would have been a lot better suited to his investment style and strategy. In this sense, then, the UK’s investment fund regime, and its legal and regulatory parameters, have failed both Woodford and his investors.

It will be interesting to see when Vanguard rolls out its private equity products to retail investors, first (presumably) in the US and then here in the UK, and what legal form those funds will take in the UK. A greater source of fascination will be the competitive effect that the availability of such products, enjoying as they will the whole support and promotion of the vast Vanguard machine, will have on the universe of active funds structured as UCITS and currently available to retail investors.

Matthew Feargrieve is an investment funds consultant. You can read more of his blogs here:

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