Abstract
This paper explores the returns of private funds and the returns of the S&P 500, to ascertain which returns are more favorable for investors for investing. The study will make use of quantitative research methodology in the collection of the required data for use in making comprehensive conclusions on which returns are better. For this reason, a survey would be appropriate in carrying out the research and collecting the required information. Empirical findings have shown that returns from private funds have some edge over the returns of the S&P 500. Despite this, researches in this area are limited, and thus there is a need for more comprehensive research to bring out the varied differences between returns of private funds and returns of the S&P 500.
Introduction
There are several factors that investors have to consider before making any investment decisions. One of these factors is the number of returns to expect from the projected investment capital. As such, it becomes highly important to evaluate investment options that have a high rate of return on invested capital. According to a study carried out by Redhead (2008), investors can consider the profitability of index funds against private equity funds in terms of the returns.
However, most investors are likely to make poor investment decisions in cases whereby they lack the necessary information about various investment opportunities. Over the past decades, a lot of concerns have been raised over the behavior of stock prices, private equity funds, and the Standard and Poor’s 500 stock index often abbreviated as (S&P 500).
There has been a common belief that firms listed in the Standard and Poor’s 500 price index benefit from an increase in stock price that is permanent implying that they enjoy a permanent rise in returns on invested capital. Nevertheless, recent studies show that there is a significant relationship between the event window and the size of a price reversal, whereby a longer event window results in a larger price reversal (Jones 2009). The returns for the S&P 500 are not permanent due to the interplay of financial factors and changes in market conditions.
On the other hand, private funds have become popular in financial and economics literature. Private equity funds have grown significantly over recent years. For example, there was an increase in private equity funds in the US from $5 billion to $300 billion between 1980 and 2004. Even though private equity funds are considered a good example of major classes of financial assets, there is limited literature on how such funds perform in terms of returns. This paper provides a research proposal for the study analyzing the returns of private equity funds and S&P 500, in an attempt to compare the two types of funds in terms of their returns.
Research Question
A research question will be important in the investigation of returns of both the private equity and the S&P 500. As such, the study will use the following research question to help in achieving the study’s objectives: Which is the better investment management strategy between S&P 500 and private equity funds for the investors?
Research Objectives
Based on the research question outlined above, the study will seek to fulfill the following objectives:
- To determine which is more effective for investment between S&P 500 index funds and private equity funds.
- To find out the advantages and disadvantages of private equity funds.
- To find out some of the advantages and disadvantages of S&P 500 index funds
- To examine the returns of investing in either private equity funds or S&P 500 index funds.
Literature Review
The focus of the study will be on the returns of private equity funds and the S&P 500. As such, this section of the paper will provide an in-depth review of related literature on the phenomenon under study to ascertain which of the two is likely to have better returns. To achieve the objectives of the study, various studies will be reviewed. As such, the literature review will be based on key concepts, theoretical research, and empirical studies to critically examine all aspects of private equity funds and S&P 500 index funds.
Private equity funds
Investors of private equity funds carry out their investments via a partnership structure that is limited and whereby the general partner is the concerned private equity firm. In this kind of arrangement, the limited partners are wealthy individuals and institutional investors whose primary responsibility in the provision of capital. In return, the general partner carries out various investments using the committed funds. Often, the limited partnership under the class of private equity funds has a finite life, after which the general partner is required to acquire subsequent commitment funds.
According to Jones (2009), private equity returns can be categorized according to individual investments’ economics in any given company. The volatility of the returns decreases with stages (Shankar 2007). Nevertheless, most private equity deals are affected the macroeconomic conditions as well as the level of competition experienced in the private equity funds industry, and subsequently, affect the level of returns from investments involving private equity funds.
There has been tremendous growth in the private equity sector, especially venture capital over recent years. For example, empirical literature shows that there was less than $10 billion in terms of commitment among investors within the private equity sector in 1991. However, nine years later, over $185 billion were used in private equity funds (Jones 2009).
Such a high increase in the amount committed by investors can be attributed to the availability of abundant information on returns from several private equity funds. Even though private equity funds have a heightened rate of returns, a fact that has increased the popularity of this type of asset class, information on the dynamics of private equity is scarce. This scenario has been heightened by the unavailability of the necessary data because most private equity firms do not disclose their information to the public as in the case with public firms.
Although private investments have low volatility when compared to the public equities, they exhibit high performance. There are various categories of private equity investments and thus can be categorized as public-traded equity investments’ complementary or even as supplementary to other types of investments. The success of private equity investments in the future cannot be evaluated based on past performance (Shankar 2007).
The application of private equity funds as either supplementary or complementary investment brings the possibility of reducing the volatility of the overall investment portfolio by either setting up suitable avenues to maintain or improve returns. As pointed out earlier, the percentage of returns received from any private equity investment is affected by actual circumstances. This is attributed to the fact that the private equity asset class is not homogeneous.
Standard and Poor’s 500 Index funds (S&P 500)
The Standard and Poor’s 500 funds refer to an index that comprises of some of the largest companies in the U.S that are either listed on NASDAQ or the New York Stock Exchange. The eligibility of any company to be in the S&P 500 index is determined by the company’s level of market capitalization. In the U.S, the Standard and Poor’s 500 Index funds are used to measure the level of the equity market in the country. investors in S&P 500 Index funds enjoy the privilege of establishing major allocation in equities since such funds can replicate the performance and operations of benchmark index through investments in constituents of S&P 500 that have equal weights in the market.
The S&P 500 makes use of the passive investment approach. As such, the S&P 500 is passively managed and depends on the conception that the market is efficient and the stock would always operate at a fair price which might reflect all available market information. Therefore, the passive manager would not look into individual firms or securities. According to Hebner (2006), a passive fund manager holds all the bonds and stocks in a specific market and they do not invest by tasking personal judgments or analyzing market forecasts. Thus, an index fund or a large-cap passive fund can hold all 500 stocks in the S&P 500 Index as the manager only makes adjustments to the fund for reflecting changes in the index.
On the other hand, Shankar (2007) stated that very low fees are associated with the S&P 500 as there is no requirement to assess the securities in the index. Thus, the investors make their own decision whether to buy or sell the stocks in a specific market. Moreover, investors would have full information about the bonds or stocks that are contained in an indexed investment. Besides, since the buy and hold style of index fund does not ensure high annual capital gains tax, it is considered tax-efficient for the investors.
Often, the index funds track an index or a target benchmark rather than searching for winners and hence, lower operating costs and lower fees when compared to private equity funds. By tracking an index, it becomes easy to ensure returns are in line with the overall market performance. Despite this, Roth (2010) pointed out that index funds are risky. This is attributed to the fact that the entire market is tracked by the index funds implying that if there is a fall in the overall bond prices or stock then there would be a decline in the index too.
Measure the performance and liquidity
In both the types of managing funds, private equity, and S&P 500, the performance is measured by how much return is received by the investors after a set time. It is studied that as the individual manager seeks to outperform market index then the index is set as a benchmark by the managers so that the investors can earn a higher return. However, if the market is not in favor then it may limit the performance of managers to outcast the market (Redhead, 2008). On the other hand, in the case of the S&P 500 investment, the investors focus on matching the performance of the market to gain an expected future return.
Also, the success rate is calculated which indicates that the amount of actively managed funds that generated returns over those produced by the average passive fund in the same period (Swensen 2009). This helps in measuring the performance of both the funds. According to Hebner (2006), despite mixed performance in recent years, more capital has moved to passively managed funds in 2014-2015 than actively managed funds. In 2015, there was a total of $413.8 billion invested in index funds, which marked withdrawal of $207.3 billion from the mutual funds.
Also, in 2014, passive US equity fund inflows were $166.6 billion. On the other hand, lack of liquidity in the market may not be an issue for the investors as the general partner ensures that there is the effective management of large cash in comparison to the case of index investors (Roth 2010). Additionally, any cash held in terms of bonds can be reinvested, especially in cases when such cash is liquid. In the case of S&P funds, investors are offered passive funds at a low cost to boost their investment.
Comparison between private equity and S&P 500
Dunn (2011) noted that private equity investments aim at selecting securities that would outperform the market, thereby gambling across comparatively few securities. The implication is that the wrong choice of stocks would lead to significant underperformance of the involved firm. On the other hand, passively developed portfolios could be more diversified and would enclose thousands of shares/securities allocated among different investment groups ensuring the generation of more returns with lower volatility.
Swensen (2009) opined that in S&P 500, tracking an index would not be safer for the investor as the funds match the upswing in a bull market and money is lost by the investors in a down cycle as they remain stuck to the index despite taking action to decrease risk. In certain niche markets, where assets are less liquid, it becomes hard to be difficult for investors to buy securities while it is not the same in the case of private equity funds.
Modern Portfolio Theory
The theory presents a notion that risk-averse investors can develop portfolios for maximizing their expected return. Constructing an efficient frontier of optimal portfolios can offer maximum potential expected returns to the investors for a given risk level. Moreover, by using this theory, investors can decide whether private equity funds or S&P 500 would ensure better return with less risk in a particular period. Since the stock markets are efficient, no investor, manager, or analyst can use the information which may allow them to outperform the market of other investors over time. Elton, Gruber, and Goetzmann (2009) asserted that there is a common assumption that investors are rational in making investment decisions. Passive management is more efficient and could provide better returns.
Research Methodology
This section provides details of the techniques to be used in collecting and analyzing the necessary information for the study.
Research Philosophy
Research philosophy can be positivism, realism, interpretivism, or pragmatism.
In this study, the positivist philosophy will be used to determine the link between the private equity funds and the S&P 500 and to know which fund can be most effective for the investors to generate better returns.
Research Approach
A study can use deductive, inductive, or abduction approach in collecting the required information from various sources or even developing new concepts (Bergh & Ketchen 2006). The study will use the deductive approach to develop hypotheses based on existing literature on the study phenomenon.
Strategies
The validity of collected information depends on the research strategies adopted (Kumar 2014). In this study, an archival research strategy would be used to get the opinion of the investors and fund managers and what risks they face when operating investments either through private equity funds or index funds. This strategy is suitable for acquiring valid data for any study.
Data Collection
A mixed-methods design will be used in this study to ensure the collection of both quantitative and qualitative data. Various past studies will be reviewed to obtain the necessary data on the two classes of assets. Thus, credible secondary sources of data such as journals will be used for this study. This will be done through examining trends in the use of private equity funds or index funds to ascertain which investment management fund has shown growth and has been accepted by the investors.
Ethical Consideration
Throughout the study, the ethical code of conduct would be maintained. The participants would be completely informed about the purpose and nature of the study. Also, voluntary participation would be sought. No individual would be pressurized to give their opinion. Additionally, the research would be carried out only for academic purposes and as an original piece of work.
Time Horizons
Table 1: Gantt chart
Resources
The table below highlights the budget for this study.
References
Bergh, D & Ketchen, D 2006, Research Methodology in Strategy and Management. UK: JAI Press.
Dunn, J 2011, Share Investing, China: Wiley.
Elton, E, Gruber, M & Goetzmann, W 2009, Modern Portfolio Theory and Investment Analysis, Delhi: Wiley.
Hebner, M 2006, Index Funds. China: IFA Publishing.
Jones, C 2009, Investments: Analysis and Management, USA: John Wiley & Sons.
Kumar, R 2014, Research Methodology: A Step-by-Step Guide for Beginners, India: Wiley.
Redhead, K 2008, Personal Finance and Investments: A Behavioural Finance Perspective, London: Routledge.
Roth, J 2010, Your Money: The Missing Manual, USA: O’Reilly.
Shankar, S 2007, ‘Active versus passive index management: A performance comparison of the S&P and the Russell Indexes’, Journal of Investing, vol. 16, no. 2, pp. 85-95.
Swensen, D 2009, Pioneering Portfolio Management, New York: Free Press.