Timing the Market and Adding Value Are Not the Same

In a recent study entitled The Risk and Return Characteristics of Institutional Buyout Fund Investments (See below), Dr. Oliver Gottschalg compared performance as measured by IRR versus other performance benchmarks – market returns, PERACS Alpha, and PERACS Rate of Return (a measure that combines market returns and PERACS Alpha) – for the purposes of understanding which benchmarks, when used, more accurately contribute to accurate fund quartile performance classification. In other words, the study was designed, in part, to determine the extent to which funds were classified as top quartile when, in fact, they weren’t.

Dr. Gottschalg determined that the extent of misclassification of quartile assignments was least when using the PERACS Rate of Return, the benchmark that combines the both market returns and PERACS Alpha. “Only” 6.34% of funds were misclassified when using PERACS Rate of Return. This indicates that the majority of differences in classification between IRR and PERACS Alpha are attributable to the fact that the former measures absolute returns, while the latter measures relative returns.

screen-shot-2016-11-30-at-8-35-16-pmThe study also determined that more than half of the funds (59.73%) compared were in a different quartile than originally thought when using Market Returns as the benchmark, indicating that the ability of buyout firms to “time the market” and their ability to add fundamental value were very different and, in fact, not highly correlated.

In short, employing a performance measure that considers performance relative to the public markets provides a more accurate understanding of whether a fund is top quartile or not, because it gives a better understanding of which funds are creating value versus simply timing the market.

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The Risk and Return Characteristics of Institutional Buyout Fund Investments on Scribd

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