indexfundfan @ indextown

Powershare’s Listed Private Equity ETF (ticker PSP) started trading on Oct 24, 2006. The trading volume on the first two days were quite reasonable, averaging around 100k shares traded each day. This number certainly looks promising for a newly traded ETF and I am willing to spend some time to investigate further to see if it is a good candidate to add on to my portfolio.

The objective of this ETF is to allow retail investors an easy way to gain access to private equity investments. Private equity investment is considered by many as an “alternative” asset class. I had previously written a post on private equity investments when the SEC filing for PSP ETF was made. Now that the ETF has started trading and its holdings are disclosed, let’s look at it in more detail.

According to this article, which was published before the PSP ETF launch, there are three ways to gain access to private equity investments:

1. Investing in Private Equity Funds: Investors can get exposure to private equity investment through investing in a partnership specializing in private equity. When an investor commits to a private equity fund, the commitment is typically to provide cash to fund on notice from the general partner. Redemptions and transfers usually are subject to strict limitations; it is not uncommon for general partner consent to be required for all transfers/redemptions and for the
   general partner to have complete discretion with respect to granting such consent.
2. Investing in Private Equity Fund of Funds: Investors can also get exposure to private investment through a pooled fund vehicle, fund of private equity funds. The advantages of investing in fund of funds are greater diversification, access to top fund managers, less cash commitment and reduced due diligence work. The drawback of investment in fund of funds is that investors may have to bear two layers of fees, at both fund level and fund of funds level.
3. Directly Investing in Private Companies: The third way available for investors to gain access to private equity investment is direct investment in privately held companies. However, compared with investing through funds it requires more capital (to achieve similar diversification and exposure), a different skill set, more resource and different evaluation techniques. This strategy is only suitable to experienced private equity investors. For most investors, the use of private equity funds or fund of funds would be preferred.

This PSP ETF seems to be variation from the second category (or it can be considered as a fourth category), whereby your money is not used directly by the company for making private investments; rather your money is used to purchased shares of companies that make private equity investments.

This will make the ETF behave somewhat differently from a true private equity investment, as the performance of the ETF will be affected by the way the stock market perceives how the listed company is doing, and could be affected by many other factors such as management changes at the listed company or general economic conditions.

Based on the above, I would therefore say that this ETF can be considered to give some characteristics of private equity investments but it is not a true private equity investment. Investors should therefore keep this in mind when considering this ETF.

Some other factors I looked look at include the following.

Tax efficiency. I expect that this ETF will be fairly tax efficient in terms of not distributing a lot of capital gains distribution since the fund manager can tax-swap to minimize on capital gains distribution. But, a look at the top few holdings suggest that the income dividend distribution could be quite significant. For example, the top holding American Capital Strategies, Ltd. (ACAS) has a 8% yield, most of which are in “unqualified” dividends. “Unqualified” means you have to pay tax at the full income tax rate, not the preferential 15% tax rate. Therefore based on information currently available, I would not think that this ETF will be very tax efficient.

Diversification value. True private equity investments should perform quite differently from general stock and bond investments. The following table shows the correlation of private equity investments with the S&P 500 and the bond market from 1990 to 2005.

However, as this ETF does not actually make private equity investments, rather it invests in listed companies that make private equity investments, I think its diversification value will be diminished. Besides, if you are invested in a total stock market fund, you already have some money invested in the listed companies held by this ETF.

Cost. This ETF has an expense ratio of 0.6%. This expense ratio is reasonable but certainly not cheap when compared to many of the sub-0.2% ETFs.

In conclusion, at this point, I am not convinced that I should add this ETF into my personal portfolio.

Disclosure: At the time of this writing, I do not have a position on PSP.

This entry was posted on Thursday, October 26th, 2006 at 9:42 am and is filed under ETF, Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.