New Private-Equity ETF Has Limits

I don't know if private equity is a mania or a bubble. I don't know if it is inflating, deflating, popping or anything else. But I do know that PowerShares just listed its second private-equity exchange-traded fund, the International Listed Private Equity Portfolio (PFP), and I suspect it suffers from some of the same flaws as the first one.

The difference between PFP and the older PowerShares Listed Private Equity Portfolio (PSP) is that PSP invests in the U.S. and PFP invests overseas, so it captures a slightly different slice of this universe.

I have written a couple of skeptical articles about PSP since it listed. The drawback I see to investing in a variety of private equity firms that specialize in different types of deals is that the individual characteristics of the component companies get blended away. That's going to limit its effectiveness in diversifying your portfolio. And the real appeal of private equity is its low correlation to stocks.

PowerShares does not provide information on PFP's correlation with the S&P 500, but it may be possible to approximate it. The firm does provide back-tested results indicating the ETF has a 0.77 correlation to the MSCI AC World Financials Index, a cap-weighted index dominated by the mega-cap banks. And HSBC (HBC), which can be seen as a proxy for the MSCI World Financial Index, has a 0.75 correlation to the iShares MSCI EAFE Index Fund (EFA), which in turn has a 0.88 correlation to the S&P 500.

These are all fairly high numbers and, while this kind of analysis is far from exact science, I think it suggests PFP is much more highly correlated to the U.S. stocks than people would expect from a true private equity investment.

This does not mean that PFP is without merit. I do believe the fund can add value to a diversified portfolio. That's because, beneath the surface of the private equity theme, it offers access to smaller cap, foreign financial companies.

The fund allocates 76% of assets to the financial sector. It also allocates 17% to industrials, which could be enough to have an impact on the fund, but I don't think the 3% it allocates to both utilities and consumer discretionary stocks will matter very often.

Outperformance, But Not Much Diversification "PFP's Back-tested performance" and source "PowerShares