“DOES VENTURE MAKE SENSE FOR THE INSTITUTIONAL INVESTOR

2. “Does Venture Make Sense for the Institutional Investor? Part I,” David F. Swensen,

Investing in Venture Capital (ICFA, 1989)

Purpose:

To test the candidate’s ability to compare the strengths and weaknesses of two different but related

asset sub-classes.

LOS: The candidate should be able to

Emerging Stock Markets (Session 7)

• discuss the potential benefits from investing in emerging markets;

• summarize the problems or constraints facing the emerging market investor;

• comment on the historical performance of emerging equity markets;

• discuss the risks involved in investing in emerging markets;

• discuss performance comparisons between indexes of investable securities and indexes of all

securities in emerging markets.

“Does Venture Make Sense for the Institutional Investor? Part I” (Session 11)

• describe the distinguishing characteristics of the private equity asset class;

• determine how the inclusion of private equity might enhance the opportunity set of a multi-asset

portfolio, leading to a more efficient portfolio.

Guideline Answer

A. The potential benefits resulting from overweighting in both emerging market equities and

venture capital include the following:

• Higher Expected Returns. Over certain past time periods, both of these asset classes

experienced favorable returns relative to other asset classes. It is entirely possible that

expected returns for both will be higher than those for other asset classes.

• Low Correlation with Other Asset Classes. Likewise, over certain past periods, both of these

asset classes’ returns had low correlations with other asset classes, resulting in reduced

portfolio risk. Similar low correlations and risk-reduction effects may be forecast for the

future.

• Increased Portfolio Efficiency. If both of these asset classes have higher expected returns

and/or lower expected correlations relative to other asset classes, their inclusion in portfolios

may shift those portfolios to a higher efficient frontier.

B. The potential problems resulting from overweighting in both emerging market equities and

• Illiquidity. Both of these asset classes may have less liquidity than other asset classes. That

is, it may not be possible to sell either at fair value in a short period of time.

• Long Time Horizon Requirement. Both of these asset classes may require investors to adopt

a long time horizon, primarily because of the high volatility each of these asset classes

exhibits.

• High Transaction Costs. Both asset classes are likely to have high transaction costs, in the

form of timing, market impact, opportunity costs, and large bid-ask spreads.

• High Information Costs. Both asset classes are likely to have high information costs,

especially relative to U.S. equities and bonds that feature easy and cheap access to massive

quantities of data.

• Low Expected Returns. Forecast returns for both asset classes may, in fact, be lower than

those for other asset classes, regardless of past return experience.

• High Future Return Volatility. Both asset classes may have high return volatility that is not

offset by prospective low correlation effects, with the net result that portfolio risk may

actually increase as a result of including these asset classes in portfolios.

• Higher Future Correlations, Especially in Down Markets. Even though return correlations

of both asset classes with other asset classes have been low in the past, they may be forecast

to be higher in the future, especially in down markets. The result will be a much lower risk

reduction benefit to the portfolio.

Level III: Question 10

Topic: Ethical and Professional Standards

Minutes: 6

Reading References: