Episode 384: Mamdouh Medhat - A Profitability Retrospective, and Private Fund Performance

Episode Summary

Executive Summary: Episode 384 of the Rational Reminder Podcast features Mamdu Medhat, VP and Senior Researcher at Dimensional Fund Advisors, who discusses the profitability premium and its role in explaining quality investing, defensive equity, and value strategies. He also covers research on tilting by country/industry, and presents findings from his paper on private market fund performance, showing that average private fund returns align with style-appropriate public benchmarks after accounting for factors, and that apparent diversification benefits are partly due to return smoothing. The conversation emphasizes using simple, distinct factors (price-to-book and profitability) for efficient portfolio construction and cautions against over-allocating to private assets without understanding their true risk-adjusted returns.

Main Topics: Profitability as the Core of Quality Investing (Priority: 5/5): Profitability subsumes all quality metrics examined (15 total) – they add no alpha beyond simple profitability; it is the key explanatory factor. Quality composites like QMJ and quarterly ROE are noisy versions with mechanical tilts to earnings surprises. Defensive Equity via Profitability and Low Investment (Priority: 4/5): Long-only defensive equity strategies have zero five-factor alphas; they mimic high-profitability, low-investment portfolios. A simple 80/20 portfolio of such stocks plus T-bills outperforms standard defensive strategies. Alternative Value Metrics = Profitability Rotation (Priority: 4/5): 13 alternative value metrics produce no alpha over standard value and profitability; their improvement comes from rotating into profitability, not better value measurement. Price-to-book remains the cleanest valuation measure. Country and Industry Tilts Are Unrewarded (Priority: 3/5): Aggregate country or industry tilts on size, value, profitability yield weak, unreliable spreads and no alpha beyond security-level factors. Industry momentum exists but has high turnover (~400-500%/year). Private Fund Performance Matches Public Benchmarks on Average (Priority: 5/5): Using the Kaplan-Schwar PME, buyouts and VCs outperform the S&P 500 but are in line with small-cap value/growth indices. Private credit matches high-yield; private real estate underperforms REITs. Wide dispersion exists, but similar to public active funds after accounting for survivorship. Return Smoothing Exaggerates Diversification; Post-2007 Correlations Rise (Priority: 4/5): Pre-2007, lack of fair value accounting overstated diversification. After 2007, factors explain 70–80% of private fund returns, though 100% is rejected, implying some (but smaller) diversification benefits. Manager Selection Is Critical but Persistence Is Scarce (Priority: 3/5): There is no evidence of persistence in buyouts, and VC persistence disappeared post-2000. Due diligence on the full investment proposition and continuous monitoring are essential; illiquidity and vintage diversification amplify selection risk.

Key Arguments: Profitability explains all quality metrics tested; none span profitability in reverse, so investors should focus on simple profitability rather than complex composites. Long-only defensive equity strategies offer no alpha beyond a simple combination of high-profitability, low-investment stocks plus T-bills. Alternative value metrics (e.g., EBITDA/EV) are not better value measures; they mechanically add profitability exposure. Price-to-book plus operating profitability cleanly separates the valuation and cash-flow channels. Tilting portfolios by country or industry aggregate characteristics provides no benefit over security-level factor tilts; Dimensional sorts within countries and holds market weights. Average private fund returns match style-appropriate public benchmarks after fees and carry, using the Kaplan-Schwar PME. Pre-2007 return smoothing overstated diversification; post-2007 factor exposures explain most variation. The wide dispersion in private fund returns is similar to that in public active funds when survivorship bias is considered. Manager selection is crucial but persistence is weak; due diligence and continuous monitoring are necessary. Increased demand and democratization of private markets may compress future returns, and illiquidity/manager selection risk make large allocations (e.g., 25-30%) questionable versus the ~10% market weight.

Data Points: Number of quality metrics examined: 15 - 12 academic measures + 1 composite + QMJ (28 signals) + quarterly ROE, all subsumed by profitability. Number of alternative value metrics examined: 13 - None produce alpha above standard value and profitability; improvement comes from rotating into profitability. Half of value's post-2007 underperformance explained by profitability: ~50% - Standard value’s negative correlation to profitability accounted for half of its underperformance since 2007. Private fund count in the study: ~6,000 - Funds spanning vintages from 1980s (VCs, buyouts) and mid-1990s (private credit, real estate). Global investable universe in alternative funds: ~10% - Remainder: ~45% global equities/REITs, ~45% global fixed income. Factor explanatory power for buyouts post-2007: 70-80% - Post-fair-value accounting, buyout returns are largely explained by public market factor exposures. Top/bottom 5% private fund outcomes: Top: 2-3x capital; Bottom: lose ~50% - Wide dispersion; widest in VC, narrowest in private credit.

Pivotal Quotes: "Profitability is, by and large, all you need. If you want to capture this dimension of expected returns, which we have a theoretical underpinning for, and there's lots of evidence for it in the U.S., developed markets outside the US, and emerging markets, then profitability is all you need." — Mamdu Medhat: Explaining that profitability subsumes all quality metrics; investors should focus on profitability rather than complex quality composites. "We present value with the correct benchmarks... on average, you see that buyouts and VCs look like they outperform the S&P 500... but when you calculate that same KSPME relative to a small cap value index or even a small cap growth index that is tilted towards the highly profitable, small cap growth ones, then you tend to see that they on average perform just about in line with that." — Mamdu Medhat: Highlighting that benchmark choice dramatically changes conclusions about private fund performance; average funds do not beat style-appropriate public indices. "You should really have this middle-of-the-road view of private assets. They're neither a fantastic unicorn, but it's not just, you know, complete bogus, all of it. There are some positives and some negatives." — Mamdu Medhat: Advising listeners to avoid extreme views on private markets; recognize both dispersion/illiquidity risks and modest diversification benefits.

Implications: Investors can simplify factor tilts: use price-to-book and operating profitability rather than quality composites or alternative value metrics. For private market allocations, match benchmarks to style (e.g., small-cap value for buyouts) and be cautious of overstated diversification. Manager selection is critical, with weak persistence; consider the ~10% global market weight as a starting point. The democratization of private assets may compress future returns.