Become a Private Equity Star in Seconds

07/08/2011 8:30 am EST

Focus: ETFS

Nicholas Vardy

Editor, Oxford Wealth Accelerator

It’s important for investors not to get too carried away with recent gains in the market, and exercise caution when choosing sectors to invest in, notes Nicholas Vardy of The Alpha Investor Letter.

US markets opened last week with two consecutive days of strong gains. Asian markets rose as well, but with less conviction.

The S&P 500 and NASDAQ indexes both bounced up off of their 200-day moving averages. The S&P 500 Index has not closed under the 200-day moving average since September 2010. A clear move above or below this level can have a significant effect on the market's future direction.

Several indicators continue to show markets as “oversold," and due for a bounce. The question: is this bounce sustainable?

Most of the bad news spooking markets over the past seven weeks persists. Chinese inflation has remained stubborn, and the words “China” and “bubble” are now appearing together in the media like never before. The Greece situation does seem to be mitigating a bit, but a long-term resolution is still years away.

Yet the markets seem to be shaking off all of this bad news. From a market-sentiment standpoint, this is a bullish sign.

Second-quarter earnings season is due to begin soon, and this will certainly have an effect on the market’s future. However, expect a weaker, more directionless market as we head into the “Dog Days of Summer.”

Although recent, strong upward movements may make some investors feel at ease with the markets, caution is still the order of the day. Market movement is currently range-bound, and it likely will be several more weeks before a defined direction emerges. It is certainly too early to become bullish.

One of the best choices now is a well-diversified ETF in a sector that is well-funded and doing well in this environment: private equity.

Tom Wolfe popularized the phrase “Master of the Universe” in his 1987 book Bonfire of the Vanities. Wolfe’s phrase referred to the Wall Street elite of the 1980s, who at that time were making their millions as bond traders on Wall Street.

Well, in the intervening 20 years, many “Masters of the Universe” on Wall Street have migrated to the mysterious world of private-equity funds. And my pick invests alongside this new group of market mavens through the PowerShares Listed Private Equity (PSP) exchange traded fund.

First, let’s start by defining “private equity.” Private equity is essentially the equivalent of “private investment.” It is an asset class consisting of equity securities (stocks) in companies that are not publicly traded on a stock exchange.

So, if you have a stake in a local restaurant as an investor—or if you have private investors in your own company—you are involved in the world of “private equity.”

Private-equity firms do not make their money by guessing price movements of various assets. Instead, they earn their keep by huddling, late at night, in boardrooms across the world, negotiating investments and restructuring privately held companies.

Private-equity funds then reap their gains by “exiting” these labor-intensive investments—often through a sale to another investor, or an initial public offering (IPO) on a stock exchange. In the meantime, private-equity firms also take their pound of flesh, by charging hefty advisory fees to whoever has deep enough pockets to pay.

Spurred by cheap money and financing during the past two decades, the very best private-equity firms have been remarkably successful. In fact, large allocations to private equity have been a key reason for the strong performance of the Harvard and Yale university endowments since the mid-1980s.

Early in its short history, PSP had focused solely on US companies by tracking the Red Rocks Capital Listed Private Equity Index, a purely US domestic benchmark. But in October of 2009, PSP switched to tracking the Global Listed Private Equity Index, thereby confirming that private equity had become a global phenomenon.

Today, PSP still maintains a 38.42% allocation in US-listed companies. But its largest allocations outside the United States include the United Kingdom, France, and Sweden.

Another unheralded advantage of PSP is its remarkable diversification. Although PSP invests in approximately 60 companies, these constituents in turn have investments in more than 1,000 firms. That means that PSP is diversified across a huge number of countries, as well as sectors.

Because each of these component holdings has interests in dozens (if not hundreds) of additional companies, PSP is significantly more diversified, in terms of both underlying holdings and industries covered, than investing in just 60 firms would indicate.

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