Over time, there have been considerable changes in the makeup of institutional investment portfolios as those institutions have moved beyond typical stock and bond portfolios and introduced alternative assets such as private equity, venture capital, private credit and hedge funds. The reality is that traditional stock and bond portfolios no longer allow institutions to meet their investment return targets. As the chart above illustrates, active long-only U.S. equity and bond funds are more likely to have tight return distributions than alternative asset strategies, and as a result, a traditional stock and bond investment portfolio is likely to result in performance that falls short of expectations, even if the portfolio consists solely of top-quartile performers. Additionally, while investing in alternative assets can increase returns, it also increases the range of potential outcomes (there are no guarantees that taking more risk automatically increases returns).
There are many reasons for the difference in return distributions between traditional and alternative assets, but perhaps the biggest is that traditional stock or bond funds often manage to passive, investible benchmarks. Because most long-only managers do not wish to underperform their benchmarks, their after-fee performance tends to closely track that of their benchmarks, and thus their relative performance versus their peer group. Conversely, the universe of private companies is much larger than the universe of public companies, and because passive indexes that track the performance of a portfolio of private companies are not feasible, they tend to have much greater dispersion than their liquid investment strategy brethren.
What that means for investors who wish to invest in alternative assets, especially those who do not try to time when to commit to certain strategies, is that manager selection is the factor that determines the ultimate performance outcome within this part of the portfolio. In these strategies, if you’re able to consistently choose top quartile private money managers, you can earn pretty nice returns on your capital. If you get it wrong, however, performance is much more pedestrian – and can lag the performance of active long-only equity and bond funds.
Unfortunately, the solution is not easy. The effort involved in evaluating an alternative investment opportunity is significant and requires a different set of analytical tools versus what is required to analyze a traditional investment opportunity. Comprehensive diligence is particularly critical for alternative assets, where the spread between the best and worst-performing managers is substantially wider than in other asset classes, making manager selection a paramount issue. Further, because many managers and/or strategies need to limit the amount of capital in order to continue to generate outsized returns, access to the best managers is often limited.
David Swensen, former CIO of the Yale Endowment summed it up best in his 2012 endowment update: “Selecting top managers in private markets leads to much greater reward than identifying top managers in public markets. On the other hand, poor private manager selection can lead to extremely disappointing results as a consequence of high fees, poor performance, and illiquid positions.”1 When it comes to alternative investing, barring tactical commitments, manager selection is the most impactful tool in an allocator’s toolbox. Strong due diligence and access to the best managers can result in thousands of basis points of outperformance versus category averages. Nothing is a given, but take the time, put in the effort, and build relationships with strong general partners, and you should increase your chances of producing strong portfolio returns. Enjoy the holiday season and have a safe and healthy new year!
1Source: Yale Endowment: 2012 The Yale Endowment; 9/27/12
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