Finding Enhanced Returns in The Information Age
The twentieth century saw substantial growth in financial companies dedicated to active investment management. During the second half of the century, analysts would directly analyze data obtained either by visiting the companies, from market studies or from regulatory disclosures. Those who had access to more data and had the necessary analytical capabilities could make investment decisions that were ahead of the curve, achieving healthier returns that compensated for their higher fees.
Increased access to information in the internet boom of the 1990s, as well as greater scrutiny by regulators, reduced this competitive advantage and the spread between the best and worst active managers. This is when portfolio indexing, ETFs and passive investments mushroomed. These changes brought an opportunity for investors to substantially reduce portfolio management costs, with little or no reduction in returns.
During the last few years, it has been shown that more than 85% of active managers are not able to consistently beat their benchmarks or referenced index. More importantly, there is evidence that portfolio returns are impacted at least as much by asset allocation and accurate portfolio construction as they are by the selection of specific managers or securities. Considering all this, with little chance to surpass benchmarks after fees that, in many cases, are 10 times higher than their passive counterparts, we must ask ourselves: why do so many investors still entrust their assets to active managers who do not achieve their goals consistently and who put their own economic interests before their clients?
The main problem lies in the business model of most asset managers. Instead of focusing on meeting investors’ goals, such as liquidity, necessary cash flow, investment horizon, risk aversion, etc., most money managers are looking at how much compensation they will obtain by managing their clients’ money.
As mentioned above, historically, the competitive advantage of managers was in having access to information first. Nowadays, in most public markets, that differentiation does not exist. In recent years and in the foreseeable future, the best investment opportunities exist in instruments that are not listed and are typically unavailable to the general public. Currently, the access and ability to analyze these options is one of the greatest differentiators between managers. This has been an advantage for sophisticated investors — such as those with family offices, sovereign wealth funds or endowments — who, because they have longer time horizons and are not subject to short-term performance rankings, have been able to invest differently and in most cases, with much better returns.
If an investor is willing to assume illiquidity and a longer investment period, there are very interesting opportunities in private debt, equity and venture markets, as well as in different niche markets of real estate and infrastructure. I believe in the coming years a combination of illiquid investments and low-cost liquid investments may well offer investors a better chance of achieving higher overall portfolio returns than those exclusively in public markets, along with greater diversification and efficiency, and likely less volatility.
Finally, it’s important to have active engagement when it comes to the appropriate distribution of assets, that is, in the asset allocation. Historically, asset allocation has been the primary driver of a diversified portfolio’s returns, so periodic review and re-allocation are important here.
Above all, it is crucial to have an advisor paid only by the client, who avoids or minimizes conflicts of interest, and whose business model and culture demonstrate a commitment to act in clients’ best interests: in other words, a true fiduciary.