Where Do Returns Come From?

The beginning of 2021 has been nothing short of interesting. So far, we have seen Bitcoin make geniuses out of speculators, and then lose $100 Billion in two days. We have seen a siege on the Capitol, and a new president take over. This is just in the first 21 days (of course there are more, and more to come), but if you look back on what all happened in 2020, its literally unbelievable.

We had wildfires in Australia (you remember that?), President Trump impeached, numerous protests across the nation, a wildly contested presidential election, murder hornets, a massive explosion in Beirut, wildfires along the west coast, and of course the one that still rocks us is the global pandemic led by Covid-19.

My question, if you knew all of that was going to happen on January 1st, what would you have done with your portfolio? Clearly the (global) markets should have been down on a year like that, so its crazy to think that the S&P 500 ended the year with a 16.26% gain on the year.

We can clearly see that trying to time the market looking back is easy but looking forward is impossible. So, I thought it would be helpful to talk about the drivers of returns in both your public investments and your private investments.

In the public markets, there are three real sources of returns; Enterprise Risk, Engineered Risk and Manager Skill.

Enterprise Risk

When we think about Enterprise Risk, we are thinking through the factors that make up the market, i.e., size of company, value over growth, profitability, etc. This allows for evidence-based investing to give you quantifiable evidence for where you would like to place your money. Every investor knows they should diversify, but where? Of course, the line in our industry is that past performance is no guarantee of future results, but research shows that there are areas of the market that have historically outperformed if you can invest for the long term. And certainly, when any investment is made, you should go into that investment with an expected return. This is the type of “risk” that gives us the highest confidence in achieving the expected return long term.

Engineered Risk

Next is what we like to call Engineered Risk. This is an attempt to “boost” returns through tools like options and leverage. As you can imagine, this is often sold as a sophisticated way to increase your returns and reduce your risk…but is it really? Often, there are significant costs associated with these types of investments that can dramatically erode your returns over time. There is also the consideration of how taxes are factored into these types of investments. Traditionally, the only investors who can handle the type of risk associated with these strategies are those with the type of wealth/income that tends to be in the higher tax brackets. If you are not focused on your net returns, you are certainly not maximizing your net worth.

Manager Skill

And finally, is Manager Skill. There is entirely too much research over time that would lead to relying on manager skill to give you confidence that you would consistently achieve higher expected returns. Some of the strategies employed (or sold to the investor) are being overly concentrated in a “hot stock” or area of the market or by trying to select individual securities based on market trends or news that is breaking. Then there is the “strategy” to try and time the market and “trade” based on news or trends or whatever else.

What we know is the data consistently shows this is the absolute least effective way to have consistency in trying to achieve an expected outcome. Turnover costs, managements costs, conflicted advice, you name it, all leads to underperformance over time. The data just does not support managers having the skill to consistently outperform over time, so why on earth would you pay for someone to pretend they have a better understanding to the information that every trader on the planet also has access too?  More importantly, why would you reduce your financial advice to just your stock portfolio.

Now, what we do know, if you are trying to “outperform,” the best and most consistent way to achieve this is on the private market. This should be very intuitive. Access to information is the truest form of alpha generation. The only problem is getting access to that information is typically reserved for a very small group of institutional type of investors. Often what I see is brokers trying to sell the next Private Equity Deal as exclusive access. The reality is that by the time those deals reach the brokers and wire houses, they have been picked over by the institutional investors and you are left with table scraps.

What we also know is historically, after you layer in the costs of private equity, since 2006 there is no edge in private equity performance over the S&P 500. And if you consider the leverage and fund management costs, illiquidity, and tax complexity, I will argue the juice isn’t worth the squeeze! The same can be said for Hedge Funds once you back out the reporting backfill biases and internal management costs/hurdles.

So, where is there opportunity on the private market? One area which most investors are keenly familiar is commercial real estate. I intend to do another blog later completely devoted to sourcing those opportunities, but for now, I will highlight Venture Capital.

The interesting thing about Venture Capital is their truest form of currency is relationships.  I once heard the VC world compared to NCAA D1 Football. In college football, there are roughly 300 D1 teams that technically can compete every year for the national championship. But how many of those teams have a chance to win?  4? 6? The real question is why is it so low? The reason Alabama is probably going to win again next year (and I have no bias) is because they won this year and have for the last several years been a championship contender. If they recruit you, you go there, and they only recruit the best.  Venture Capital is the same way.  

If you have a history of outperforming, you are going to consistently outperform. Why? Because you will be presented with the best deals first. If I invent a new technology, I will most likely try to find the VC firm that has the best track record in my space of strategically adding value to turn my product into the next Peloton…you get the idea. Therefore there is actually persistence in returns in Venture.

What we also know about Venture is they have the absolute highest expected outcome over 5-, 10-, 15-, 20- and 25-year periods of any asset class. But what we also know is only the premier top decile venture managers can outperform over multiple economic periods.  The challenge: Access to these fund managers is nearly impossible as they are oversubscribed by an average of 3x their target raises, partly because they have historically returned 2.6x more in gross realized multiples compared to the average funds in their space. Without relationships that can get you early access to the best of the best, you are wasting your time trying to “win the lottery” on the “deal down the street.” I recently listened in on one of the VC companies we use that said in 2020, they were presented over 500 different opportunities and invested in 8.

DUE DILIGENCE BY EXPERTS IS ESSENTIAL TO HAVE A GOOD EXPERIENCE.

In tying these sources of returns together, my goal is to demystify some of the sales tactics used to manage your money. The reality is the greatest driver of your net worth is your ability to earn, save, minimize taxes, and invest for the long term.

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