Private Thoughts: Want to Beat the Stock Market? Try Getting Out of the Stock Market

Professionals can gain a significant advantage in the private markets

Private or alternative investments are always an interesting topic because with prudent use of these asset classes, assuming one can invest with top-quartile managers, they can tip the scales in investors’ favour. This is due to what is known in the industry as manager dispersion: the range of possible returns on an investment.

In the public markets, there’s been plenty of study around the fact that 80% of active equity managers, a.k.a. stock pickers, in a typical year underperform a broad equity index after fees, and especially after taxes. In effect, public-equity markets are generally deemed efficient by themselves. Most managers will slightly underweight or overweight the stocks making up a broad market index in an effort to outperform their benchmark. Managers who create concentrated portfolios of typically less than 40 stocks subject themselves to career risk if they underperform the markets for even a moderate period of time. Their investors will usually leave for what appear to be greener pastures before the potential harvest comes. But if managers come across inside information on a company that could lead to a bonanza, they can’t trade on it as that would be considered insider trading. If caught, the profits from the trade would be taken by the authorities and the manager would get jail time. It’s a no-win situation.

Simply put, a significant percentage of any outperformance on the stock markets comes from luck. That’s why the phrase “past performance may not be indicative of future performance” is required by many regulators around the world. John Bogle understood this, which is why he founded Vanguard Group with the intention of tracking broad market indexes by utilizing a low-cost and efficient approach. To say that he succeeded is an understatement, and he’s been credited for creating the first index fund.

All of which brings us back to the private markets. This is where professionals can gain a significant advantage over the marketplace. The private markets are nowhere close to being efficient and that is shown by the incredibly wide dispersion of manager performance. Invest with a bottom-tier third- or fourth-quartile manager here and you would have been significantly better off just buying an index fund. Access managers who are in the top quartile and your portfolio’s outperformance may exceed 10% per year.

Good managers have a skill set that is often repeatable, so they are able to successfully raise enormous amounts of capital from investors, deploy it into great opportunities and, in the case of private real estate, private equity and venture capital, nurture and grow these businesses and then harvest the gains by selling them at the correct moment of the cycle — via a public listing or selling them to a larger private buyer. The ability to execute on this complexity is what separates the wheat from the chaff.

The challenge for investors is to access these best-in-class managers. Top-performing alternative investment managers have extremely high minimum investment thresholds, often exceeding US$10 million, or are closed to new investors. For investors with portfolios worth less than $100 million, it can make sense to use the services of a multi-family office to source, do due diligence and invest in these top managers using lower amounts, typically in the range of $100,000 to $1 million, depending on the relationship the family office has with the manager. In this way, the scales can tip in your favour.

Arthur Salzer is CEO and chief investment officer at Northland Wealth Management.

The original article featured in the Financial Post.