Institutional Investing and Inefficient Markets
In the last few weeks, I've been working on the Yale Financial Markets course
available on Open Yale with some other hirsute learners
. We have a good textbook and a good mass market book for the course, but the really valuable stuff we've read have been the selections from other works. One of my favorites has been Stocks for the Long Run
, a good read for Mustachians about how stocks outperform debt over the long term; combined with textbook readings explaining things like who buys mortgages from consumer banks, the course has been really valuable.
But the best thing we've read is a chapter from Pioneering Portfolio Management
, by David Swensen
, manager of the Yale endowment. The chapter is on "alternative asset classes", things that Yale holds in its endowment other than (funds of) stocks and bonds. Yale works and invests some in private equity and venture capital, to name the most important two. Swensen is a cautious supporter of weak-form EMH, which states that most assets are priced pretty efficiently in general. So how does the man beat the market? Well, that's the point of the book.
Swensen includes a fantastic table that's the best question he can think of to measure efficiency or inefficiency of markets: how much better do the "good" managers do than the "bad" managers? (His thought process on that is here
in his lecture for the Yale course; CTRL+F your way to the third use of the word "measure".) Here's the table:
The last two columns on the right are stocks here and abroad. He shows that domestic equities are so efficiently priced that even if skill in picking them can exist, two thirds of annual returns lie within 1.3% of the mean return. To be willing to pay a 1% expense ratio premium for an actively managed mutual fund, then, you have to be pretty damn sure that you can pick someone who's at least a percentage point better at generating returns than an index fund -- and the quartile evidence suggests that 75% of managers aren't. (The number is really probably slightly worse: this is before the trading fees, which are not disclosed as part of your expense.) For real estate (at least real estate available available to institutional investors) and international stocks, the efficiency of the market is not dramatically less: two thirds of managers perform with 2.5% and 2.1% of the median manager, respectively. In other words, it's an investing environment in which for those three classes there is very little or no opportunity for "skill" to give you better returns. The individual investor looking for advice can stop here: active management just does not work for these asset classes--it's not compelling. (Swensen doesn't include bonds, but they are likely priced even more efficiently than stocks.)
As a Mustachian who wanders wide-eyed through the advanced and crazy world of finance, you may be interested in the rest of the story for personal edification. So, how does this affect institutional investors? Swensen says that for these asset classes, there's so little to be gained by "picking right" that they don't even try. Identifying the top quartile hedge funds and venture capital opportunities does much more good than identifying even the top percentile of stocks or real estate. (I'm not enthralled with the idea that one can
pick the best hedge fund or mutual fund manager, of course, but apparently Swensen is able to do it year in and year out; his ability to do so is how Yale's endowment generates outsize returns.) Here's the crux of the issue, though: on a risk-adjusted basis, venture capital and private equity don't outperform the efficiently-priced opportunities in the stock market and commercial real estate investment. The fields are only worth investing in if you're confident that you can pick the best 20% (venture capital) or even 10% (private equity) of opportunities (Swensen explains this more clearly in the text than I do here).
So why invest in inefficiently priced assets at all? Like a local financial planner explained to me in a recent job interview, "We know that mutual funds lost to index funds 80% of the time. We take great pride here in being able to pick the other 20%." But doesn't every financial analyst and small institutional investor think that? In the end, don't 80% of them lose? Aren't Fidelity and Blackrock the only real winners? I think to invest in things like venture capital, institutional investors must fall prey to the same thinking. (And remember, some institutional investors are nonprofit boards of directors and pension funds--not everyone is even gifted with expertise in finance at all!)
In summary, for the institutional investor who can't beat most other institutional investors at picking winning investment options, there's no reason to even venture into private equity, venture capital, and similar sectors of Wall Street. For the institutional or individual investor investing in stocks, real estate, and bonds, the assets are so efficiently priced that nearly no mutual fund manager is capable of earning his fee through his performance.