Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. This week’s article comes to you from Swen Lorenz, author of Undervalued-Shares.com and CEO of Sarnia Asset Management. I have been a long-time fan of Swen and his writing - and am honored to have him as our guest author today. Enjoy, and make sure to subscribe to his own newsletter.

Public markets are making a comeback, and so will active investment strategies.

However, picking a manager who can generate alpha in public markets is really
hard.

We have all seen the statistics. Depending on your country of reference, 70 - 93% of active fund managers in public markets underperform their assigned benchmark over 3- and 5-year periods.

How can you make sense of the vast amount of historical statistics about actively
managed funds? Which managers should you trust with active investing in public
markets?

I would like to propose an approach that puts an emphasis on applying common
sense.

Charlie Munger once said: “Never, ever, think about something else when you should be thinking about the power of incentives.”

The statement is a variation of his famous maxim: “Show me the incentive and I'll show you the outcome.”

Buffett and Munger had well over 90% of their net wealth invested in their own entity, which in turn had a fairly concentrated portfolio. They put most of their eggs into one basket and watched that basket very carefully. Investors who used the opportunity to latch on to their work did as well, as we all know.

In fund management and wealth management, not enough emphasis is put on factors that anyone with common sense would ask for.

“Skin in the game” is one such factor.

In 2016, the Financial Times and Morningstar analysed whether the interests of portfolio managers are properly aligned with those of their fund investors.

Even back then, half of the 15,000 mutual funds in the US were run by portfolio managers who had not invested a single dollar of their own money in their products. Among the worst offenders in this regard were famous names like BlackRock and Schroders.

Since then, this situation is likely to have gotten worse.

Who hasn't yet met a fund management professional who admitted in private: “I am hoping this job will get me a share in the performance fee. And if the investments don't work out, I will have received a decent salary.”

Why would anyone back a fund manager that operates on such a basis?

Investing is – ultimately – about underwriting a person (or a team). When investing with a portfolio manager, why isn't more emphasis put on their personal alignment?

The proverbial “skin in the game”, which is primarily seen as the manager investing their own cash, is a subject with its own complexity and nuance. The causality is not necessarily entirely clear amidst the confounding variables. E.g., a large amount of personal investment can also be a sign of dangerous over-confidence.

Also, personal alignment does not necessarily need to consist of a portfolio manager putting cash into their fund. A younger fund manager at a smaller firm may have a more significant career incentive to outperform, as their reputation and future opportunities depend directly on generating superior returns. An established manager who puts a large amount of their own cash into a fund may simply view it as a punt on getting a potentially lucrative, fee-generating new product off the ground.

Still, despite these complexities, the matter of personal alignment is one of incredible importance.

To repeat: “Show me the incentive, and I will tell you the outcome.”

The second common-sense factor that deserves attention is the importance of investing in assets that are not already included in every other widely-held fund. 

Sameness feels safe, but it doesn't usually deliver alpha. 

Just what defines a niche is up to interpretation. For some, it's about being non-consensus and right. For others, it's a formula consisting of “Mastery × Focus × Network”. This formula was first laid out in a book written by Sabrina Paseman and Simon Lancaster: “Unlocking Alpha: The Rise of Niche VC”.

In any case, it's not surprising that alpha tends to be found in under-researched sectors. Europe has 837 stocks that are contained in the MSCI World Small Cap Index, but there are a further 8,100 European stocks that are not contained in a major index. Where do you think the alpha-generating outliers are likely to hide? 

To get exposure to inefficient parts of the market, you need to allocate to fund managers who have a personal knack for finding and pursuing unusual investment ideas. These types of portfolio managers will naturally be more likely to work for emerging managers and boutiques, rather than for a mega size corporation. Purely by way of personality, they wouldn't fit into a more consensus-driven, constrained corporate environment. 

But how does one counterbalance the risk that such a portfolio manager's unusual ideas have you end up with troublesome investments? Refer back to the previous point about the portfolio manager's personal alignment. Is the portfolio manager a salaried employee who is taking a mere crap-shot using client money, or is there true personal alignment because of the fund manager putting his own cash on the line? If he puts a significant percentage of his family money on the line, you'll probably be in as safe a pair of hands as you can get.

Also, to deal with the risk of outlier ideas not always working out (as would be the case with any set of investment ideas), watch out for the fund's size and its degree of agility. A fund that is smaller in size and invests in PUBLIC markets can more easily bail out of a position when their view or external circumstances change. 

Personally, I have long been amazed at the investing public's infatuation with private market investments. Why was the lack of a daily price and the lack of daily liquidity ever seen as a disadvantage? Circumstances change often, and rapidly. Public markets offer the ability sell out of a bad position that isn't working out. Also, starting valuations remain the #1 determinant for long-term performance, and public markets offer pockets of attractive valuations at almost any given time. Why would I not invest in a market that combines lower starting valuations with almost immediate liquidity?

The evidence for decreasing returns as active funds scale in size is pretty robust. There is no fixed rule for judging a fund's size, but research has repeatedly identified $100m as the initial threshold where advantages in agility begin to diminish; $400m as a significant performance deterioration point, and $1bn+ where underperformance compared to smaller funds becomes systemic.

As part of your manager evaluation, you should ask about their commitment to closing a fund at the right fund size. There is an incredible temptation for fund managers to become asset gatherers as soon as the market allows them – everyone who is in this industry naturally would like to manage more money, right? A focus on asset gathering doesn't just make for less agile portfolio sizes but also quite simply distracts from the primary task of generating performance. A portfolio manager who spends lots of time hosting fundraising meetings, doing media interviews or posting on X, inevitably pays less attention to his portfolio. 

Julian Robertson of Tiger Global famously generated outstanding returns on small AuM, but underperformed when he had an amount of AuM that was simply outsized for his strategy. Leaving such high-profile examples aside, there is 25-30 years of industry data to show that emerging managers have a higher chance for outperformance than larger peers. Their agility is a key factor. 

Admittedly, the right kind of fund manager has become harder to find. There are simpler fewer of them nowadays.

Setting up a new fund manager has higher barriers to entry than ever before, and operating a boutique nowadays requires a careful balance between having critical mass to achieve operating efficiencies but not growing to a size where agility suffers. I speak from my own recent experience when I say that being a portfolio manager is tough, but building a fund management company is even tougher!

Still, such portfolio managers and fund management companies do exist, and their outperformance makes them worthwhile to track down. 

Selecting them does not necessarily require you to fall down the deep rabbit hole of academic research about active management, much of which is too theoretical to be of much use in real-world decision-making. Simply check whether a manager's track record, strategy, and references stack up and form a convincing picture. Just like in venture, picking portfolio managers that aim to generate alpha out of public markets is about underwriting a person (or a team). Applying common sense helps in identifying them, and you should combine that with relying on incentives doing their thing in the powerful way that they do. It shouldn't be less than that, but also doesn't need to be much more than that. 

This approach comes with a few soft benefits for fund investors. For example, your emerging manager will probably reply to your WhatsApp messages requesting information. The fund selector expert and family office manager, Harald Berlinicke, once set out in a LinkedIn post why he prefers this type of manager. 

It is not all that difficult to identify the key ingredients for a fund that has a real chance to generate alpha while taking a careful approach to managing risks. Please refer to the points mentioned above, and never hesitate to apply the common sense that allowed you to build the wealth that you currently have. (Alternatively, ask Cape May Wealth Advisors to help you find and evaluate such managers!)

Then, use such funds to surround your benchmark-tracking core with potential structural outperformers that can provide some asymmetric uplift from time to time – while providing you with the ability to bail within a few months, rather than to be stuck for years.

Now is probably a particularly worthwhile time to make an effort in this regard. There is a long list of reasons why over the coming 5-10 years, active managers focused on public markets could do very well. Key factors that play into this are lower valuations (e.g., among UK small and midcaps and among undervalued European tech and healthcare companies) and less research coverage (e.g., as caused by MiFID II). If Jan's observations about a tentative return to active management and public markets prove to be right, then we should see continued flows into the sector.

I am not surprised that private markets have been exposed to have engaged in volatility laundering, circular transactions, and overpromising on liquidity. But let's not dwell on these issues and look towards the future. Some actively managed funds focused on public markets can at least provide a counter-balance for portfolios that have too much exposure to PE and VC in private markets.

About the author: Swen has 30+ years of investing in public markets, and writes about it on his widely-read blog Undervalued-Shares.com. He is currently launching Sarnia Asset Management as a platform for fund managers who fit the criteria described above. You can subscribe to the company's mailing list by visiting their website.