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One of the favorite articles that I’ve written over the last couple of years is What’s Your Alpha. If you didn’t have the chance to read the (reworked!) article last week: We are convinced that investors should be realistic about where they can, and where they can’t generate outperformance over the benchmark (i.e. Alpha). If there is an asset class where they feel like they have an edge - fantastic. If they don’t - they are better off with either picking a beta-oriented investment, or simply not investing in that asset class at all.

As I outlined in the article, finding Alpha tends to be a bit of a more personal affair. Generating Alpha through your own investment decisions requires proprietary access and knowledge, for example in an industry in which you built your prior (successful) venture. Alternatively, for an asset class or sector where you see Alpha but are not sure if you can access it yourself, you can also allocate capital to someone who you think can access it - i.e. manager selection, in public and private asset classes. And also a skill in itself.

In this newsletter, we’ve outlined a few times where we think investors can access Alpha. For example, in our recent hedge fund primer (leaning more on Alpha through manager selection), or our recent piece about a little ‘renaissance’ in the search for Alpha in public markets.

But today, it’s not Alpha that we want to talk about. Rather, we want to talk about its less exciting sibling - Beta. Not the outstanding investment, but rather the average one. While it might sound less thrilling than chasing outperformance, you might still be well off, perhaps even better off, than with an Alpha-oriented one.

So where do we think Beta-oriented investing makes sense? And where not? That’s what we’ll address today.

Let’s start with the most prevalent beta-oriented investment - the humble equity ETF or index fund. While many market participants argue for ETFs to be a bad thing (forcing capital into the companies with the highest valuations, diluting shareholder rights because ETF providers participate less in governance, etc.), it cannot be argued against that ETFs have been immensely successful in providing low-cost, but extremely efficient access to public equity markets.

To this regard (as we already did in last week’s article), I want to point to S&P Global’s annual SPIVA study. In their study, S&P measured actively managed funds against their respective benchmarks, comparing what percentage managed to outperform their benchmark over a given timeframe. And as is widely known at this point, the stats speak strongly for using ETFs over active funds: in the US, for example, only ~14-15% of managers managed to outperform their benchmark over a 10-year period. The numbers are even more shocking in Europe, where only 3% (!) of managers outperformed the (admittedly less-frequently used) S&P Europe 350 (tracking the 350 largest companies in developed Europe, including euro-denominated stocks as well as other European countries such as Switzerland or the United Kingdom).

In case it isn’t clear - based on figures like those (and many, many other studies), we find it extremely hard to argue against utilizing index funds in your portfolio. While banks and asset managers like to argue that their US/Europe/global fund is apparently capable of outperforming the index over the long term, our own anecdotal evidence from working with affluent investors and family office supports the SPIVA figures mentioned above - extremely few “broad” managers outperform their benchmark over notable periods, and the few that did mostly did so through what we argued is levered beta or a strong country bet (i.e. an overweight to US and/or tech).

Still, as I also argued recently, there is a bit of a renaissance in active, liquid managers. However, those are not global, generalist managers (that we would find likely to fall into SPIVA’s category of underperforming funds), but rather, extremely specialized funds - focusing on specific sectors, regions, and/or sizes. If that renaissance will go on (especially if private markets, at some point, come more into favor again) remains to be seen. But even if it does, we wouldn’t expect it to justify a broader shift back to active managers, but rather, a more diligent approach to ‘core-satellite’ investing.

Moving on to another liquid asset class - bonds. Here, we can also (partially) point to the SPIVA study, which shows a similar picture of active fixed income (in the US) underperforming their benchmark over long time periods (with one exception in short- to intermediate duration fixed income, for whatever reason). Hence, our preferred instruments here would also be ETFs. (There’s also operational reasons that we think should be considered, such as the substantial bookkeeping effort with managing a portfolio of individual bonds at the level of your German holding GmbH.)

However, bonds tend to be a bit less straightforward than public equity ETFs. In many cases, simply buying one global equity ETF - assuming you can take the risk and volatility -, is not such a bad way to go. Things can be a bit different for broad bond ETFs, as we saw in a most painful fashion to many investors a few years ago: amid 2022’s rise in interest rates, seemingly safe government and investment grade corporate bonds saw their values fall 10%, if not 20%, and many of them remain far from their peak. The culprit, of course, was neither a sudden drop in credit quality nor a question of supply and demand, but rather, one of the key parameters to manage in a bond portfolio - duration, i.e. a bond’s sensitivity to a change in interest rate. (For more insights into the basics of bond investing, check out our recent bond primer.)

Hence, while ETFs tend to be our preferred instrument in many cases, we would encourage investors to think in a bit more detail about what they look to do with their bond allocation. Do they see it as an extremely safe cash replacement? Then a government bond ETF might be the way to go. Do they want a bit of return (and perhaps income), but with limited risk? Investment grade corporate bonds could be an option. Or do you see bonds as another return driver in your portfolio? Take a look at high-yield bonds, emerging markets, and maybe even some niche private credit options. (If we move beyond bonds into the broader asset class of ‘fixed income’, even esoteric investments like music rights might fit into that category.)

The more niche the opportunity, the more potential we see to actually generate (risk-adjusted) Alpha. Beta-oriented investments might be limited, expensive, or might simply not exist at all.

Moving on to the illiquid side of your strategic asset allocation, we have to make one thing clear first: technically, there are no beta-oriented investments in illiquid asset classes such as private equity, venture capital, or hedge funds. There is (at least to my knowledge) no sufficiently established index fund providing broad access to i.e. a private equity benchmark. Hence, all products that I talk about in the following paragraphs technically try to achieve alpha. 

Today, let’s talk about the two alternative asset classes that I am most familiar with - private equity and venture capital. Both asset classes typically benchmark themselves to public equities, with a targeted outperformance over a full fund life cycle of 2-4% over equities p.a. In other words, if equities revert back to their long-term average of 7-8% p.a., a private equity fund typically would target a performance of 9-12% p.a. (Specifically, they’d likely not target a cash-on-cash return but rather an IRR-based return, which might be closer to a ~15-20% target but typically reverts back to the ~10-12% range if adjusted for cash drag, as outlined here.)

But of course, no PE/VC fund would ever call themselves average. As one finance proverb says, “half of managers say they are in the first quartile”, meaning they all try to achieve the best potential performance. Statistically, that is impossible - but you might still be inclined as an investor to try to take a shot at only picking good managers. (As we outlined in The Quantitative Approach to Private Equity a few weeks ago, there’s not so much evidence at how well you can pick well-performing managers, but at least some evidence that it might be possible to at least avoid the bad ones.)

However, this article is not meant to become a deep-dive into manager selection - that was more the point of last week’s article. Instead, we want to consider if there is a reliable way to generate a beta-oriented return (i.e. close to the asset class benchmark) - and at that point, we can assess if we, as the investor, would be happy with this ‘average’ asset class return. We can do this, asset class by asset class.

First, private equity. There are two beta-oriented approaches that we typically see - one, some sort of ‘replication’ of PE’s return factors (also outlined in the aforementioned article), and two, the use of funds of funds. I am highly sceptical of the former, so we will rather focus on the latter, which is also my preferable approach. As discussed in prior articles, we think that the humble fund of funds is a greatly misunderstood vehicle, especially if done right. We personally track various PE FoFs that have achieved stable outperformance relative to their public equity benchmark over many fund generations. However, the emphasis should be on ‘done right’, as many funds of funds are simply bad vehicles - you need to pick the right one. (For more on that topic, read The Case for Funds of Funds.)

Based on my anecdotal experience, a good PE FoF can reliably achieve ‘average’ private equity returns. And at least based on historical data, that can be enough to warrant an investment. Take a look a Cambridge Associates’ US Private Markets Returns:

While the last 12 months (driven by a massive tech/AI rally less represented in your typical PE fund) obviously don’t look so rosy, I like to take a look at the longer periods - i.e. 10 to 20 years. Here, the average private equity fund (measured by Cambridge’s US Private Equity Index) has managed to generate the 2-4% target outperformance per year, exactly in line with what we want a beta-oriented product to achieve. (Before some of our GP friends come at me in the comments - many FoFs actually manage to achieve performance above that average, whether through outstanding manager selection and/or co-investments. But as I mentioned, today is about beta, not alpha.)

There is of course, the question, if 2-4% p.a. is enough for you. Relevant factors, based on our discussions with affluent investors, include:

With that in mind, let’s briefly touch on another private equity investment - venture capital. Here, many of the factors above apply, such as the desired goal (2-4% p.a. excess return over public equities), the way to get a beta-oriented investment (to our preference, again a fund of funds), and the question of sufficiency of the 2-4% excess return (risk-adjusted return being even more of a question at play here).

Most telling to me, however, are the performance figures. Let’s once again look at figures by Cambridge Associates:

As we can see here, the average venture capital fund managed to outperform the MSCI ACWI as a global stock index over 10- and 20-year periods, but to a lesser degree than private equity. Furthermore, Cambridge’s VC index now stands behind the NASDAQ in all time periods, meaning you would’ve been better off, on average, with an NASDAQ ETF with daily liquidity than investing into venture capital funds.

But there is one more important fact here: the figures above are composite averages based on an aggregated data set of all relevant VC funds. And as most investors familiar with the asset class know, VC is not an asset class of averages, but outliers - meaning that few outcomes, whether that’s the companies or the individual funds invest them, greatly influence the asset class’ overall return. In other words, few outstanding funds have likely improved the average performance shown here, with the more relevant figure, the median return, likely standing even lower.

And that makes our question of sufficiency an even more interesting one. If I know that my average/median VC investment has historically underperformed a public tech index like the NASDAQ, am I still willing to invest? Because my outlier returns might just be worth it if I achieve them? Or because I believe that I as the investor have an edge that makes me more likely to generate above-average returns? That is a question you have to answer for yourself - but in my case, it has made me greatly sceptical of venture capital for the ‘average’ investor. I personally invest in venture capital (to the most part) through a fund of funds that has an approach that I deem sufficiently differentiated and thus capable of achieving alpha. Other clients of ours either put in the effort to try to pick outstanding funds, while others simply decide not to play at all. (We regularly help our clients figure out whether VC, PE, or a fund of funds is the right choice for their portfolio - and whether the expected return justifies the effort. Interested? Send us a message.)

There are other alternative asset classes, which we will not cover today. There’s hedge funds, which we covered in our aforementioned hedge fund primer. (To give a short assessment: we also think that a FoF is a great instrument here, because the alternatives accessible directly either aren't worth their fees and/or require minimum tickets well beyond most clients' allocation.) There’s private credit, where we start to see more FoF-like products as well (especially in semi-liquid forms), but which we admittedly have not yet screened in sufficient detail to want to make an assessment here. And there’s real estate, for which I would love to have a tax-efficient, index fund-like solution for our clients, but yet haven’t found one.

In the end, the decision between alpha- and beta-oriented investment is up to you. While last week’s article was perhaps focused more on helping you find your own source of Alpha, today was meant as the opposite - helping you figure out where an ‘average’ return might still be worth the time and effort. And with that in mind, I want to leave you with two pieces of further reading:

One, Simple Investments, Complex Investments, where we talk about one of my favorite examples of (successfully) taking beta-oriented investing to the next level.

And two, A Case for Investment Outsourcing, where we give two examples of extremely savvy family offices actually making the choice for not trying to aggressively generate Alpha. Rather, they understood that sometimes the winning move is to simply be in the market, in the right asset classes - and not to waste time (and beta-oriented return) trying to find the perfect investment.

Wondering where it’s worth finding genuine Alpha - and where you might be better served with a beta-oriented, time-efficient investment? We’ve helped 50+ affluent investors answer that question, covering aspects ranging from asset allocation, to your personal objectives, to the final implementation. We’d be happy to help you as well.