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. Busy day - apologies for hitting your inbox so late today!

For the first time in my career in wealth management, I am seeing a turning point to what previously seemed like an unstoppable trend: affluent investors turning away from private equity and venture capital, and back towards liquid markets in search for Alpha. 

For many years, the investors we work with rarely looked to outperformance in public markets. Active management had been struggling for years, making PE and VC the obvious places to go for Alpha (or at least higher returns in the form of leveraged beta, as some would argue). And for many years, that approach did work out well, particularly during the ‘boom years’ of 2020 and 2021, and the associated exit environment.

But today, things look different. Even I as a cautious believer in private equity will admit that the asset class is not a ‘no-brainer’ investment opportunity right now. Whether it’s continued geopolitical challenges, the risk of disruption by AI, and a generally choppy economic situation, there are many reasons not to invest in private equity (and admittedly other asset classes) right now. And that doesn’t even include the general challenges of building an allocation to illiquid assets, such as finding the right managers, liquidity management, and the time it takes to actually be fully invested.

While most investors choose to simply stay the course, we are starting to have more conversations about liquid Alpha opportunities. It’s a slow return from purely ETF-based portfolios to what market participants like to call the ‘core-satellite’ approach, combining broadly diversified index funds with select, return-oriented active managers. Partially because of the worse perceived opportunity set in PE, but equally because of an investor desire to be contrarian and see if public equities might warrant active management after all.

As with Gold and Hedge Funds recently, we like to use this newsletter as a ‘platform’ to share our views on certain trending topics. Active management in liquid assets is one that we’ve only touched on lightly over the years. So today, let’s talk about core-satellite, why we think it works in theory but not so easily in practice, and what would need to happen for us to revisit our current approach.

—

Imagine your typical 60/40 portfolio, consisting of 60% public equities and 40% bonds. In its most simple form, you might be able to construct such a portfolio from two building blocks, one for equities (i.e. a globally diversified index fund) and one for bonds (i.e. bond ETF replicating a global aggregate index consisting of government and corporate bonds). If you want to be more fancy, you can also break the equity and bond building blocks down further into regional allocations, i.e. for equities, splitting it into allocations for US, Europe, and other regions. (We think there are good reasons to do so, ranging from lowering the fee load in your portfolio to select opportunities in Structural Alpha).

So let’s say a purely benchmarked portfolio isn’t what you are looking for. You believe in active management to a degree, and want to define a modest allocation to active management to have a chance at higher returns relative to the benchmark (i.e. Alpha) and/or lower risk. In other words, you want to complement your ‘core’ portfolio of broadly diversified, beta-oriented investments, with a select number of ‘satellite’ active managers. So with that in mind, how do we get from 60/40 to this core-satellite logic?

In the simplest form, we can stay with that 60/40 split, but consider how we implement those building blocks. Take our equity allocation: If we reference a global index like the MSCI ACWI, we would split our equities regionally into a ~65% allocation to North America, 14-15% to Europe, 7% to APAC, and 10-11% to Emerging Markets. We could also keep those allocations, but finally decide where we think that an index fund is the best option, or where we see potential for an active manager. To give an example of what we typically see:

As so often, in theory, the core-satellite logic makes sense. Allocate most of your capital to index funds so that your long-term average return should not deviate too far from the benchmark. Complement that with a few regional and/or sectoral managers in ‘niche’ areas of the market in which you’d expect them to deliver some modest long-term Alpha, even after fees. And if all goes really well, perhaps paired with some good calls in regards to your overall strategic asset allocation, maybe your portfolio will look like as if you had invested in private equity (i.e. that 2-4% excess return).

But well, the reality can look very different.

Unfortunately, while many wealth managers and private banks follow the core-satellite approach, very few actually manage to achieve what they set out to do, for a number of reasons.

It’s no secret at this point, but active management, no matter what sub-asset class, is really hard. According to S&P’s SPIVA Scorecard, fewer than 25% of equity managers managed to outperform their benchmark over the last 10 years. And that’s in US Small Caps, the equity sub-asset class where active managers actually had the highest percentage of outperformance - in funds benchmarked against the S&P 500, the percentage of managers that outperformed is a stunningly low 6,6%. In bonds, the picture doesn’t look much different. We can argue why these funds underperformed - I would say fees are too high, paired with ‘benchmark hugging’; investors who believe in active management might argue that market cap-weighted benchmarks simply distort the picture. In the end, it doesn’t matter, the odds are just somewhat against active management.

But let’s naively leave that fact aside. Let’s assume that we are able, with a sufficient probability, to pick active managers that can generate some degree of outperformance across the cycle. In that case, core-satellite (or maybe even 100% satellite?!) might be the way to go - but some challenges remain.

Starting with the big question of how to implement those satellites. There are typically two ways of how we see this done in action, and unsurprisingly, both approaches have their challenges.

First, the logic as outlined above, i.e. staying somewhat close (or entirely in-line) with a global benchmark like FTSE All-World or MSCI ACWI, but replacing some of the regional exposure with select active managers. Here, we face the first challenge, which is the question of how much active exposure we should replace.

A client of ours recently sent us a number of specialized active managers to review, and despite our scepticism around active management did actually end up liking one of his picks - a small-cap specialist focused on a single European country. However, that region only made up a few percentage points of their equity allocation, which in return was only one part of their asset allocation. Even if they wanted to allocate all of that country weight to that manager, the allocation would’ve made up less than 1% of their portfolio, meaning that even if that fund outperformed in a reasonable fashion (i.e. 2-4% of Alpha per year after fees), the contribution at the overall portfolio level would be negligible. (If you're wondering whether your current active managers or Vermögensverwaltungsmandat are actually moving the needle at the portfolio level, that's exactly the kind of question we work through in our Vermögenskonzept. Reach out.)

We see this approach to core-satellite investing quite frequently in the portfolios of private banks: something that looks active and thought through, but likely has no meaningful impact on a client’s overall portfolio - or if you are somewhat involved in your portfolio yourself, likely just costs you time and effort but likely will generate marginal benefit over simply going 100% passive and just investing that time elsewhere. Or, as Andrew Spence of Aspen appropriately called it on LinkedIn last year - it’s like moving the deck chairs around on the Titanic.

Alternatively, you can just deviate from that benchmark. Rather than finding yourself limited by only being able to invest <1% of your portfolio into a niche manager you like, you can decide to be over- or underweight in certain regions or sectors, or even decide to be fully benchmark-agnostic, instead aiming for an absolute return. Once again, there are some challenges to that. 

As we outlined, picking the right active managers is not easy, and doesn’t get easier either if you’re now also the person to make active macro bets. For example, by now having to decide which country/region/sector is the right one to pick right now. In my personal view, simply opting for managers to make those active bets for you is even tougher - if there is one form of active management that I really don’t believe in, it’s global, fully unconstrained (equity) managers. (As I like to say it - just some middle-aged white man who turns on their Bloomberg every morning in their home office, deciding what markets they find interesting today. In my view, not a formula for success, sadly.)

But let’s assume that despite this even bigger, even more unconstrained opportunity set, you are somehow capable of picking the right managers. Now things should work out after all, no? Well, maybe, they just might. Maybe you will pick those outperforming managers. But outperformance can come in many shapes and forms, and it isn’t always the ideal kind: it could be outperformance but still negative performance, which often happens in specialized managers focusing on a country or a sector (or maybe even both). Or it could be outperformance against your sub-asset class but underperformance against your asset class benchmark, as we saw in recent years in certain styles (i.e. value vs. growth or small-cap vs. large-cap).

Which brings us from the question of how we implement the core-satellite logic, to how we deal with this implementation in the day-to-day. In my view, this might (perhaps once again naively!) be the even bigger challenge than picking the right managers: it’s how you deal with the ups and downs of a portfolio of active managers. That includes the constant review of their performance and performance attribution (i.e. which sector/region/stock picks contributed positively or negatively to performance), and more importantly, the decision on when to stick with a manager despite bad (or sometimes also good) performance. In my personal experience, the time investment required here shouldn’t be underestimated - even if things are going reasonably well, expect to spend a couple of hours of every quarter on auditing performance. Time that, for our clients, is almost always better spent elsewhere.

If anything, it’s the time investment required to maybe achieve outperformance that makes the core-satellite approach the most difficult for me to accept in practice. Perhaps like any somewhat skilled investor, I assume that somehow I can pick outperforming managers even though the probabilities are not in my favor. But in the end, I don’t do it in practice - because even if things go right, the margin of outperformance is simply not worth it relative to the effort I have to put in. If I do want to achieve performance in excess of long-term equity returns, I would personally lean towards (levered) beta - such as a private equity fund of funds, or simply a well-diversified, leveraged portfolio of liquid assets.

I will admit - this article does generally give a somewhat negative view of the core-satellite approach. If anything, it sounds like some of the worst fee-based advisers (Honorarberater) out there who simply opt for as little as one multi-asset fund, and just categorically refuse to even engage with any form of active management because some paper told them so. That’s certainly not the type of advisor that I want to be.

So what would it take for me to be more bullish on core-satellite, or more precisely, on active management? I think it’s two things:

One, actually seeing long-term success stories of investors who did well with active management. Most of the track records (esp. those shown by banks and ‘retail’ asset managers) tend to actually make me more sceptical of asset management - while their performance might’ve been good in the earlier part of the 2000s, recent years paint a clear picture of active management struggling, despite those aforementioned different market environments. And if you sell me a fund based on its ITD return despite the fact that the last five years were a disaster, you’re not doing a great job of convincing me.

But at least based on some of the podcasts I listen to, there seem to be some larger institutional managers (think family offices, endowment, pension funds), who have done well with active management, and thus continue to redeploy money there. What do their portfolios look like? What type of managers do they invest in, and how do those differ from the “retail” active funds that we’ve seen in action? If you have some insight, I would love to know.

Two, and perhaps most importantly, I would like to see more managers that my readers think are worth looking into. In recent weeks, a few clients have asked us for liquid, alpha-oriented investment opportunities - think your typical actively managed equities fund, but also hedge funds. While Markus has a great network in the latter asset class, the number of active equity funds that we would generally find intriguing is somewhat limited. So once again, if there are active managers out there that in your view have a clear edge, I would love to learn about them. (And if you are a client or prospective client who’s thinking about opportunities to generate higher returns today without active management, don’t hesitate to get in touch.)

I will admit - in the end, this might not matter for most of our clients, anyways. They’ll add another zero to their net worth not by choosing between private equity or an active equity fund, but rather by making the right bets in their ‘Aspirational Bucket’. But nevertheless, any basis point counts, and just as we are focused on finding Structural Alpha, I would also consider adding some actual, old-fashioned stock picking Alpha if I can find a product that passes our high bar.

I look forward to revisiting this topic next year - hopefully with some more insights.

Over the last three years, we’ve prepared personalized wealth concepts for 60+ affluent individuals and family offices. We’d be happy to help you as well, outlining individual ‘quick wins’, areas of improvements, or blind spots that you might’ve missed. Reach out for a first call with me: