What's your Alpha?

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My unpopular opinion: Direct investments in venture capital is not worth the effort for most family offices.

Why?

First, venture capital is very competitive. Unless you are well connected in your local ecosystem, it is likely that the best deals never cross your table. Adverse selection is real.

Second, many family offices don’t understand the venture capital ‘power law’. They are too focused on downside protection, leading them to miss out on winners due to a lack of risk tolerance.

Third, and perhaps the biggest miscalculation: Even if you can get access to good deals, and structure your portfolio right, the absolute return might not be worth it. Yes, an investment of 100K€ might turn into 1M€ or even 5M€. But if venture is just a tiny allocation (<5% of your overall portfolio), even a good return might not be worth the effort.

So why am I telling you this? Because this way of analyzing venture capital direct investments (admittedly, your view might differ) can, and should, be equally applied to any other asset class that you aim to invest in.

It’s the question of where, and how, you can generate Alpha: Identifying where you as a private investor, family office or even institutional investment firm can generate outsized excess returns on your financial and time investment.

Let me take you through the framework that I used to find my Alpha.

The basics: Beta and Alpha

Before we answer our first question, let’s clarify our key terms. (I am not a finance PhD, so don’t murder me for what might not be an academically accurate definition - it’s how I try to explain the matter. Feel free to correct me about any blatant mistakes.)

First, the Beta: The expected market return of a given market or benchmark. For example, if you invest in public equities, your “equity Beta” return is typically what you would get from a simple market-based investment, such as an index fund. Beta is also a way to measure relative risk - if an investment has a Beta higher than 1, you would expect it to be more volatile than the market benchmark, and vice-versa.

Second, the Alpha: The excess return of an asset over the market Beta. If your market equity benchmark generates a 5% return and an actively managed equity fund generates 7.5%, you could say that their Alpha is 2.5%. However, things are not as simple: Using the aforementioned concept of Beta as a relative risk measure, maybe the equity fund invested in stocks with a relative beta of 1.5, meaning that their outperformance was generated not by active management but rather higher risk. On the other end, if the fund beta was lower than 1.5, there might be the chance that the outperformance resulted from better, “unexplained” stock-picking choices. (There’s also other risk factors such as small-cap, profitability, etc. that can also help explain differences in performance, but that’s beyond the scope of this article.)

Question 1: Is there an opportunity to generate Alpha?

You should consider Alpha and Beta potential for every investment and asset class. Whether you make those investments yourself or entrust a manager with capital to invest on your behalf, you should first analyze whether the given asset class offers a sufficient probability of generating sufficient Alpha. Sufficiency is key in both regards: In every market, you have the mathematical ability to outperform, but if the chance to outperform is slim (sufficient probability), or if the achievable outperformance is not large enough (sufficient Alpha), a Beta-oriented investment might be a better choice.

For example, I think that both sufficiencies are not given is US large-cap public equity, as I analyzed last year in a LinkedIn post based on S&P Dow Jones’ 2022 figures. A first-quartile US large cap manager generated returns of 11.87% p.a. over the 2012-2022 period. This put them approx. 1% ahead of second-quartile managers with a return of 10,91% p.a., compounding to ~25,3% more return over the period. However, only 8,6% of managers actually managed to achieve this result - meaning that if we pick any manager and hope for them to hit that 10-year first-quartile return, our simple probability-weighted outperformance is just 25,3% * 8,6% = 2,2% (compounded, not annualized). Since we don’t hit a first-quartile return in >90% of cases, to me, that is not a risk worth taking - it’s neither sufficiently probable nor sufficient in size.

Question 2: Can I, the investor, generate Alpha?

So you’ve identified (for yourself - views differ after all!) an asset class with a sufficiently probable, and sufficiently large Alpha. The next question to ask is whether you yourself - the investor at hand - can capitalize on that Alpha generation opportunity.

The capacity to generate Alpha exists in many ways. You might have an analytical edge in regards to specific industries or regions, as some value investors or hedge funds have. You might have superior analytical capabilities to act more quickly than other market participants, as is the case for ‘quant funds’ or high-frequency trading firms. In more ‘practical’ industries such as real estate or private equity, your firm might have superior personnel to drive value-creating initiatives.

And depending on the industry, there is a good chance that you don’t have any of those skills required to generate Alpha. For me personally, that industry is real estate: I’ve never been passionate about it, I don’t have the relevant deal flow to outperform (I am not a big fan of working with real estate agents), nor do I have the ability to drive value (I’m literally left-handed, with little sense for what it takes to renovate a building). Do I think that there is alpha in real estate? Definitely - but you wouldn’t want me to be the guy to manage a real estate portfolio for you. Hence, I’ve never been a direct investor in real estate - but I trust my manager selection skills, and hence, have allocated capital to real estate managers in the past.

A more positive, personal example for myself is private equity. If you just achieve average private equity returns, it might not be worth the effort and risk - you can more easily replicate the average return, at lower risk, through a leveraged public equity investment. But things are different if you have access to first- and second-quartile managers, where you can no longer replicate their returns through a leveraged public investment given the outsized leverage required. And while some academics argue that you can’t accurately predict future manager quartiles, you can identify (and thus avoid) fourth-quartile managers, which underperform public equities. 

And as a whole, that makes private equity worth the effort for me: As long as I avoid fourth-quartile managers (which I am convinced I can do through proper sourcing and due diligence), my worst-case return is the public market return (achieved at the level of a third quartile-manager). If I avoid the fourth-quartile and just blindly pick from the first, second and third quartile, I am more likely than not to achieve above-market returns (sufficient probability). And if I pick at least a few first- and second-quartile managers, which I hope is at least statistically given, I can generate substantial Alpha (outperformance of 5%+ p.a. over public equities). 

(For more insights into my views on private equity, check out my recent series, The Quantitative Approach to Private Equity - Part 1 and Part 2.)

This is truly the key question any investor should truthfully ask themselves. As I wrote last week, everyone thinks they can outperform the market - but the numbers show that’s not the case. But luckily, as I explained with real estate, there are levels to accessing Alpha. Even if I will likely never be a first-class real estate investor, I can still generate Alpha in real estate by partnering with first-class managers.

Question 3: Is the Alpha worth the effort?

Finally, let’s move on from the asset-class level to the portfolio level. Let’s say you found an asset class where you think there is potential for Alpha - and you think that you can directly or indirectly (through manager selection) access this Alpha. Should you invest? As with so many things in life, it depends.

As a multi-asset investor at a family office, your opportunity set of investable assets is often very broad, and you’re likely capable of at least accessing asset class Alpha through manager selection. But most and foremost, your time is limited: You only have 24 hours to your day, so you can likely not be a top-quartile investor in every category. Among the different asset classes with Alpha potential, you should quantify both the degree of achievable outperformance, and time investment required to generate this Alpha. Just recently, I spoke with a fellow family officer about the trade-off between private equity fund investments and co-investments. Purely mathematically, co-investments are clearly ahead given less or no fees and carry. But direct investments take much more effort in sourcing, selection and management than a private equity fund, and LPs might face challenges such as adverse selection. The final answer is dependent on the individual, but the required time and effort should be part of getting to the answer.

And of course, this is further complicated by your asset allocation, and the invested capital in each asset class. This takes us back to my initial example around venture capital: I would say that I am an above-average venture capital investor based on the returns that I generated so far, and I love to work with portfolio companies. But that's not enough: Direct venture capital investments is an incredibly time-intensive endeavor, and I often find myself spending time not on the winners, but on the losers that are unlikely to drive returns. A less ideal use of time that could be used to create value elsewhere.

But even if I was just spending time on the winners, the question isn’t settled. Often, venture capital was only a small part of the overall asset allocation. To really drive returns at the portfolio level, and not just in the venture allocation, our venture returns would need to be truly outstanding. Assuming that the Alpha we can generate is not substantial enough to drive portfolio-level returns, we could instead consider increasing the venture allocation - which might not be desired given the associated level of risk and illiquidity. Or it might even reduce our Alpha, as the potential multiples logically decrease with an increased ticket size.

In the case of venture, the logical yet personally unsatisfying answer for me was to not spend more time, or capital, on venture. Yes, returns were decent, but our absolute financial return was higher if I spent my time in other asset classes that offered comparably less Alpha potential but to which we were allocating larger amounts of capital. But while it was personally unsatisfying (I like spending time with innovative start-ups), it was the right one.

And you should keep the same in mind. Especially for affluent individuals, personal passions and preferences often play a disproportionate role in their investment decisions. But you should be mindful of what you know, and what you don’t know. If you don’t have expertise, a Beta-focused investment can be good enough. But likewise, that also frees up your time for areas where you think you can generate Alpha. After all, it’s in those asset classes where you are much more likely to outperform.

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