Can Active Management Benefit Your Portfolio?
Is private market investing naturally passive?
No. That’s important to understand if you are allocating investments into private equity, venture capital, real estate, or private credit for your portfolio.
There is always a debate in public markets, like U.S. equities, over which performs better, active or passive strategies. As an industry, active US equities managers underperformed the US stock market indexes 72% of the time (13 out of past 18 years). However, with 62% of active investment managers outperforming US stocks in 2022 for the first time in 13 years (since 2009), according to data from S&P, there is likely to be more talk about whether we need active management in our portfolios.
The answer lies with the investor, not the investment. Naturally, it depends on your investment time horizon. For anyone with a longer-term investment horizon I would argue the answer remains “no” to active management for US equities.
But could active management play an accretive role elsewhere in your portfolio? I would argue definitively “yes” in your allocations to private markets.
Let’s discuss why active investment strategies make it so difficult to outperform public market indexes consistently over time. Using the S&P as an example, there are at least two structural reasons:
Active managers are not as heavily positioned in U.S. tech giants (FAAMG1) as the U.S. stock index, and FAAMG has massively and consistently outperformed the rest of the index:
FAAMG stocks in the past 10 years have returned +23% while US stocks are returning +9%, according to market data.
Given this, if an active manager used a lower allocation to FAAMG stocks in their portfolio relatively to the US stock index, they would historically consistently underperform, and if you view the technology sector as the fastest growing in the broader economy, likely continue to underperform the index over time.
But there's good reason why so many active managers are underweight -- namely it is difficult for any manager to justify their fees being overweight in just 5 stocks (stocks that make up ~20% of the index).
Data shows it becomes harder and harder for an active manager to outperform the index over time. Data from S&P shows the percentage of active managers underperforming US equities indexes increases over time:
1 year: 55%
5 years: 85%
10 years: 90%
15 years: 89%
20 years: 95%
This data suggests active managers might be able to beat the market in singular years but once we string together a few years it is particularly difficult to be beat, especially once you factor in the higher fees active managers charge.
So, should we simply avoid active strategies for portfolios seeking more alpha? Hardly.
For accredited investors, alpha can be produced in the active management of portfolio allocations to private market investments. Active management strategies for private market investments look different. Since we are dealing with more illiquid alternatives, you don’t have the opportunity to “trade” in and out of funds. After all, that would defeat the purpose of the reduced volatility protection private markets often offer portfolios.
Rather, active strategies come down to how diligent wealth managers are in selecting opportunities for their investors’ portfolios. One option is to identify which private market managers employ their own active strategies in their underlying holdings. Though the investment may look passive because of the reduced liquidity, there could be quite a bit of underlying activity in the funds themselves.
Then there’s access. Having an advisory firm that can get access to the top quartile active managers in any of the core private market asset classes (private equity, venture capital, private credit, and real estate) can make a significant difference in portfolio performance.
Let’s not close the book fully on active investment strategies just because they’ve proven less effective in public markets. Let’s just look at what that activity is investing in and how it can be best used. For accredited investors, I believe alpha can be produced by the active management of portfolio allocations to private market investments and getting access to the top quartile managers.
Reach out to learn more about how Ballast Rock Private Wealth can help you and your family achieve your financial goals with wholistic financial planning, portfolio construction and investment advice, all with a particular focus on identifying and diligencing private market investments.
This material provides general information only and is not intended to provide personalized investment advice. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Past performance does not guarantee future performance. Future returns may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions, and security positions, when sold, may be worth less or more than their original cost. You should always consult a financial, tax, or legal professional familiar with your unique circumstances before making any financial decisions.
