Several months ago, I wrote a blog post about how in today’s hyper-competitive business environment, those who win are only marginally better than their competitors. In this blog I want to describe what that marginal advantage is and how the “winners” in business maintain it.
Prior to the invention of the internet, gathering information was a slower and more manual process. Now it seems we suffer from having too much information, most of which is neither useful nor beneficial. Having access to information is great. But if you’re an investor trying to make an investment decision, you have to be able to determine what information is important and what information can be ignored. For anyone who has ever invested in any type of professionally managed investment fund (mutual fund, private equity fund, venture capital, real estate investment fund, etc.) it’s important to understand how professional money managers use information to (hopefully) produce profitable returns. As such, the two most important questions you should want to know are “what enables this manager to identify outperforming investments?” and “what makes this manager smarter than other managers?” If, say, two managers have access to the same information, how can either manager have an advantage over the other?
According to the Chartered Alternative Investment Analyst Association (CAIA), there are two types of investment managers. The first is an Information Gatherer (or Searcher). An information Gatherer has the ability to access and gather information in a way that creates advantages for them. These managers may not be great at analyzing information, but they have a great range of data they can use to source opportunities from. As a result, they create a moat built on superior information that their competitors do not have.
The second kind of manager is an Information Filterer (or Analyzer). This kind of manager has the ability to extract competitive insights and knowledge from a set of data that its peers are unable to derive. These managers use a commonly-known approach to data evaluation called the mosaic theory. Mosaic Theory is a style of financial research that pieces together public information in a way that allows an investor to “develop insights that others would be unlikely to discover (1).”
Whether a manager is an Investment Gatherer or Filterer isn’t the main point. The key takeaway here is that, according to CAIA, “to have and maintain a competitive investment edge based on information, a fund manager must demonstrate at least one of these competitive advantages.”
For private market fund managers, the potential to generate attractive returns isn’t based solely on an ability to gather or filter information. Private market fund managers must also have an astute ability to network and build relationships in order to uncover opportunities that are not widely available (i.e., it is an inefficient market where information is not evenly distributed). After discovery, private market fund managers seek to add value beyond simply making a financial investment. Value-add activities may include sitting on a board, assisting with recruiting, or providing operational advice (to name a few). The varying degrees of effectiveness in these types of non-financial investment activities are often what separates “average” private market fund managers from the upper-echelon of private market fund managers and forms the crux of a phenomenon in private markets investing called “persistence in performance.” In short, “persistence in performance” in private markets investing suggests that managers that outperform in their current fund are more likely to outperform in their next fund and managers that underperform in their current fund are more likely to repeat that performance in their next fund. If you’re interested in reading more on this topic, click here.
For public market fund managers, it’s different because the assumption is they are investing in a perfectly efficient market, where everyone has access to the same information thereby eliminating any advantages. In some cases, active managers have been scrutinized for the fees they charge because critics say that an investor can produce the same level of returns by simply investing in an index fund (i.e. an unmanaged fund that tracks the stock market). One of the more prominent critics is Warren Buffet. In a 2016 interview with CNBC, Buffet stated that “Active investing as a whole is certain to lead to worse-than-average results.” Warren’s two reasons were 1). Beating the market is hard, even for the pros; 2). and the fees for active management erodes the outperformance (alpha) created by the fund manager (2).
Warren Buffet is a well-respected, proven investor, but is he completely correct? Warren is assuming the public market is perfectly efficient, but in reality, no financial market is perfectly efficient. According to CAIA, “it is more useful to describe markets as displaying varying degrees of informational market efficiency rather than attempting to divide markets into those that are and those that are not informationally efficient. I’ll dive deeper into market efficiency at some point in the future, but if you’re interested to learn more about the varying forms or levels of informational market efficiency, click here.
I’ll summarize this post by saying that the concept of analyzing and piecing together public information doesn’t just apply to fund management, but to all types of businesses. Companies that are able to create informational advantages are for more likely to outperform their peers, whatever the industry.
These days, information is abundant, but it’s what one does with it that matters.
Cheers – KM