Does Human Capital Still Add Value in Investing?
Usually at the beginning of every year, market pundits feel compelled by journalistic necessity to publish articles predicting the resurgence of active management (see recent articles in BARRON’S and Forbes). For those unfamiliar with the financial jargon, “active management” is just one way to describe the conventional approach to investment management. This conventional approach is built on the premise that stock and bond prices are consistently and predictably mispriced, and professional investment managers can take advantage of this mispricing through their own human capital – that unique blend of education, experience, and insight that creates value – and build a thriving business doing so. Since the 1960’s, many investment firms have built incredibly profitable businesses using this approach.
Deep down, I think many of us and nearly every newly minted investment analyst or portfolio manager wants this to be true, especially for him or herself. I know I did. After all, the investment profession is exciting, intellectually challenging, and can be financially rewarding. Unfortunately, the robots or rather big data is coming for us too. And that’s actually a good thing.
To appreciate the uphill battle these conventional managers are now facing, you must understand the history of capital markets and – at least going back to the 1960’s – how technology has changed the structure and efficiency of investment markets and how fast the change is occurring. In 2017, we have access to more information and data, literally at our fingertips, than ever before. Computing power is exponentially higher than just 10 years ago. New information is reported and reflected in security prices nearly instantaneously. Recently, Charley Ellis, wrote a fantastic piece in the Financial Times, “The end of active investing?” that articulates how publicly traded stock and bond markets have evolved since the 1960’s and how the speed of change is accelerating. Some examples include:
- “Trading volume on the New York Stock Exchange has increased 500 times – from 3 million shares a day to 1.5 billion shares (while trading in derivatives has gone from zero to now exceed the entire stock market in value).
- The number of investment professionals engaged in trading has exploded from 5,000 to over 1 million.
- The number of Chartered Financial Analysts is up from zero to 135,000, with another 200,000 studying for the exams.
- 320,000 Bloomberg terminals, the internet, email, etc. ensure that all professional investors have immediate instant access to information, analysis, and insight.”
In short, Charley Ellis argues that “institutional investors have collectively created a global expert information network that produces the world’s largest, most effective prediction market.” At a faster pace than ever before, today, publicly traded stock, bond, and derivative markets are defined by:
- Far more and better educated investment professionals and trading technicians;
- Universal access to new information which enables immediate price discovery;
- Low transactions costs enabling more efficient trading volume;
- Trading decisions increasingly driven by big data computing power;
- Inability of professional investors to sustain a performance edge over their competition; and
- Ability to earn a fair return as compensation for assuming diversifiable risks.
Because public capital markets are now so efficient, the human capital associated with stock picking has been all but squeezed out. The old, conventional approach to active management that relied on star fund managers to generate consistent outperformance has created a very profitable but over-capitalized industry. The result is that higher fees associated with the conventional approach to fund management now create a greater frictional cost than an added benefit. S&P Capital has been documenting the consistently poor, relative performance of conventional active managers in its semi-annual SPIVA Scorecard report for over 15 years now.
While this fact is painful for those being displaced by big data, as at BlackRock recently, this development is actually a good thing. Why? Because it nudges people toward a more productive use of their own human capital. It forces them to look at ways that they can add value for their clients instead of taking out more value than this over-capitalized marketplace allows them to add.
The reality of public capital markets is that once a company is sold to the public via an initial public offering (“IPO”), the value has already been largely created. The entrepreneur has designed the product, acquired the initial funding to jumpstart the business or bootstrapped it, grown it to a profitable scale, cashed out, dropped the mic, and walked into the sunset. What remains to be done by public market participants is to monitor the ongoing performance of the business, provide accountability to the management team with good corporate governance, and set a fair price for the stock so that it generates a fair return. Conventional active management is largely in the business of price setting in hopes of generating an above average return. Computers and big data analytics can now do this at a fraction of the frictional cost of active managers who now only achieve below market returns on average.
At BMSS Wesson Wealth Solutions, from the beginning, one of our philosophies has been that we would take an Evidence-Based Investing (“EBI”) approach to public capital markets. In contrast to the conventional approach to active management, Evidence-Based Investing gains insights about capital markets and the dimensions of returns from academic research. It recognizes that public markets work remarkably well over time to deliver a fair return to investors for the capital they risk, but the activities of “market timing” or “stock-picking” are unlikely to add value. So instead of developing and deploying our human capital into these costly activities with diminishing returns, we focus on:
- Helping investors align their needs, goals and values with their investments through an appropriate asset allocation, and
- Educating investors on how to reduce frictional costs in their portfolios through low cost, institutional quality strategies, removing emotions from the investment process, and tax optimization.
As a firm, we invest deeply in a different type of human capital – the multi-disciplinary integration of investing, risk management, tax planning, estate planning, asset protection and business planning. We believe our ability to help clients see the big picture, provide an informed design for their entire wealth strategy, and deliver insights for better decision making will provide compelling value.
What about private capital markets, though? Increasingly, investors are looking beyond public capital markets to investments in private equity, private debt, and direct real estate. We’ve fielded more and more questions, such as, “Is this particular opportunity a good investment? What’s the right mix of public and private investments in my portfolio? This fund looks promising, but how does it compare to other opportunities? How could all of this go wrong?”
The reality is that successfully investing outside of publicly traded markets requires a very different approach. Private capital markets are defined by:
- Unequal and incomplete access to information
- High transaction costs and low liquidity
- Concentration risk due to a limited ability to diversify
- Far more idiosyncratic risks that can lead to significant capital losses
- Higher search and management costs
- Higher potential returns for exceptional human capital
- Rewarding opportunities for effective social and family impact
Investing in private equity or direct real estate is fundamentally an investment in human capital. In the most basic example, a solo entrepreneur leverages his time, talent, and personal wealth to create value for his clients. Other examples could be a real estate developer who can deploy his personal capital into a multi-family apartment development, an individual investor who can provide bridge financing for a small business’ working capital needs, or a private wealth advisor who provides his clients access to investments in the development and marketing of a new movie. In each case, the investor is unable to rely on the efficiency of markets to provide himself or herself with a fair return on capital. Instead, he is leveraging his own or another group’s human capital to create value that the marketplace will ultimately recognize and reward, or not.
Now, a needed caveat. Everyone knows that developing your own human capital takes years of education, experience, successes, and failures to cultivate. But, discerning the value of others’ human capital is equally difficult. Many investment firms specialize in capturing the returns of human capital for investors through private equity funds. Be aware that these investment firms may often fully capture the value of their own human capital via the significant fees they charge. The end investor is often left with little more than the returns of public capital markets with nothing to show for the added risk.
In evaluating private investments, here are a few principles we have shared with clients:
- Calibrate the size of the investment with the knowledge that wealth is built and lost through concentration but preserved through diversification.
- There is no one-size-fits-all breakdown of how much you should invest in public or private markets. Many investors should have none of their financial wealth invested in private ventures. For ultra-wealthy investors with enormous access to talented human capital, most of their wealth probably should be invested in private markets.
- The more layers of separation (and fees) there are between you and the source of human capital, the less likely you are to benefit from its fruits.
- When thinking about your own financial and human capital, differentiate what wealth you need for sustaining your current lifestyle needs and what is excess. Create buckets to invest your wealth for preservation goals (lifetime income needs) and aspirational goals (family and social impact).
In summary, technology is rapidly changing the value proposition for investment advisors. Creative destruction is upending the conventional fund management industry. Owning up to this not-so-new reality is a necessary first step for wealth advisory firms today if they are going to deliver the value their clients trust them to provide. Doing so will enable these firms to begin redirecting misallocated human capital toward developing a more thoughtful, comprehensive planning model and a simpler, more skeptical investment process that’s capable of adding real value for their clients.