Disentangling alpha from beta
The manager selection conundrum ?
The hottest sector in the hedge fund industry has experienced its first outflows in seven years, signalling that investors who once raced to access so-called multi-manager funds may be losing interest. Pioneered by firms like Ken Griffin’s Citadel and Izzy Englander’s Millennium, multi-manager hedge funds operate with tens, if not hundreds, of trading teams, known as "pods," running diverse strategies across equities, commodities, foreign exchange, credit, and other markets.
These funds have attracted tens of billions of dollars from large investors in recent years due to their strict risk controls and consistent returns, even during equity bear markets like in 2022. However, a Goldman Sachs report reveals that these firms faced net client withdrawals exceeding $30bn in the 12 months leading up to June, the first time they’ve suffered outflows since 2016. This marks a “significant turn in the tides,” Goldman noted in the report. “There has been a turn in allocator sentiment, and the flows picture reflects this lower appetite.” According to Goldman, the primary reason for waning investor demand is that allocators, like pension funds, feel they have invested enough after years of increasing their exposure, “The average multi-manager return in 2023 was almost identical to the risk-free rate for the year.” The report also noted a significant 13% performance gap between the best- and worst-performing managers over the past year.?
Choosing the right managers in private equity does seem to have an outsized impact on portfolio returns. Addepar, a wealth management software platform, in “Manager Selection & the Paradox of Skill,” found that top-quartile private equity managers delivered returns of nearly 40%, while bottom-quartile managers achieved only around 10%. Median returns were 20%, and the top 5% of managers generated an impressive 75% return, compared to just 10% for the bottom 5%. This dispersion is far more dramatic than in public markets, where the top 5% of managers outperformed the bottom 5% by only about 10%. To illustrate the impact, consider an investor allocating 10% of their portfolio to private equity. Successfully selecting top-quartile managers would result in an additional 200 basis points of return at the portfolio level, compared to choosing managers at random. This gap widens to 500 basis points for those able to pick 95th-percentile managers. In another note, Blackstone also identify that the performance range in private markets is significantly wider than in public markets, underscoring the importance of effective manager selection. For example, the gap between first and fourth quartile returns is over 5 percentage points (pp) for Private Credit and around 15pp for Private Equity, whereas in public equities and credit, the range is just a few percentage points. This wider dispersion reflects the diversity of approaches and capabilities that private markets managers can employ, offering investors both greater opportunity and risk.
As competition intensifies, manager selection is more critical than ever. James Jacobs, Global Head of Real Estate at Lazard’s private capital advisory team, notes in Green Street News: “Private equity real estate fundraising levels in general are similar to the early 2010s, which were very tough years, but there are now many more managers, so it’s more competitive. The market, from a fundraising perspective, is more competitive than ever.”
Despite this heightened competition, Green Street News report that it is generally easier to raise capital for targeted strategies, particularly in sectors with long-term structural tailwinds, such as residential and logistics. These sectors have shown resilience and growth potential, making them attractive to investors seeking stable returns. Manish Chande, Senior Partner at Clearbell Capital, underscores this trend: “There is more investor interest in value-add and opportunistic strategies this year than last, but it is taking time to convert that into actual capital. Where those conversions will occur more readily is for very specific, targeted strategies.”
Preqin report that emerging real estate managers, especially those focusing on niche areas, have demonstrated potential for generating alpha, particularly since the Global Financial Crisis (GFC). However, they find that ancillary real estate strategies from established firms have delivered attractive upside with more muted downside compared to pure emerging managers. A key advantage for emerging GPs in real estate is their specialisation in niche property types or secondary and tertiary geographies. These managers often have more on-the-ground knowledge and focus, giving them greater potential to generate alpha than larger, diversified funds.
Preqin identify a nuance in the debate over emerging versus established managers, noting that firms like Blackstone, initially known for their flagship buyout strategy, developed a successful real estate franchise early in their history, showing that new strategies within established firms can deliver significant value over time. LPs must evaluate whether a new strategy carries the same quality as the flagship offering, as it might resemble the risk/return profile of an emerging manager despite the firm’s established brand.
Moreover, they suggest that synergies between strategies within a multi-strategy firm can enhance performance. For example, a newly launched credit fund could provide debt capital to portfolio holdings in the flagship buyout fund, creating complementary benefits across strategies. To provide investors with more insight, Preqin differentiates between GPs’ primary strategies and emerging ancillary strategies, helping them assess how these programs might fit into a broader portfolio.
The broader performance gap in private assets illustrates how the selection of skilled managers can have a profound impact on returns, much more so than in public markets. Disentangling alpha from beta is essential in evaluating an active fund manager’s performance, but much harder to do in private markets. Alpha represents returns generated by investment skill, such as security selection or tactical asset allocation, making it scarce and expensive. Investors should expect to pay more for true alpha, as it reflects value-added performance beyond the market. In contrast, beta represents returns derived from passive market exposure, such as tracking the MSCI World index or factors like the small-cap premium. Beta is abundant and inexpensive, as it can be accessed through low-cost vehicles like ETFs or index funds. For investors, it’s therefore crucial to determine whether a manager is delivering genuine alpha or simply replicating beta returns. Paying alpha-level fees for beta exposure is an expensive mistake, so part of portfolio construction involves evaluating how much return is due to manager skill versus market exposure, ensuring that fees align with the type of return provided.
BFinance note that fundraising in real estate becomes increasingly difficult during downswings, selecting the right strategy can be the key to performance. The property market correction of 2023-24 marks the fourth significant dislocation in the asset class since 1970. Each previous downturn, whether in the early 1970s, the oversupply crisis of the 1980s/early 1990s, or the GFC, created exceptional investment opportunities as markets recovered. However, a promising vintage does not guarantee strong performance, and recovery periods also present unique risks.
Real estate downturns typically follow a familiar pattern, with markets experiencing weak performance (values dropping by 20-30%), transaction activity plummeting (down 50% in 2023), and open-end funds facing high redemption levels (over 20%). However, each crisis and recovery has distinct characteristics. The 2023-24 correction, for example, followed a pandemic-driven slump and operates in a different interest rate and inflation environment compared to 2009.
Unlike the 2007-09 correction, there is greater variation in performance across property sectors: offices are significantly out of favour, while sectors like Medical Offices and Data Centres are thriving. Moreover, ESG considerations, particularly climate risk, have taken on increased importance in this cycle, presenting both new costs and risks, such as stranded assets.
During the GFC, REITs were highly volatile but rebounded ahead of direct real estate, posting positive returns three quarters before direct markets. Real Estate Debt exhibited resilience, offering stable returns even during the worst periods. Value-add strategies fluctuated, sometimes outperforming or underperforming Core strategies, depending on the cycle stage.
In the 2023-24 correction, real estate debt continues to deliver attractive yields, with base rates higher than in 2008 but margins still appealing. Meanwhile, REITs, despite their recent poor performance, may benefit quickly from potential rate reductions. In contrast, Core Direct real estate is expected to recover more slowly, with growth likely beginning in 2025 and beyond. Value-add strategies, especially in sectors with long-term tailwinds, such as residential and logistics, may present compelling opportunities for risk-tolerant investors.
Gary Sernovitz captures the manager selection conundrum — the people, the pressures, the expectations, the norms, the managers, the stakeholders – in his fictional book published last year called The Counting House, about the inner monologue and daily meetings of a Chief Investment Officer (CIO) of an endowment of a prestigious US university. There is an endless supply of asset management firms desperate to get some of this endowment to manage.?Some of them are hustlers, some of them are brown-nosers, all of them, deep in their hearts, believe it’s their divine right to become billionaires. The CIO has seen it all and increasingly vents to the managers about the sameness he witnesses, as in this response to a presentation by a lower-middle market private credit manager: “Almost sixty incoming pitches from direct lending firms like yourself.?Sixty?firms screaming at us, “Pick me, pick me, I’m incredibly unique.” The data is compelling, picking the right manager is critical to outperformance, and in the battle of the Greek alphabet, real estate capital has a particular predilection for Alpha over Beta. When the protagonist in Sernovitz’s book tells a manager he’s looking for firms that can translate their ideas into performance over long periods, the manager responds, “We do.” But the CIO corrects the tense and cites reality, “You?did, and?maybe?you will.” As Bfinance conclude, if history repeats itself, now may be an opportune time for investors to raise exposure to the real estate market, but not all strategies and managers perform well during a good vintage.