It was tough for most investors to “beat the market” in 2024. But should beating the market be the primary focus of most investors anyway?

2024 was a tough year for investors trying to “beat the market.”

US indexes have come to be dominated by a small number of stocks – the so-called “Magnificent 7” (Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla). At the start of 2024, these stocks made up around 28% of the S&P 500, already reflecting a high level of concentration that made the decision of whether to market weight, underweight or overweight these stocks critical for US public equity investors. Overweighting stocks that already dominate the index would have felt odd from a concentration risk perspective. But by the end of 2024, the Magnificent 7 represented 34% of the value of the S&P 500. This is the highest level of concentration in the largest names since 1963. Investors who did not choose to overweight the Magnificent 7 would have struggled to beat the index because these dominant stocks outperformed the index by 23%!

Investors in private assets with public market benchmarks would also have struggled with net value add in 2024. The S&P 500 was up 25% in 2024. The S&P Mid Cap index was up 13.9%. And the S&P Utilities index was up 23.4%. Most private assets don't tend to rise that much in a single year, due to appraisal-based lagged valuations.

In years like this, it is good to remember that the primary objective of most investors is not “beating the market.” Most investors are looking to generate total returns at a level of risk that they are comfortable with. Total returns pay the bills. And risk can lead to stress, regret or worse, the requirement to increase contributions or delay withdrawals. Net value add is rarely the main game. It is a bonus.

The good news is, while it is hard for most investors to reliably generate net value add, there are investment strategies that have tended to reliably generate better risk adjusted long-term total returns.?And many larger institutional investors are well placed to pursue these strategies.?They include focusing on asset mix and diversification, reducing costs, and staying invested for the long-term. At IMCO, these are the things we focus on.

The challenge of generating net value add

Net value add (outperforming the markets) is really challenging to generate on a consistent basis. So, 2024 wasn't that odd a year in this regard.

The S&P SPIVA semi-annual report tracks the performance of many retail funds across multiple geographies and market segments. It has consistently found that most actively managed funds have underperformed their benchmarks over short- and long-term periods, and across geographies. Institutional public equity funds have tended to have a better track record than retail funds (in part, because of lower fees), although most of them have also struggled to generate net value add in certain market segments (especially US large cap public equities).

Even the biggest pensions that have long investment time horizons and the benefits of scale have only tended to generate modest total portfolio net value add over the long term. A study by CEM Benchmarking found that the average annual net value add of the largest pension funds was 26bps over 20 years. This is certainly a modest amount, especially relative to the kinds of total returns those funds were seeking to meet their liabilities. (It’s worth noting that the study also found that larger funds were able to generate better risk adjusted returns than smaller funds. This is especially important for most funds whose purpose is to generate long-term, stable returns to meet liabilities).

Net value add is difficult to achieve in public markets and challenging to measure in private markets. For most investors it contributes only a small amount to total returns – which is (or ought to be) their primary concern. This doesn't mean that net value add isn’t worth pursuing. But it does suggest that it should only be pursued in a focused way, in areas where investors have a real advantage. And investors should be careful to ensure that the pursuit of net value add does not distract from or undercut the strategies discussed below that can reliably impact total portfolio returns and risk.

Where to focus if total returns and risk are the priorities

Asset Mix and Portfolio Diversification

Asset mix has been estimated to drive as much as 90% of overall portfolio risks and returns. This is why it's important investors spend time ensuring they are invested in the right asset mix, before trying to outperform within individual asset classes. It's almost impossible to outrun a bad asset mix with outperformance at the asset class level.

The right asset mix for most large institutional investors is a diversified portfolio which includes asset classes like bonds, credit, public and private equity, and real assets (like infrastructure and real estate). US Dollar exposure can also be an important part of a diversified asset mix.

Diversification was described by the inventor of modern portfolio theory, Harry Markowitz, as “the only free lunch in investing.” There is no catch, no downside. By combining asset classes that are uncorrelated (whose returns do not move up and down in unison), investors can build portfolios that have better risk return characteristics than portfolios that are concentrated in fewer, correlated assets classes.

The risk mitigating benefits of diversification are especially important for investors (such as pension plans) who may need to increase contributions or delay or reduce withdrawals when returns are insufficient to keep up with liabilities. For these investors, their goal is both to generate long-term returns and avoid disruptive periods of underperformance.

Diversification is also important for investors with net outflows (almost all investors have or will have outflows at some point). Diversifying their asset mix helps reduce the chance that they will be forced to sell assets at depressed prices to meet outflow requirements. Selling when things are down crystallizes losses and can completely undermine strategies like investing more in riskier assets, such as equities, to benefit from their tendency to generate higher returns over the long-term (notwithstanding their near-term volatility).

A key aspect of diversification involves avoiding "big bets” – large allocations to single asset classes, market segments, individual investments or strategies (e.g., borrowing on short term basis to enhance returns) – because surprises are all too common in investing.

Entire segments of the market have endured prolonged down turns. The Japanese market peaked in 1989 and then took 34 years to reach that level again. The Nasdaq peaked in 2000 and then took 15 years to reach this level after the dot com crash. Oil hit a high of US$146 per barrel in 2009 and is still nowhere near that level. The European bank index is still 70% below its 2007 pre-GFC peak. The S&P metals and mining industry index is still below its peak at the height of the 2000s so-called “commodity supercycle.” US office real estate has generated returns of -4.6%, on average, over the last 5 years. Even the relatively safer US 30-year Treasuries have generated -7.25% returns over the last 5 years. Big bets on any of these market segments would have been a good reminder of why diversification is important.

Big bets on individual companies are also inadvisable for most investors. There is regular turnover of winners in competitive economies, like the US. For example, only one (Microsoft) of the biggest 10 companies in the S&P 500 25 years ago is in the top 10 today; only one (Bank of America) of the biggest 10 banks in the world 25 years ago is in the top 10 today; three (Tesla, BYD and Xiaomi) of the 5 biggest car companies in the world did not exist 25 years ago. Unless long term investors can reliably identity when dominant companies will be replaced by the next generation of winners, they should avoid big bets on individual companies.

Too much focus on generating net value add can draw investors into making big bets that put total returns at risk. Big bets can lead to big regrets. Focusing on asset mix and diversification are the keys to better risk adjusted long term returns.

Another key aspect of building well diversified portfolios is looking beyond shorthand measures of risk, such expected volatility of returns.? This common measure of risk is most useful for investors with portfolios that consist entirely of public investments.? However, today most large institutional investors have significant allocations to private assets, whose valuations are appraisal based, which mutes return volatility and makes measures of expected volatility much less meaningful.? In addition, expected return volatility does not capture important risks such as geopolitical risk, liquidity risk, counterparty risk and the risks of too much complexity.

Building well diversified portfolios requires that investors look at portfolio diversification and risk from a range of perspectives.?For example, investors need to consider whether the amount they have allocated to private assets could prevent important adjustments to their asset mix when market conditions change. There are real risks to being locked into an investment when things change. Investors need to ask themselves whether they are using too much short-term borrowing to enhance returns which could negatively impact returns directly (as a result of higher borrowing costs) or indirectly (by requiring the disposition of assets at depressed prices to meet liquidity requirements).?They need to be concerned about whether they have outsized exposures to countries with material geopolitical risks.?They need to be certain they don’t have too much exposure to trading counterparties that could result in losses in stressed market events.?And they need to be certain that their portfolio is not overly complex, particularly when the complexity involves both many assumptions about asset class correlations under stressed scenarios and leverage. This can be a toxic combination when correlations spike beyond expectations and borrowing becomes more difficult and expensive – which tends to happen in crises.?These risks don’t really show up in simple measures of risk, like expected portfolio volatility.?But, they are the kinds of things that can materially impact overall long-term returns if things don’t go as planned.?And they're the kinds of things that large investors are well placed to assess and mitigate as part of a well diversified portfolio.

Costs

Costs are something investors can control – to larger and smaller degrees – and they directly impact net returns.

There are many things that directly impact returns and risk that investors cannot control: interest rates, equity market returns, the relative performance of individual companies and market segments, exchange rates, geopolitics and asset class correlations. All investors can do in relation to these things is take a view on them, arrange their portfolios accordingly, monitor them and adjust as necessary. The ability to directly impact net returns through cost measures is something that can be controlled, so every investor needs to consider and act on costs, to the extent that they can.

One of the most powerful ways for institutional investors to drive down costs is through consolidation to achieve scale, which is exactly why IMCO was created.

Data from CEM Benchmarking has established that reducing costs through scale has the same ability to improve pension fund returns as active management. Large investors can use their size to negotiate preferential terms with external partners, internalize some investment activities, spread costs over a larger base and identify where to pursue active and passive strategies.

CEM’s findings are extremely powerful. It means that smaller pensions would be much better served by pursuing consolidation than seeking to generate net value add. Reducing costs has guaranteed benefits. Seeking returns through outperformance has no guarantees.

Staying invested for the long-term

Staying invested is one of the more powerful investment strategies. Staying invested allows the power of compounding to work its magic. $1,000 invested in the S&P 500 25 years ago would be worth about $6,800 today. But these results would only have been possible if the investor stayed invested that entire time. $1,000 invested over that same timeframe would have only grown to about $1,450 if an investor missed the?25 best days in the market.

To stay invested, investors need to avoid the temptation of trying to time the markets. Things that seem obvious often don’t turn out as one might expect. One might have thought a global pandemic and the highest inflation in years would make for challenging investment conditions. And yet the total returns of the S&P 500 have been 90.38% in the four years since February 2020.

Morningstar has documented the challenge and consequences of the market timing efforts of many retail investors. Their 2024 Mind the Gap report documents how most investors earn less than the funds in which they invest because they contribute and withdraw funds at the wrong times. They effectively buy high and sell low in their efforts to time things right.

In addition to avoiding temptation, sound liquidity management is critical to staying invested. Investors need to understand their liquidity requirements and have reliable sources to meet demands, including during stressed markets. Being forced to sell when assets are at depressed values crystallizes losses.

Focus on the main game

2024 was a tough year for active investors. But this is nothing new. Net value add is difficult to generate and should only be pursued where investors have a real advantage, and never to the extent that it puts overall returns at risk.

Fortunately, net value add is not the main game for most investors. Total returns and risks are the things that matter most. And some investors – particularly large investors with stable outflows – are really well placed to pursue strategies that have reliably contributed to better total returns and risk over the long term. They are focusing on asset mix and diversification, controlling costs and staying invested.