Do long term Investment Managers invest their Capital optimally?

Long term investment managers in this article refers to Portfolio managers of traditional large fund managers whose investment decisions are limited to buying and selling listed stocks on equity exchange markets. I attempt to answer the question of whether they deploy their capital efficiently by comparing them to how other investment managers, namely, Venture Capital mangers and Hedge fund managers, deploy their capital. It is worth noting that the key difference between the three managers is Risk and how they perceive it. This leads to each manager choosing to deploy their capital at different stages of the business life cycle and hence the enormous difference on their long-term returns.

In this article, I will start by defining risk and assessing how each manager, starting with Venture capital, Portfolio managers and then Hedge fund managers, perceive risk. I will include selectively biased data on each of them to support the argument that from all three managers, Portfolio managers have the least best returns in the long run. I will conclude by paying particular attention to what is emerging to be the beginning of a trend of how stock exchanges are evolving with some evidence from recent direct listings and the STAR market, which shines the spotlight on whether traditional Portfolio managers are investing wisely by just limiting their scope of investments on listed stocks.

In finance, risk is the possibility of losing your capital or total investment. Risk can be measured and because it is quantifiable in statistics, it is perceived to be objective as once it has been reduced to statistics, it is comparable. But risk to us human beings is actually subjective, and this is so because the idea of what we consider to be “risky” depends largely on how we are initially introduced to that same “risk”. Let me put it to perspective by using an analogy, if we introduced two young adults to Bungy Jumping for the first time but showed each of them different scenarios of bungy jumping, that is, one is shown a scenario where things go completely wrong, and the other person where the bungy jumping goes well and things are okay, each participant will associate a different level of risk to this “Activity” of bungy jumping because of how they were introduced to this activity, even if later we could show both participants the bad and good bungy jumping, they are still more likely to have different levels of risk associated with this activity and this will be biased to how they were first introduced to the activity, even thought they could be taking an equal risk when doing the activity.

This same concept of risk can be applied to investing. Investors might associate significantly different levels of risk to the same investments despite the actual risk being less or more the same and not varying as significantly. If risk is subjective, how is it somewhat turned to be objective in investment, this transition is made when portfolio managers make assumptions in their probabilities. Different investment managers make different assumptions when they come up with different investment models or even simple investment decisions on how the future, and in particular, the future of the business or stocks they choose to invest in, will turn out. Long term Portfolio managers will make assumptions, quantify the risk they take and measure that risk with the level of risk they can tolerate. What stands out regarding long term Portfolio managers is not necessary how they calculate risk, but how much they prioritize it in their investment decisions. This essentially means that long term Portfolio managers’ investment decisions are heavily dependent on the assumptions they make. The more accurate their assumptions, the better will their returns be, but the actual investment (listed stocks) does not necessarily significantly depend on the actual “assumptions” that these managers make, the performance of listed stocks depends on a variety of factors and it is not within the scope of this article to cover such factors.

How and when do all these three managers make their investment decision and how do they perceive risk?

Venture Capitalist.
Venture capital managers invest in start-up companies and because their investment is made in the very early stages of the business life cycle, they are perceived to be taking on more risk. Start-up companies, or just Start-ups, first start by raising seed funding, which usually includes the founder of the start-up using his/her own money and asking friends and family to invest as well. Thereafter the start-up can continue to raise capital in different rounds of funding called Series. The funding rounds will start from Series A, Series B, Series C, and so on. The idea to take from here is that each funding round of Series represent the different growth life cycle of a business. This means that a start-up raising Series A will always be “smaller” compared to a start-up that is raising Series B. Companies can go as far as raising Series G and at this stage, they would have grown tremendously and their business model and market share would have been well solidified. Some start-ups choose to do more additional rounds of funding as a means to avoid raising capital in exchange markets, and a fitting example would be Airbnb.

Investment managers that invest in start-ups usually invest a relatively small amount of capital for a share of equity in those start-ups. As most start-ups would not have solid business models at the early stages of their business life cycle, investment managers who invest in these businesses are seemed to be taking far more risk than any other investment managers. If risk is significantly correlated to the growth and scale of companies, then that would mean that an investor investing in a Series A funding is seen as taking far more risk than an investor investing in a Series G funding, where the business would have at that point, have a solid track record of growth. Another thing worth mentioning is that an investor investing in a Series A would have their share of equity diluted with every round of funding, that is, the share of equity they bought in a Series A will decrease when the start-up raises Series B and consecutive funding rounds. In order to keep the same share of equity or even increase it instead of seeing it being diluted, the investment manager who invest in a Series A round of funding will have to invest in all of the other rounds of funding that will follow. This practice is common and is seems very rational. It would also serve to prove that the investment manager well understood the growth trajectory of that start-up when they invested in the first round of funding in the first place.

The returns for investment managers in this space is staggering. Softbank’s returns are a good example and managers in this space cash out of their investment when a company goes listing or some years later. Softbank invested $20 million in Alibaba and that stake turned to be worth $60 Billion in 2014 when Alibaba listed. Another example is Accel Partners’ $12.7 million investment in Facebook that turned into more than $9 Billion. Some investment managers might also choose to cash out in the next round of funding before a company goes public, for instance, if an investment manager invested in a Series A round and got a relatively large equity share during this round, they might choose to cash out or sell some of that equity in the consecutive rounds of funding.

Portfolio Managers

As mentioned earlier, portfolio managers in this article refers to long term investment managers who choose to focus only on investing in companies that are listed on stock exchange markets. These managers would buy the very same start-ups that were successful in raising capital in the private markets with the different rounds of funding earlier. Start-ups can choose to raise capital in exchange markets after any Series funding round and this depends significantly on the kind of business model, sector, growth track record and trajectory. A start-up might choose to list after only a few rounds of funding, such as WeWork, or it might choose to raise as many rounds as possible before listing, such as Airbnb.

What is very very very interesting (not a typo, its an emphasis because this is actually fascinating) about this space of investing is how most investment managers make their decision when investing in the listed stocks. All of them convince themselves that they are highly rational beings that make logical investment decisions free of their emotions. They believe that they are exceptional beings who understand and have mastered the markets, and that their actions, or in particular, their investment decisions are better than the investment decisions of the next managers. The fact that one investment manager would be selling the same stocks while the other manager on the other hand of the transaction will be buying the very same stock is supportive of these narrative that each of them think of themselves as being smarter than the next one. Extensive research has been conducted on behavioural finance with strong evidence on the psychological bias of most investment managers.

Since most Venture capital managers and Portfolio managers have to make a number of assumptions when they take all the factors into account before making their investment decisions, they are prone to be biased in their investment decisions. I will use Warren Buffet to put this “biase” into perspective. It is worth noting that Warren is one of the best long term portfolio managers who has achieved tremendous returns in his investments but with his exceptional track record, his investment mistakes or “decisions” are often overlooked or not heavily covered compared to his success, which is fair since in this space of equity markets, in order to achieve any meaningful returns, an investor needs to be “right” at least 60% of the time, compared to a Venture capital investor, who just needs to get at least one investment right in a decade in order to see meaningful returns.

One of Warren’s investment mistake, in my opinion, is buying Apple stocks in 2016. My conviction is that he could have bought the stock well before the time he did. Although one could justify the fact that 2016 was the year when Apple’s cash pile hit a record then of over $200 billion, other investment metrics that most investment managers tend to prioritize more when making valuations looked great well before 2016. Warren’s investment philosophy works well for him as he concerns himself to only the businesses that he comprehensively understands, particularly their business models. He also prioritizes much on the managers that runs those businesses. He is often seen drinking Coca-Cola sodas in his annual shareholder meetings and inviting all the other businesses he owns to the annual gathering to showcase their products. Warren is believed to be great friends with Tim Cook, the CEO of Apple and despite the fact that Tim once said that he does send Warren the latest iPhone with every release, Warren has in turn confessed to not using the smartphone as much. While this might be taken lightly, a retrospect of this can lead to one to conclude that Warren was biased in his decision not to invest in Apple earlier. He has personally admitted to ignoring Apple because he thinks it’s a “tech stock” and he has very much stayed clear and played very far away from such stocks as he does not quite well grasp their business models. This is actually what makes him a great investor as his decisions are not based on hearsay and what everybody else is doing but rather on his research and knowledge of things. But, at the same time, this can be a disadvantage because he will personally choose to understand only certain things and therefore ignore what he does not understand. It does not take a rocket scientist to understand the business models of any business (Side note, but certain reporting accounting standards and practices make it a challenge to understand certain business models when looking at their financial reports), and therefore choosing to ignore a certain business or sector because you don’t quite understand that business model or sector is on its own a “biased investment decision”. It is in our human nature to ignore things we don’t understand or only prioritize and act on things we understand. As much as Warren can admit to his investment shortcomings, he is just as unique as his return because most Portfolio managers never admit to being wrong on their investment decisions. You will be surprised at the mounting evidence to prove this fact, which is not the purpose of this article. The point I want to make on this and particularly on Portfolio managers is that they can be very biased in their investment decisions and because the bias is not intentional, it always has significant impact on their returns.

Hedge Fund Managers
Hedge fund managers operate in the same equity market as long term Portfolio managers and what stands out about this kind of investment managers is the exponential returns that some of the best of them earn in a very short period of time. Earlier in the article, I defined risk as being the possibility of losing capital. To narrow this definition to how hedge fund managers view risk, it is the probability of deviations of the expected mean(result). Different hedge funds have different strategies, and such strategies remain a secret to the firm. Hedge funds discover new ways of making money and hence the reason to keep that new method they discovered a secret.

Jim Simon of Renaissance Technologies, one of the leading hedge funds whose strategy is a quantitative approach by analysing massive data to discover trends in the market and simply follow those trends, even when at times they cannot justify why those trends exist. This method of investing has worked so well for the hedge and it takes far less risk as they simply follow recurring patterns that they have discovered instead of guessing highs and lows. The hedge fund in question has asset under management of more than $100 Billion and has a track record of earning double digit returns for over a decade. High returns are associated with high risk and so generally the assumption that is made is that hedge funds take far greater risk to earn their high returns, but it is not actually the case with some of the best hedge funds. Renaissance Technologies continues to earn exceptional returns and most commentators are of the notion that they take far less risk than most other hedge funds, who also take on far more leverage to increase their returns. In my opinion, I think we associate risk with something we don’t know or comprehensively understand, so if one hedge funds clearly understand what they are doing, they are definitely taking far less risk than we think they do simply because we don’t understand or know what they know. Although some hedge funds can lose significant negative returns like Long Term Capital Management did, the idea that all hedge funds take excessive risk should not be extrapolated to all of them, especially as each of them use different investment strategies.

Are Portfolio Managers investing their capital efficiently compared to Venture Capital managers or Hedge funds managers?

Most Portfolio managers when asked whether they own certain stocks, they often say “the stock is overvalued” or something like “the valuations don’t make sense” to them. So the question that follows is why they did not invest in the same stocks when they were undervalued, clearly there must have been a point in the business life cycle of any business when it was cheap to buy or invest in that business. After all, all of these listed stocks don’t just fall from the sky overvalued and get listed. Portfolio managers argue that they don’t want to invest their capital in start-ups because they believe they take far more risk when they do invest at that point. But do they really take as much risk? My conviction is that they don’t necessarily take on as much risk, if they spend the same amount of resources they do eking out returns on the exchange markets, on private markets, that is, they focused some of their research understanding how society is evolving and what kind of businesses will be needed, they would definitely find and invest in start-ups that will grow as massively as the start-ups that go public later on.

It is also worth noting that because there are different stages of funding rounds in private markets, if Portfolio managers are as risk averse as they want us to believe, they can choose to invest in later stages of funding rounds like Series C, Series D or Series G, if the start-up goes to that extent. The trend that is also starting to occur is that because of the excessive capital that is now available in private markets, most start-ups have the incentive of staying private by raising more and more rounds of Series funding without having to give up too much of their equity. This is a great incentive for them not to list on public stock market exchanges, which would pressure them to perform and make profits even when they are still refining their business models. One of the repercussions of this excessive private capital which result in start-ups raising capital at a relatively low cost is that when they do list, they option for direct listing as they don’t have to raise any more new capital at that point. This has some significant impact on the returns of portfolio managers who would have optioned to buy into the stock on its inception of listing. Spotify is one example of a start-up that took this route of direct listing when it went public.

But here is a something else that is worth noting, some Portfolio managers are already aware that only investing in listed stocks does not necessarily result in better returns compared to Venture capital managers. In order to make up for this, Portfolio managers have started pouring some of their capital in private markets by actually participating in funding the Venture Capital managers who then in turn invest in start-ups. There is a problem that arises even with this kind of strategy for both Portfolio managers and Venture capital managers. Apart from the fact that some Venture capital managers are not as prudential and don’t pour as much extensive resources in their research as is needed to find start-ups that are going to grow in the future, investing dynamics in private markets are different. Most of the funding that happens is through networking and start-up founders have the option of declining capital from Venture capitalist manager who they don’t want, unlike in public equity markets where you cant stop any one investor investing in your stock. This is not a global problem though, well at least until last year in 2019 when STAR was launched in Shanghai, China. The Shanghai Stock Exchange STAR Market or Shanghai Stock Exchange Science and Technology Innovation Board, or simply STAR, is an exchange market launched in China for tech start-ups to list in the market. Its listing requirements are not as stringent compared to traditional exchanges and therefore allows a lot of tech start ups that are based in China to easily raise capital. An interesting observation to make about Chinese tech start-ups is that they have a lot of pathway of growing very fast due to the scalability of their products or business models. This is because of the large population base in China. Essentially, when a start-up comes up with a solution, they are not solving it to a few groups of individuals but to a lot of people that potentially have the same problem. One good example is Tik Tok and how quickly it grew. The dynamics of its quick success might be misunderstood because its owner, ByteDance, has other different operations in China, but on closer inspection, you might find that ideas like Tik Tok are derived from data or signals from those very same operations.

Whether long term Portfolio managers could be earning better returns if they chose to operate more like Venture capital managers or hedge fund managers can remain a contested question that is often resolved by managers choosing to have a specific well defined risk appetite. But risk is subjective and so will the risk appetite that they choose. The question should be then, is the risk that is being taken really risk at all?