By: Miran Ahmad, CAIA, AllAboutAlpha.com Editorial Board
The search for alpha would not be complete without the search for managers who consistently beat their peers year after year, despite the ubiquitous disclosures that “past performance does not guarantee future results.” The groundbreaking and wildly popular AllAboutAlpha.com post “What US college basketball can teach us about survivorship bias” taught us two important lessons: first, Duke actually stopped choking long enough to win a tournament; and secondly, that “hidden survivorship bias” might be a better metric when looking at hedge fund database returns (Editor’s Note: The occasionally misguided sporting opinions of the author are not necessarily shared by AllAboutAlpha.com…). So if basketball can teach us about survivorship bias, what can NASCAR and Formula One racing teach us about return persistence?
Start Your Engines
In the high octane world of NASCAR and Formula One racing, competition is intense. With fractions of a second separating winners from losers, it is not surprising that drivers are vying for the coveted “pole position,” and for good reason. The car who posted the fastest preliminary lap time earns the “pole position” and as such starts the race in first place. Craig Depken’s “The Value of the Pole,” tells us that the probability of the pole position driver eventually winning the race was a respectable eleven percent for NASCAR races and an astonishing sixty percent in Formula One races in 2004. Per Depken, while the odds of the pole-sitter winning the race is declining (see Figure 1 below), the expected value of winning the race is increasing (see Figure 2 below). So in racing we learned those who start in front have a better chance ending in front (let’s call this phenomenon persistence), and that ending in front is lucrative (let’s call this value).From the Track to the Market
At the very least, NASCAR and Formula One share two things in common with the alternative asset management industry: Competition is intense (for talent and capital versus 40 cars behind you), and it is financially lucrative to be in front. Steve Kaplan and Antoinette Schoar’s “Private Equity Performance: Returns, Persistence and Capital Flows” looks at the performance of leveraged buyout and venture capital funds and the persistence found in their returns. Through their research, the pair “find that returns persist strongly across funds raised by individual private equity partnerships,” similar to the persistence we found in car racing. As an additional note, the pair also found “that these results are unlikely to be induced by differences in risk or sample selection biases,” an important statement given the private nature and ever present biases in alternative assets.
Kaplan and Schoar conclude that consistently delivering positive returns year after year (persistence) allows the General Partner (GP) to raise capital for follow-on funds (value). More follow-on funds mean more money under management which means more management fees and carried interest to collect. Replace “pole position” with “top quartile” and it appears that like competitive car racing, it pays to be in front.
Don’t Jump the (Starting) Gun
However much venture capital (VC) or private equity (PE) funds like to tout in their marketing prospectuses that they are in the top quartile when compared against their peers, such remarks should been taken with skepticism. Cheng Wang and Andrew Conners “What’s In a Quartile” illustrates that over 60% of funds in their 1,545 fund data set could claim to be top quartile sometime during their history.
So while investing in quality funds is important, be sure that the search for ‘top quartile’ does not come at the expense of another important two word phrase: due diligence.
Learning what NASCAR and Formula One racing teaches us about alternative asset management would be meaningless unless there were some value to an end user. For individual investors, given the 5-7 year lifespan of many alternative funds, the importance and results of due diligence will have an impact on multiple-years’ returns. The decision to invest (or not) by a potential individual or institutional investor in a start-up fund, or a fund created by an unproven management team, can have an impact on future returns.
Going back to our NASCAR analogy, the performance of a new start-up fund is similar to the performance of a driver during his preliminary laps. Much like sponsoring a race car becomes more difficult and expensive after he has proven successful behind the wheel, chasing an alpha-generating investment manager after his success will be a bit more daunting. Not investing in a start-up PE fund that ultimately becomes very successful may bring up issues of accessibility to future follow-up funds. Additionally, issues of capacity can suddenly emerge. With too much money chasing too few truly persistent funds, certain managers and investment styles can only deploy so much money before diluting returns.
Individual inaccessibility to a successful manager increases the value generated by Fund of Fund (FoF) vehicles who, through prior investments and contacts may still have access to “closed” vehicles. Utilizing these FoF investment vehicles may alleviate any accessibility issues, but the additional fees of the FoF intermediary may eat up any alpha (manager skill) generated by the underlying fund manager. Repeat success in the VC space may garner positive exposure and create a sterling reputation in the industry. This in turn may lead the GP to have first access to future investment opportunities at the expense of other venture capital firms looking to make investments.
With careful due diligence and a skeptical eye, investors can still find alpha. They just have to remember that whether it is the finish line or the bottom line, being persistent has its advantages.