The Benefits of Investing “Inefficiently”

I had an excellent discussion with Craig Martin, partner in fee-only financial advising firm Family Wealth Consulting Group. We were talking about our mutual interest in alternative investing and how it has the potential to decrease volatility and increase returns for individual investors. During our conversation, Craig passed along a bit of wisdom that he had picked up from legendary money manager David Swensen. Mr. Swensen, you might recall, has managed Yale University’s endowment fund since 1985, and has grown the fund at an amazing 14.2% compound annual growth rate over the last twenty years.

“So what was the secret to his success?” you might ask. Fundamentally, it was the observation that it’s harder for good managers to get outsized returns in efficient markets than in inefficient markets. He went further and actually analyzed returns for a large set of managers in a series of markets from bonds to stocks to real estate to private equity. Specifically, he looked at the performance of “first quartile” managers (those who outperformed 75% of their peers) versus “third quartile” managers (those who only outperformed 25% of their peers). What he found was very interesting.

For the bond market, there was almost no difference in performance between the first and third quartile managers. That meant it was very difficult for even the best managers to outperform the bond market as a whole. Stocks were moderately better, but real estate had almost twice the difference. Thus the real estate market is less efficient than the stock market, which is less efficient than the bond market. And lower efficiency means that an experienced manager has a better chance of significantly outperforming the market. (By the way, private equity had the widest range of all four.)

So, what does all of this mean to an individual investor? It means that the winning combination is an inefficient market (such as real estate) with experienced managers providing opportunities to outperform. We couldn’t agree more.