Since I became an institutional investor, my #1 learning is: this is a highly unusual and somewhat baffling industry. Asset management shows the traditional earmarks of an industry ripe for disruption — most obviously, unhappy customers and extremely profitable incumbents.
Despite this, it’s hard to think of good examples of disruption to asset management in the classic, Clay Christensen sense. The best examples I can think of include index funds (Vanguard); ETFs (iShares); crowdfunding (Indiegogo); discount/online brokerages (Charles Schwab); online wealth management (Wealthfront); back office management (Addepar); principal-protected investments (JP Morgan, numerous others); and expert network investment research (my former company, Circle of Experts).
Clay Christensen observes that disruptive companies often emerge from firms that serve one use case well (“jobs to be done”), and then grow from there. In investing, I can think of a few examples of this paradigm. Index funds serve the goal of returns well, but do not satisfy the need of an allocator to think that he can pick above-market returns providers. Inflation-linked bonds serve the goal of inflation protection, but also do not satisfy the need of an allocator to pick an above-market return provider. They also can generate low returns in a low-inflation world. Angel investing provides good returns, but typically provides poor liquidity, mediocre transparency, and requires a lot of manual effort per dollar invested.
I think there are many more opportunities to disrupt the space. At my firm, ff Venture Capital, we’re trying our part to rethink how the industry works, and also actively looking for opportunities to invest in companies creatively disrupting this sector, e.g., our portfolio companies Addepar and Indiegogo. We think that one vector for identifying great entrepreneurial opportunities is to identify disruptable behavior patterns which are probably not sustainable.
Disruptable Pattern #1: The asset management industry collectively adds minimal or negative value to its clients above the option of investing in index funds.
Almost every other industry collectively does what it promises; the restaurant industry does give all its customers food. However, the asset management industry collectively plays a near-zero-sum game. Each new investor tends to raise valuations and lower returns for all the other competitive investors. It is mathematically impossible for the median investor to beat a low-cost index, after expenses. (Of course, asset management firms also sell peace of mind, tax minimization, and other services besides just increasing the value of your assets.)
This is a key reason why the average retail investor consistently earns below-average returns. For the twenty years ending 12/31/2012 the S&P 500 Index averaged 8.21% a year, an attractive return. The average equity fund investor earned a market return of only 4.25%.
I can only think of a few exceptions to this zero-sum principle. One are investors in truly new asset classes, e.g., frontier markets like the Pakistani stock market, which really do provide new opportunities for companies to put capital to work, who otherwise would not have access to that capital. Another exception are investors who proactively add value to their portfolio companies (as ffVC strives to do), which some of my research indicates should help to increase returns. Another are product manufacturers who identify a unique use case and sell a specific solution for it, e.g., the vendors of inflation-linked bonds.
Disruptable Pattern #2: Asset managers are motivated to add more assets under management, not increase returns.
This is like a restaurant which keeps opening more branches while their profits per customer (and utility derived by each customer) steadily decline.
There is an inevitable tension between size and returns in asset management. Angel investors earn higher returns than small VCs, who in turn earn higher returns than large VCs, let alone most other asset classes. The Kauffman Foundation reports that no VC fund larger than $1 billion returned more than twice the invested capital after fees. Of course, it is true that large size does create certain proprietary advantages, e.g., some large fund of funds negotiate preferential management fees from certain funds in which they invest.
The compensation structure of the industry encourages raising ever-larger pools of capital. For example, VC funds earn 2/3 of their compensation from fixed fees, not carry. As a result, almost every asset manager we know has a very strong focus on increasing their total pool of assets under management.
Disruptable Pattern #3: Investors typically pay asset managers far more compensation than is appropriate for their real value-add.
Would you pay a $379 tip for a $70 meal?
Asset managers can earn far more money at less risk than in any other industry. Simon Lack reports in The Hedge Fund Mirage that from 1998 to 2010, hedge fund managers earned $379 billion in fees, while their investors earned only $70 billion in investing gains.
Strictly by chance, some significant percentage of investors will reap returns above the norm, and earn a blowout amount. They’ll then typically raise much larger pools of capital, and then their returns revert to the mean. Think John Paulson.
This is a great example of the poor (and middle class) generously sharing their modest wealth with the rich. Most institutional LPs represent the middle class and below: think pension funds, hospital endowments, etc. However, by the structure of the industry, those people collectively end up giving large amounts of money to the top 1%.
I suggest smaller funds are typically better aligned with investor interests; the principals cannot earn significant compensation without generating high returns.
Disruptable Pattern #4: Most investors put in only a modest amount of their own money into their funds.
Would you eat at a restaurant where the chef eats only eats 2% of the time?
In the asset management industry, the norm is that the General Partner puts in 1-2% of the total assets under management. I know of some managers who brag about putting in 5% of a fund size out of their pocket…but since they can earn 16-20% of the fund size in management fees just for showing up at the office for the next 8 years, that’s a fairly unimpressive commitment.
Disruptable Pattern #5: Institutional investors are eager to cut larger checks rather than smaller ones.
This is like a chef who likes to buy a whole cow in order to serve a client one hamburger.
I have frequently heard the expression from other investors, “We can put a lot of money to work here.” This is the psychology that drives VCs to load up a company with more capital, rationalizing that $5m at a $20m pre-money valuation is little different than $10m at a $40m pre-money valuation. By spending more money, investors can justify managing more money, which in turn increases their fees.
This is very different from the way most of us think about investing; in our personal lives and in most operating businesses, investors try to spend as little as possible for the maximum results. I believe it’s healthier to stage our investments in a series of modest-size checks. This lowers our risk and, we believe, creates a healthier corporate culture. According to CB Insights, there is little to no relationship between financial runway and startup success.
Many large public markets investors will point out that with $X billion under management, they can’t make investments for less than approximately 1% of X. There’s an easy way to address that : consider hiring more people. Countless small funds make money by writing smaller checks into smaller public companies. However, most public markets investors are hesitant to expand their staff too much.
Disruptable Pattern #6: The VC industry collectively has a structural incentive to destroy value … and does.
Most investors in traditional asset classes value a potential investment based on some permutation of a discounted cash flow (or multiple, which is a proxy for a discounted cash flow). However, I’ve seen many VCs who value companies as an option: the company has a 1% chance of being worth $1b, therefore it’s worth $10m. This may make sense from the individual perspective of a given VC, but collectively it ensures that early-stage companies are overvalued. Assume that out of 100 companies, 99 will go to 0, while 1 will yield a 100x return. What happens if you don’t get into the one VC that gets into Cornerstone On Demand (ffVC company, now the 10th largest SaaS company in the world)? This is one of the reasons that VC returns are consistently mediocre. And what if that one long-shot that everyone is hoping for doesn’t actually pan out? This option-based valuation methodology can also be used to explain the early 2000 internet/telecom bubble in the public markets.
I don’t think that a Net Present Value calculation is appropriate for every company. The one fact we know for sure about every financial model we see: they’re wrong. However, I do think an investor should assess if the business has a logical financial model. And the VC industry collectively, I believe, has an inherent tendency to produce mediocre returns. Another reason for that: various strategics and economic development entities really like to allocate dollars to VCs, because VCs are seen as job-creators. This means that when the VC market is booming, it tends to attract excess capital.
Disruptable Pattern #7: Most retail investors underallocate to the single-highest-yielding asset class, angel investments.
Angel investing is the highest-performing asset class we know. Of course, it’s also the most illiquid and opaque, which helps to preserve those high returns. Across a dozen different research studies, we’ve seen median returns of 18%-54%. But, the traditional wealth management industry does not make fees on angel investing, so it’s an underpublicized opportunity.
In aggregate, angels are significant investors. Over the past decade, angels have averaged more than $20 billion annually in the US. That’s a sizeable amount, especially in comparison to the US VC industry, which similarly invests a little over $20 billion annually. In 2012, 268K angels invested in 67K entrepreneurial ventures, according to the 2012 Angel Market Analysis released by the Center for Venture Research at the University of New Hampshire.
However, those angels constitute only about 5% of the estimated 5.1 million households in the US with a net worth of $1 million or more. I’d argue that many more investors should consider angel investing. First, because of the returns. But second, almost all other asset classes are passive: you put your money in and take your odds. In angel investing, a proactive approach will directly increase your returns. At Harvard Business School Alumni Angels of Greater New York, we have put a lot of energy into educating our community about the returns potential and process of angel investing.
Services like Angel List syndicates are disrupting angel investing and reducing the traditional information costs and access issues that have made angel investing more work. However, I’m obliged to emphasize that the time people put into angel investing is precisely what makes it a high-returns asset class. The jury is out on whether the increasing ease of angel investing will potentially lower returns.
Of course, you should not become an angel investors without doing your background reading, joining an angel group, and generally moving slowly. As always, anyone who tells you about a get rich fast investment opportunity is probably a reason to run away fast.
In the long run, most asset classes correlate with the rate of GDP growth, and most forecasters expect the economy to grow at anemic rates for the next decade. We are extremely fortunate to finance the growth side of the creative destruction we are witnessing all around us. We hope that more individual investors who are inspired by all of the amazing entrepreneurs building visionary companies will join us as angels.
Update: I’m now working on a research study on this topic with Katina Stefanova. Here’s a slide deck on this topic that I’ve presented to some institutional investors: