One of the persistent questions for anyone investing money (whether in the public or private markets) is how to achieve excess returns. I have been thinking about this quite a bit over the last weeks as we have prepared for our annual meeting with the Limited Partners in Union Square Ventures and as I have talked to a close friend who is managing a large trust. I believe that out-performance comes down to two key factors: perception and concentration. By perception I mean the ability to make sense of the heaps of available data. The foundation of perception is a deep understanding of what is going on in one’s target market. Without understanding, there is no way to extract a signal from the data Without a signal, investors are reduced to guessing, which generally results in becoming followers rather than leaders. Only leaders can deliver excess returns. Concentration is the willingness to remain focused and make sufficiently few investments to avoid regression to the mean. A large portfolio is much more likely to perform like the overall market than a small one. Now some might argue that you are just taking more risk. While that is correct, I believe that concentration risk is not efficiently priced so that even on a risk adjusted basis it allows for delivering excess returns. The reason is that mis-aligned incentives push the bulk of investors towards large diversified portfolios (e.g. growing the asset base to collect more management fees). Achieving perception and maintaining concentration are really hard, which explains why sustained excess returns are so rare. I certainly find myself struggling with both!
