Achieving outperformance needs a structured approach and understanding 9 outperformance generators

Every investor is keen to compare his performance with the relevant market index. This ‘benchmarking’ has the goal to evaluate and improve the performance. Some investors will settle for the index’s return, but typically the goal is to outperform the index. There is, however, no uniform guidance on how to best achieve this. 

In my experience, the key to create outperformance is a well-structured approach and full understanding of the benchmark and nine outperformance generators. I have mapped each of these outperformance generators by likelihood and potential magnitude. The black colour indicates a potential yearly outperformance, while the grey ones need (each for different reasons) a full cycle. This mapping is done based on an indirect real estate benchmark, but it can be done by using other benchmarks as well.  

It is important to understand the portfolio’s and benchmark’s composition and the portfolio’s risk budget. Based on this information, it is possible to set up the strategy and decide where to generate outperformance. The 9 outperformance generators are:

1) Fees & Costs: If you can lower fees and costs to a level below the market average, it basically means that you generate a consistent annual outperformance. This is the type of outperformance that is 100% certain every year. Up to 30 bps contribution is possible, although this could be higher for larger institutional investors and lower for smaller investors.

2) Portfolio Management: Avoid an over-diversified portfolio. A small investment takes up the same amount of time as large investment, but it will have less impact. Especially in downturns the problematic investment(s) will consume all of your resources, leading to missing out on opportunities.

3) Leverage: Academic literature is very clear on what works and what not. An efficient leverage policy will certainly add a lot of value over the full cycle, but the effect is strongest in downturns.

4) Combining private and public: Private and public markets have their own qualities. Using these qualities and the occasional mispricing, can help you improve your performance substantially over a full cycle.

5) Development: Knowing when and where to develop is a skill that could lead to outperformance. It is similar to leverage, where a downturn can wipe out all profits. A good strategy could add some extra return.

6) Style: Style has a lot of overlap with some of the other generators, like leverage and development. When you look at the historical data and academic literature, there are clear indications which styles are working better than others and there are ways to benefit. 

7 & 8) Sector and geographic allocation: Both these segmentations are prone to cycles and structural changes. Playing the cycle is tough, but possible. Using structural long term differences will generate extra return in the long run. However, it has been proven that specialised funds /managers outperform on average. Large investors should be able to benefit from this best.

9) Asset / manager selection: Although this generator is the focus of many investors and managers, only 50% of the managers can outperform, by definition! Due to proven manager’s performance persistence, it is still a potential generator (although with low likelihood).

ESG is excluded, as it is not yet an integrated part of the benchmark. However, ESG can be used as a factor to increase returns. Finally, it is not possible to aggregate individual outperformances, due to the overlap between the generators. Still, the potential provides an idea on the possible magnitude. I believe it is substantial and should be part of every investors’ strategy.

The potential outperformance is estimated based on academic and market research. More in-depth analysis on these generators will be covered by later blogs. If you want to know more, or if you are interested in applying this methodology to your own portfolio, please contact us.