Worldly Philosopher: Some Investors Are More Equal Than Others
This week's Worldly Philosopher, Raphaele Chappe, questions the inequality in investor returns.
As discussed at great length in prior posts, Piketty has argued that inequality is directly linked to the return on capital r exceeding the growth rate of the economy g. Yet a fascinating (perhaps controversial, and less discussed) claim is that the average rate of return on capital is not the same for all investors depending on the size of the portfolio – in short, contrary to the efficient market hypothesis, some investors do earn higher returns in the long run.
Piketty points to the fact that the wealthiest individuals in the world have earned annual returns of 6.8% per year since 1987, compared to the world average of 2.1%. Using university endowments as a case study, he also points to higher endowments earning higher returns in the long run (see Tables 12.1 and 12.2 in Piketty, 2013). Other research confirms that rich universities are getting better returns and do seem to benefit from better asset selection abilities.
Finance tells us that higher returns for wealthier investors could be achieved in two ways. First, by taking on more "risk" and investing in stocks with higher "beta," or products with embedded leverage (such as derivatives). Second, by getting a higher return per unit of risk than what should be expected given the beta. This second component is known as the "alpha," measuring the return above the risk-adjusted performance of a benchmark index and (supposedly) a measure of the skill of the active asset manager. We can imagine that factors such as better information (or even insider information), arbitrage opportunities, or advanced tax planning can generate considerable alpha. Piketty points to significant economies of scale associated with the size of the portfolio.
Do higher returns to high net-worth individuals or institutions come from an ability to take more risk or from higher alphas?
This is somewhat of an open question. Alphas are often fully absorbed by management fees. Some research shows that passive portfolios (index funds) have outperformed actively-managed funds from 1980 to 2011 in great part because of the increase in management fees. It is debatable whether the hedge fund industry produces any alpha (see this recent Wall Street Journal article). On the other hand, top universities and clients can potentially negotiate lower fees, directly hire highly-skilled investment managers, or form superior investment committees. Ability to invest in illiquid assets, like real estate or private equity, could also generate alpha.
Where does this leave us? Unfortunately, there is still little transparency regarding wealth holdings and returns (see Piketty's discussion of this in his SCEPA lecture, starting at 39:27). If wealthier investors do earn higher return on capital, the distribution of r across investors plays a role in furthering inequality, in addition to the r-g differential in the aggregate.
Policy implications are significant. While more information on the source of superior return is needed, reform of both the asset management industry and retirement plans could be necessary to provide all investors with the same investment opportunities.