OCIOs vs The Magnificent Seven

You May be in VC but not know it: OCIOs versus “The Magnificent Seven”

While OCIOs performed well in 2023 overall, within their public equity allocations few OCIOs successfully positioned themselves to take advantage of key equity market dynamics of 2023.  This briefing examines the reasons why that was the case.  In particular, we look at the impact that the “Magnificent Seven” performance phenomenon had on OCIO performance, and the stealth “megacap venture” allocations that have been growing in institutional portfolios.

The Year of “Negative Alpha” In Public Equities 

Across the 50+ OCIOs that we monitor, we have seen many cases of strong alternatives performance, yet we have not found an OCIO that exhibited meaningfully positive alpha in their public equity allocations in 2023.  Several OCIOs described the 2023 experience, where gains from the top seven market cap companies [the “Magnificent Seven”] exceeded the gains for the entirety of the rest of the S&P 500, as a “more than three standard deviation event.”  They believe equity markets are primed to mean-revert, that is, returns on the rest of the stock market will catch up to the Magnificent Seven returns, or that Magnificent Seven valuations will fall back in line with market norms. 

We approach this “mean reversion” line of thinking with a note of caution.  It sounds similar to other mean-reversion themes over the last 10 years: for value stock performance to catch up to growth stock performance, or for European equities performance to catch up with U.S. equities performance.  In both instances, there has yet to result in a meaningful catch-up of value or performance relative to U.S. growth and U.S. broad market index performance.

The Magnificent Seven

The impact of the performance of the Magnificent Seven on OCIOs’ 2023 equity performance should not be overlooked.  You have probably seen this performance data for 2023 but it is worth revisiting:

Magnificent Seven Average: up 111%

S&P 500 Capitalization Weighted: up 24%

S&P 500 Equal Weighted:  up 11%

MSCI ACWI: up 20%

The very large difference between the capitalization weighted and equal weighted gains reflects both the large Magnificent Seven returns, and the now-29% share of the S&P 500 that the Magnificent Seven represent. The 13% gap between the equal weighted and capitalization weighted returns means that your experience seeking alpha in public equity markets depended almost entirely on the extent of your allocation in the seven largest megacap stocks last year.  If your OCIO’s strategy is to find talented public equity managers who pursue unusual sources of alpha in overlooked investment themes, your OCIO has probably significantly underweighted the Magnificent Seven megacap stocks.  Thus, your public equity return might be somewhere closer to the 11% equal-weighted gain than the 24% market cap-weighted gain.  If your OCIO mostly allocated public equities to indexes, or was careful to align your underlying stockholdings’ weights with the market capitalization weights, your public equity returns were probably closer to the 24% return. 

Investors fall in and out of love with specific assets over time and you likely have heard of the nifty fifty, Tech Bubble, etc. over the years.  The Magnificent Seven are viewed as a group much like the old FAANG stocks of only a few years ago.  (Facebook (now Meta), Apple, Amazon, Netflix, Google (now Alphabet).)    The change from FAANG to the Magnificent Seven is the addition of Microsoft, Nvidia and Tesla, and dropping of Netflix. The incessant AI chatter and hopes are tempting investors that the megacap outperformance will continue.

So are the Magnificent Seven a fad that will mean-revert, or is something else going on?

An Alternative View: Are the Magnificent Seven the Premiere Venture Investors?

While we are familiar with macroeconomic debates about monetary policy, a key interest of macroeconomists has been identifying the reasons for economic growth.  Technological advancement is viewed as a major driver in macroeconomic models, and the United States’ private sector has been a major contributor to economic growth by investing heavily in research and development (R&D).  As investors, we think of venture capital as a major area of technological evolution, but since we are more aligned with allocators, not stock analysts, we can easily overlook the extent of technology investing derived from publicly-held companies.  Let the data do the talking: 

Sources: market cap and 2023 % Gain are from multiple market data sources; R&D figures are from annualization of third quarter R&D spending from third quarter financial disclosures of each company, total commitments to venture capital funds by year provided by Pitchbook.

Notes: Amazon does not break out research and development (R&D) expenses from spending on all technology and infrastructure. 

Clearly we are equating venture investing with R&D investing, yet we accept this linkage as being very close, since almost all R&D spending by these companies will be invested either in developing new technologies or finding new applications for existing technologies.  That’s pretty much what almost all venture capital managers seek to do. 

From the data, we can see that the Magnificent Seven’s R&D budgets far outstrip the R&D budgets of the venture capital industry in 2023.  Recognizing that 2023 was a weak year for venture fundraising, we thought it important to compare as well to venture’s peak fundraising year of 2021. Even then, the entirety of the venture capital industry likely just barely kept up with the R&D spending of the Magnificent Seven.

Are Magnificent Seven Investors Unknowingly the Biggest Venture Investors?

So the Magnificent Seven are big R&D spenders, but how much of an investment in these companies is really a venture-like investment?  Each firm already has a well-defined source of cash generation from their ongoing businesses, after all.  A quick look at their financials shows that R&D spending represents about 10 to 25% of these companies’ revenues, and 25% to 100% of their profits, in the third quarter of 2023.  Those are big commitments! 

We would argue that the outstanding returns of the Magnificent Seven represent the result of many years, even decades, of venture program-like investing.  Most recently, cloud computing and storage have brought major new business lines to Microsoft and Amazon, with others trying to catch up.  In fact, cloud computing, a business that barely existing 10 years ago, represents the majority Amazon’s revenues now.  AI opens the potential for vast new markets and could stimulate more technological advancements in sciences, law, education, medicine, and other areas, though it is possible that the value from AI accrues almost entirely to clients rather than the producers. 

The net result is that investing in the Magnificent Seven may be like investing in a blend of mature businesses alongside well-established and successful venture investing programs.  While determining the mix between the two may be beyond the scope of this discussion, such considerations haven’t stopped us from positing a rule of thumb: if company management is spending 25% to 50% of profits on R&D, then what is the venture mix of an investment in that firm? Is it close to that profit share (we’ll just refer to this as “megacap venture”).  Moreover, since the Magnificent Seven represent about 29% of the S&P 500, does that mean that institutional investors’ indexed U.S. public equity allocations are implicitly 7 to 15% invested in venture?  After adjusting for non-U.S. holdings in equities, that would be an “average” global equity investor is 5 to 10% invested in “megacap venture.”

You may already be a substantial venture investor through your indirect “megacap venture” allocation, even if you do not have a formal venture allocation.

Venture Investing and Volatility

Experienced alternatives allocators have many stories to share about volatility in their investment strategies, and no major group of alternatives investments is riskier than venture investing.  Some of that riskiness clearly shows up in the volatility of the megacap stocks.  However, the operational aspects of R&D investing in a corporate framework are quite different from within a venture-backed startup’s framework.  Incentives to venture founders are exceptionally strong.  Conversely, oversight by talented project managers in a proper corporate setting may allow for a more efficient allocation of resources among R&D efforts, both to deploy capital and to cease investments in less promising ventures.

Reconciling the Megacap Venture Experience with our OCIO’s Allocations

Here we face the crux of the problem.  If an alpha-seeking allocator will look for equity managers with an “edge” for investing in or trading stocks that will inevitably scan the universe broadly for best ideas, the result for 2023 will be greatly reduced allocations to the top-performers, the Magnificent Seven.  That allocator will likely see a substantially negative alpha in their liquid equities allocations, despite the talents of their underlying equity managers.

However, looking at a partial picture can be misleading.  Many OCIOs are keenly aware that private equity, growth equity, and venture capital investment programs are inherently turbocharged growth equity allocations over the long term, so they tend to hold value biases in their liquid equity portfolios to create a more balanced growth/value portfolio.  In other words, if your OCIO has been investing in venture and growth equity strategies, it is likely that you will have positive experiences in your private holdings offsetting the lagging performance in the public equity portfolio over the long term.

Conclusion #1: Don’t Expect Mean Reversion, Megacap Venture-Like Investments Have Succeeded

We see a permanent change in the U.S. public equities market structure.  Technological innovation appears to favor very large companies, rather than large numbers of small companies.  Now we are projecting outside our core expertise by pretending we are stock analysts, but we’ll share our perspective on the seven companies.  Unlike in prior “tech bubbles,” the tech giants [MSFT, AAPL, GOOG, AMZN, FB] possess true “know how” that is difficult to replicate, defended by myriad patents, and fortified by continuing research. We see an oligopolistic market structure, with wide profit margins and stable to expanding market share, as a long-term structural change in the public equity market that will continue to flummox the talented alpha seekers.  We also see these vast businesses as exceptionally difficult ones for equity managers to understand at a level where they have a material “edge” over the market.  The net result is that about 25% of the public equity market represented by these five stocks is both critical to asset allocators and opaque to alpha-seekers. 

We also believe that TSLA and NVDA, both excellent firms, face greater risks in their more-concentrated business models; TSLA because they face rising competition from auto manufacturers entering the EV market and waning EV market growth, and NVDA simply because their already-high valuation implicitly depends on programmers failing to increase the efficiency of large language models and other AI programs by 90%+ [which is believed possible], and the failure of meaningful competition to arise over the next few years. The great stock pickers can hopefully discern better than we can how material these risks are to TSLA and NVDA.

The net result: generating alpha from large and megacap public equity allocations is harder than ever, and under allocating to megacaps likely means under allocating to some of the U.S. economy’s greatest economic growth engines.

Conclusion #2: What We Would Like Every OCIO to Consider

As search and evaluation consultants, we are pleased that the impressive array of OCIO managers we recommend continues to produce returns for their clients meaningfully above OCIO market benchmarks. These OCIOs have created a culture of excellence that extends throughout their investment process, and they often achieve their greatest alpha-generating successes with their alternative investment programs. 

While OCIOs also strive to generate alpha with their selection of public equity managers, now may finally be a time of reckoning.  Finding alpha investing in large cap equities is exceedingly difficult, and we rarely see active managers [or hedge funds, for that matter] who have truly demonstrated an edge in analyzing megacap stocks.  Conversely, equity managers that focus on stocks that they can analyze with some edge will likely be underallocating your capital to megacap stocks, leaving you underweighted to that critical growth engine, “megacap venture.”

We ask our talented OCIO managers to consider [again] the possibility that increased use of indexing in the large and megacap parts of the public equity markets may actually be desirable, unless the OCIO has rare capacity with the very short list of alpha-generators in large cap markets.  OCIOs need not prove they produce alpha everywhere, and it is better to concentrate efforts where they have demonstrated a meaningful advantage.

We would be pleased to discuss this topic further, and to hear any feedback or experiences you may wish to share with us.  We can be reached at 917-287-9551 or at info@manageranalysis.com.

Manager Analysis Services LLC

February 1, 2024

Are Today’s Private Equity Market Challenges Signaling a Shift Back into Public Equities?

Our team of experienced investment consultants at Manager Analysis Services analyzes over 50+ OCIOs for our Outsourced CIO Search and Evaluation services.   Private Equity’s (PE) ever-growing share in investors’ portfolios provided a catalyst to ask our OCIO relationships what they are seeing currently.  We also have reviewed over 2,000 alternatives managers and we recall a particular review, where a specific manager asserted to have “unlocked the secrets” of private equity performance.  Moreover, the manager claimed he could exceed private equity performance using a quantitative small/microcap public equities strategy. 

It sure would be nice if this manager’s thesis worked. Investors would have short-term liquidity, rather than face 10-year capital commitments with high fees.  Perhaps most compelling would be that small and microcap companies could remain part of the “open and democratic” public markets…one share, one vote…which we would strongly prefer over the current trend of private equity funds subsuming all of microcap into their orbit.

What Are OCIOs Seeing in Private Equity Markets Today?

There is no shortage of challenges in private equity markets today.  Private Equity fund raising in 2022 was off nearly 40%, and about 75% in the first quarter of 2023, according to Pitchbook data.  The biggest drop has been in Asia with China concerns leading to a decline of nearly 2/3rds in 2022, and near zero fundraising so far in 2023.  Concomitant with the decline in fundraising has been a decline in distributions from seasoned private equity funds.  Weak public equity markets have slowed the path for private equity fund managers seeking liquidity from IPOs, or acquisitions of their holdings by larger, publicly traded companies.  The net result is that the size of the private equity market has not really decreased much from the slowdown in fundraising, and asset owners’ private equity portfolios have experienced decreased turnover.

Private equity valuations have been relatively resilient, but experience demonstrates that private equity valuations tend to lag public market valuations by 6 to 12 months.  The public markets’ sharp declines in 2022 caused large PE investors to become overweight (on an allocated basis), and many have reduced or paused additional monies to private equity. 

Bright spots and New Opportunities:

In our conversations with OCIO managers, we have heard that:

– The “denominator effect”:  Is not impacting all investors.  Some have responded by raising their private equity allocation percentages so they could continue their programmatic allocations to private equity managers.  Most OCIOs are not concerned about having to raise this allocation percentage, and they encourage investors to sustain their pace of investing in PE to ensure a diversification of vintage years.

Price Outlook: OCIOs expect more markdowns.  With respect to most private equity strategies, markdowns will not be as bad as feared, nor as bad as public equity market declines.  Late-stage, venture capital strategies do remain a big area of concern, because those strategies often depend on public market IPOs or buyouts by public companies to provide exits.

Size: Large, established PE managers are currently more willing to accommodate smaller LPs.

Fund Sources: Secondary and continuation fund opportunities have grown, offering liquidity to LPs who are overallocated to PE, and interesting opportunities to investors who understand the secondaries markets.

Financing: Growth opportunities are more appealing; buyout funds are facing much higher financing costs.

Private Equity vs. Public Equity

So why do so many OCIOs like PE?  Do PE strategies outperform public equities, and if so, why?

A quick look at the most recently available Pitchbook data on private equity performance shows the average private equity fund over the 10 years to September 30, 2022 returned an 18% IRR, compared to about 12% for the S&P 600 small cap index, when including dividends.  Private Equity funds in the smallest size category materially underperformed but still beat the 12% return of small caps.  Overall private equity fund returns beat every major public equity benchmark over the last 10 years ending September 30, 2022.

While PE managers excel at explaining why they “outperform,” let’s take a look at the converse: reasons why their public market-equivalents, microcaps and small caps, tend to underperform private markets.

The Long-Term Assault on Public Equity Markets

American regulators have a practice of creating layers of complexity in reaction to crises, rather than designing and implementing sensible regulatory processes. The US should revisit the regulatory structure for smaller equity issuers, and it should be re-engineered to reflect how smaller public firms can function in a sensible way.

Here are some of the myriad challenges of being a smaller public company, and in some of these cases sensible regulatory reforms could be a big help:

i) High Fixed Costs for Being Public: Not all of our readers may remember the Enron and WorldCom frauds, where both large-cap companies materially exaggerated the scope and profitability of their businesses, yet had a then-big five auditor, Arthur Anderson, conduct and sign off on their audits.  Congress’ response was to pass the Sarbanes-Oxley Act [“SOX”], effective in 2003, which created extensive control and testing requirements for publicly traded companies.  While the desire for better controls was certainly understandable, SOX reflected regulators’ pattern of throwing additional regulatory burdens on commerce, rather than offering a well-conceived approach to constructing a rational and efficient regulator process.

SOX was a boon to the auditing community, creating an additional ~$1 million in financial statement preparation expenses for every small public company, which posed a heavy burden particularly on microcap companies.  Additionally, companies’ CFOs would also be held personally liable for misstatements.  The line by which executives could be held personally liable was never very clear, further raising the implicit costs of being a public company. 

ii) Scarce Analyst Coverage for Small cap Companies: Small Cap and Microcap executives’ committed substantial energy towards attracting interest from stock analysts and investors.  A common thread was that, by not locating sufficient long-term investors who were committed to their investments, the stock price would decline sharply just from lack of focus or interest. Such a decline could render the company vulnerable to activists or takeovers at depressed valuations.

iii) Availability of Growth Equity Capital: If a public company wants to make new investments or acquisitions that require substantial amounts of fresh capital, the company is dependent both on current equity market conditions and market perceptions of it.  This contrasts with being able to rely on the perceptions of a smaller set of long-term PE investors who would likely be more receptive to their business plan.

iv) Insider Trading: One way to attract investor interest is to speak with investors about the company’s activities.  Some investors would push the limit of these discussions and seek tips or induce a flow of information that would favor their position over other investors with inside information. 

v) Market Manipulation around Critical Corporate Events: This topic is too extensive to cover in a briefing, but let’s consider an example of an eminently sensible merger, where Company A is buying Company B at a 50% premium to its stock price and there are no other bidders.  The merger arb managers have bought up as much of Company B stock as they can, and it now trades at only a 3% discount to the agreed-upon merger price.  To everyone’s surprise, Company B shareholders voted down the merger!  How could that happen? 

Stock lending desks can sometimes not be careful about who is borrowing the vast amounts of shares available to borrow from institutional custody accounts. Some hedge funds have been known to borrow this stock around the date of record for voting for mergers, while discretely shorting the stock synthetically with over-the-counter swaps.  The net result is that the hedge fund had the full voting power of a large shareholder while being heavily short the stock. The hedge fund would induce a sensible merger to fail, and reap outsized profits at the expense of all stakeholders involved.

Risks around the stock-lending process are material, and they are also such a technical niche that corporate management teams, busily focusing on running businesses, are often not prepared for surprises from the stock loan market.

vi) Activist Demands to Pursue Short-Term Gains: To be clear, we like constructive activism, but we are also aware that some activists press companies to make short-term moves that could be viewed as contrary to long-term commitments to a business. We take particular note of news regarding Icahn’s IEP, where this activist seems to be better at extracting short-term gains than actually managing a portfolio of profitable enterprises.

Having analyzed the challenges Small Cap public companies face, let’s look at how Private Equity Markets counteract these challenges and provide investors with an opportunity to consider these markets.

Advantages Offered by Private Equity Markets

Private Equity markets offer Small Cap companies solutions for each of these challenges:

  Public Company Challenge  Private Equity Solution
i) High Fixed Cost for Being PublicPrivate companies face greatly reduced regulatory costs.
ii) Scarce Coverage for Small Cap CompaniesPrivate companies can focus on relationships with a much smaller number of private equity managers that specialize in their markets.  
iii) Availability of Growth Equity CapitalPE managers are receptive to requests for growth capital because they understand companies’ businesses and recognize opportunities.  
iv) Insider Trading RisksGenerally not relevant, although investors should be cognizant that “continuation fund” offerings can create conflicts of interest between investors seeing their capital being returned at the end of a PE fund’s life, and the general partner seeking to start a new investment vehicle with a lowered high-water mark.  
v) Market Manipulation Around Critical Corporate EventsThe technicalities of stock loan markets are not relevant for private companies.  However, private equity investors should understand, analyze, and value any “consulting” or “advisory” agreements between portfolio companies and PE GPs.  
vi) Activist Demands to Pursue Short-Term GainsPE managers are heavily incentivized to produce the best long-term returns for investors and can do so by ensuring high quality management teams manage portfolio companies.  

Given the many advantages for companies to be privately held, it should be no surprise to see private equity markets continue to grow.  Currently the combined U.S. private equity/venture capital market is about $4.5 trillion.  Private real estate, private credit, and private infrastructure represent another $2.3 trillion of private markets.  In comparison, U.S. public equity markets are about $51 trillion in size.  We view some of the real estate and infrastructure investments as comparable to private equity strategies, and we assess the private equity share of the combined U.S. equity markets as being about 10%. 

What should this 10%-share-of-equity-markets mean to institutional investors? 

At a minimum, those overlooking this “10%-of-equities” allocation have incomplete portfolios, and they are missing the interesting growth and innovation that historically derives from small and microcap companies.  To achieve that allocation, we strongly believe that institutional investors need to develop their PE investing capabilities if they do not already have them. 

What about the manager who asserted to have “unlocked the secrets” behind private equity returns, using a quantitative public market strategy? 

After about four additional years of performance from this manager, the public markets, and the private markets, the results have been telling.  Recalling that the average private equity fund over the 10 years to September 30, 2022 returned an 18% IRR, compared to about 12% for the S&P 600 Small Cap index when including dividends, this manager’s performance has been materially below the S&P 600 small cap index.  They marketed a compelling thesis and raised over $500 million, subject to long-term lockups despite the strategy’s relatively liquid holdings allowing much better redemption terms.  Moreover, they had outstanding references from notable leaders in the asset management industry.

Why did we recommend the client not invest? 

Aside from having unnecessary investor lockups for a small manager in public markets, our concerns were as follows: poor investment thesis through their weak understanding of the PE markets, the convenient omission of the strategy’s poor first year performance from marketing materials, a weak back-testing methodology, flaws in the implementation process, and lack of a sufficiently deep industry experience.  We certainly have nothing bad to say about the principals of this manager, but we are pleased to have had the opportunity to redirect our client’s capital to more profitable investments.


We have yet to experience an OCIO manager tell us that the recent challenges in PE markets have caused them to reconsider or reduce their PE allocations in favor of any other asset class.  Rather, they see Private Equity continuing to provide an attractive alpha opportunity while diversifying risk in a portfolio:

  • Typical OCIO allocations are to be in the 10 – 12% range of equity allocation, and that share continues to grow. 
  • OCIOs that strongly embrace private markets have private allocations ranging from 25% to 40% where client liquidity profiles allow.
  • OCIOs encourage clients to maintain their rate of commitments to PE funds despite 2022 performance and the recent slowdown in PE activity.
  • 10 Year PE year returns of 18% are better than both S&P 600 Small Cap Index returns of 12% and other broad equity market indexes.
  • PE-owned companies can be better managed, or more inexpensively managed, than public small companies, as they are not subjected to many challenges that public-listed companies face. PE-owned companies have managers that can focus almost exclusively on the direction of their core businesses.
  • Any indexing effort to achieve a truly representative allocation to broad equity markets is incomplete if it does not find a vehicle to include a 10% allocation to private equities.

Therefore, we believe that current challenges faced by PE Markets are not signaling any shift into Public Equities. Instead, we see PE markets continuing to take a growing market share within the Small Cap equity markets.

Should you wish to have a complimentary discussion of your private equity investment program, or your OCIO’s investment performance, you can reach us at 917-287-9551, or at cutler@manageranalysis.com

Manager Analysis Services performs diligence specifically on Private Equity, Venture Capital, and Hedge Fund Managers for investors.  We have analyzed over 2,000 funds since our founding in 2003 and we are fully independent.  We also offer Outsourced CIO evaluations and searches for Pensions, Endowments, and Foundations. Our 3 Senior Principals have a combined 90+ years in Investments, Diligence, and Risk Management.