ReSolve Riffs with Ted Seides on Capital Allocators
This is “ReSolve’s Riffs” – live on YouTube every Friday afternoon to debate the most relevant investment topics of the day, hosted by Adam Butler, Mike Philbrick and Rodrigo Gordillo of ReSolve Global*
Our guest this week was none other than Ted Seides, host of the popular Capital Allocators podcast. Ted began his career under the tutelage of endowment legend David Swensen at Yale University Investments, then went on to found Protégé Partners, investing and seeding small hedge funds. This career arc gave him a unique perspective into the decision-making processes of multi-billion-dollar institutions, as well as the portfolio managers on the receiving end of their allocations.
After almost 200 podcast episodes and a recently released book – Capital Allocators, How the world’s elite money managers lead and invest – it’s hard to overstate the breadth and depth of Ted’s institutional “inside baseball”. We covered:
- The range of disciplines that are leveraged by some of the world’s most successful investors
- Why capital allocators are essentially interviewers (and can make for good podcast hosts)
- Repetition, pattern recognition, and separating the wheat from the chaff
- Governance and the constant tussle between CIOs and investment committees
- Negative screening, triangulation and reference checks – above and beyond due diligence
- Performance chasing, familiarity and other biases – why institutions often resemble retail investors
- Leveraging the work of Annie Duke, Gary Klein and Michael Mauboussin
We also discussed the difficulties of high information asymmetry, behavioral fortitude, and cognitive diversity. Ted even shared a few interesting anecdotes from his time working with Swensen.
Thank you for watching and listening. See you next week.
Ted Seides, CFA, created Capital Allocators LLC to explore best practices in the asset management industry. He launched the Capital Allocators podcast in 2017 and the show reached five million downloads in January 2021. Barron’s, Business Insider, Forbes and Value Walk each named it among the top investing podcasts.
Alongside the podcast, Seides works with both managers and allocators to enhance their investment and business processes. In March 2021, he published his second book, Capital Allocators: How the World’s Elite Money Managers Lead and Invest, to distill the lessons from the first 150 episodes of the podcast. You can follow him on LinkedIn and Twitter.
Rodrigo:00:01:29You’re looking good, man.
Mike:00:01:31It’s just a thing I do; I’m sorry.
Adam.:00:01:34Anyway, you don’t look like a guy who’s been holed up in your house for a year. You get out and like going hiking, how are you?
Ted:00:01:42I mean, honestly, I just finished a week of quarantine. So been inside for a week basically, in this room for a week. But all good, everyone’s healthy.
Rodrigo:00:01:52That’d be great. So you get to do your like military-style push-up, pull-up in your hotel room? Is that a hotel room, or is that just quarantined?
Ted:00:02:04No, this is our house. No, it’s the house.
Mike:00:02:08Before we get too far in, just want to warn everybody, there’s no investment advice here. Especially from four scallywags on a Friday afternoon. This is all for entertainment purposes. So we hope to amaze and entertain you, but with that, we can keep going. On that note, who wants to start? Let me just jump in.
Ted: 00:02:28Wait, hold on. Aren’t I supposed to ask the questions?
Mike:00:02:32Right. So Ted, tell us the questions you would ask yourself about you and your book and your podcast and tell us everything.
Ted:00:02:43Yes. I mean, the first question is, how is it possible that everyone in the world isn’t already listening and reading this bestseller? I don’t know.
Mike:00:02:51You did get a number one seller out of it; I mean, it is number one new release, I believe?
Ted:00:02:57Yes, it’s great.
Mike:00:02:57Anyway, you’re right. Before we get ahead of ourselves, just for people who don’t know Ted. Maybe, Ted, you should give us your history and your arc, and all of that stuff. So we can set the table for a conversation because I’ve gotten ahead of myself a little bit. But why don’t you do that for us and for the people joining us today?
Ted: 00:03:17Sure, happy to. So I spent my career really in the institutional investing world. So for 20 years, I invested in managers. My first job out of college, I worked for Dave Swenson at the Yale endowment, back from ‘92 to ’97, in the early years. And went to business school, came out, invested directly with a couple of Yale’s managers. And then got back onto the manager side back in 2001-2002 and formed a partnership called Protégé Partners, which was a hedge fund of funds, investing in early-stage, and seeding hedge funds. And I did that for 14 years; the fund grew to probably a peak just under 4 billion dollars.
And left in 2015, just not sure what would come next. And out of that came a bunch of projects, a lot of investment-related projects. I worked with CDP on a project and a couple of family offices. And along the way, I started a podcast. It came out of having too much time on my hands, with no objective, no thought that it would be; I was like, I’m going to have conversations with a couple of friends and share that for free.
It doesn’t sound like a business, not a good one at least. And I kept doing that alongside of all the other work I was doing, and about two years ago, everything else or the major projects I was working on fell away. I still have a bunch of advisory relationships. And around the same time, advertisers started calling, and so I kind of thought, well, let’s see what happens with the podcast.
Capital Allocators – The Podcast and The Book
So I have a podcast called Capital Allocators, it’s four years old. It just got named recently the number one institutional investing podcast. It’s had about five and a half, six million downloads. And mostly, I interview CIOs of big pools of capital. So the chief investment officers, big endowments, foundations, pension funds, sovereign wealth funds.
And I also interview some of their favorite money managers and anyone else that I meet along the way who you could think about decision-making theorists, leaders, great managers of people, that will help CIOs get better at their craft. So that’s been the podcast, and starting, I guess about a year ago, I had started forgetting what I had learned.
So I started forgetting the conversations after about 50 interviews, and after a 100, I really was forgetting them. So I decided to try to just distil a bunch of the lessons really for myself and ended up turning it into a book that just came out maybe two weeks ago called Capital Allocators.
Mike:00:06:08Great book, by the way, if anyone who hasn’t had a chance to.
Ted: 00:06:11Thank you.
Mike:00:06:13Right. I really enjoyed the fact that you read, I think most of it, I think I heard one different voice, but you did a lot of the actual reading of that?
Rodrigo:00:06:21Of the audiobook.
Ted: 00:06:22Oh, on the audiobook? Yes, I did the whole thing. It turns out for anyone who wants to write a book, by accident, I did the audiobook before the book was done, which allowed me to find about five typos in every chapter that we hadn’t through all the editing process.
Usually, the editor says, okay, we’re printing the book, now read the audiobook, and then people get incredibly frustrated. So that publisher had never done that before, but it was great because I think there are; I only found one mistake in the book post-printing, so yes.
Adam.:00:06:51That’s incredible, really.
Ted:00:06:52Yes. Someone came to me and said people are used to your voice; you might as well do the read. So if there is someone else’s voice there, I haven’t listened to the audiobook. If there is if like Rodrigo’s voices in there, it’s probably a mistake, and we should do something about it.
Mike:00:07:05No, actually, it could have just been me walking and thinking. I thought there was a chapter in there. I misheard it, I guess. But I knew you were most of it, if not all of it. I thought there was one part that sounded like a little bit different, but anyway, it was great.It was great for you to use your own voice, and there’s value there, I think, in identifying with your podcast listeners as well.
Mike:00:07:28So that’s great. And if anyone hasn’t picked it up, it’s full of all kinds of knowledge. So I don’t know, maybe I’m going to start with a question of what was, in running the podcast for four years, and then sort of a culmination of sort of reviewing all those thoughts. What were sort of your top, and I know you said this in the book, don’t ask two questions, but I’m going to ask them anyway? So what were your top findings, and what was the most surprising?
Lessons Learned from Interviews
Ted:00:08:02Yes. So the top lessons for me, the biggest learnings came from all the disciplines that are involved in investing but aren’t investing. So we all want to talk about stocks and portfolio construction, and I’m talking to CIOs about investment managers and their process.
And all of that are variations of the same theme, there’s a lot of little nuggets of wisdom you can pick up from that, but those weren’t the biggest lessons. The biggest lessons were the things that we need to be good investors, that you don’t learn in the business of investing or in the profession of investing, I should say.
So those are things like decision-making theory. You can get there, and people are more privy to it now. But I had never been exposed to it until I had Annie Duke on my show a couple of years ago. I knew everything about behavioral finance and behavioral bias, but no one ever tells you what do you do about it.
In sort of all, in my years of experience. So that was one, then really what came out of the podcast was interviewing. So it’s true of stock pickers, it’s certainly true of allocators, which is the core of their interaction or interviews.
And in all the years I had done all these interviews, I never once left an interview and said, how did I just do as an interviewer? You’re always leaving evaluating the person across the table from you. And so I had to do that in the process of trying to get better at interviewing for the podcast.
And then there are things that were just always interesting to me, right? We know in this business that people are good managers of money, but stereotypically not good managers of people. Well, that’s only specific to our industry, that’s not true in business generally. So I was kind of interested in learning because what you find when you start to learn what’s the body of knowledge about kind of leadership and management.
Is like anything else, there is a body of knowledge. It sounds so simple when you hear it, but we’re just not taught it. So if you’re never exposed to it, you wouldn’t know even if it’s really kind of obvious, particularly like management disciplines. So those were the types of things that were the biggest learnings for me because I had never been exposed to it.
And then you start to realize, wow, I bet we could have made better investment decisions if I understood some of the key tenets of what a good decision-making process are. The most surprising was on the investment side, which has to do with governance and that part of decision making. So when I worked at Yale, Yale has one of the best governance structures for its type of pool of capital, in that it works.
I mean, you have an investment office. David Swenson’s known as the CIO; he actually doesn’t legally make the investment decisions at Yale. It is the Yale investment committee, which is a subset of the corporation. And in that interaction between the CIO or the investment team and the committee, sometimes it’s not that smooth, and it’s not the case that the people doing all the work can do what they want with the portfolio.
And that came up over and over and over again, interviewing CIOs about how challenging governance was, how much they had to work at keeping their investment committee informed in what they were doing. Then you talked to, say, a public pension fund and the decision-making body; they’re not sophisticated investors; they don’t know anything about investing.
Take CalSTRS as an example. It’s firemen, policemen; those are the types of people that are making the investment decisions. And so the CIO’s job becomes a constant teacher like they’re constantly a professor of 101 of investing. Forget about getting into the subtle things that go into it.
And so that was the most surprising at how consistent that challenge is because all of us in the money management world think, hey, we’re in front of the CIO of a big pool of capital, we’re trying to win that business from them. And if they like us, they’re going to invest.
Well, turns out there’s a whole another layer, that even if that person likes you, they may call you someday and say hey, sorry we can’t make the investment or we can’t do it now. And you never know as the money manager what’s in-between sort of the person who seems like they’re interested in your fund, and the ultimate decision getting made in your favor.
Rodrigo:00:12:08Are there some commonalities across these different pension plans and organizations that involve governance? Where an asset manager, for example, might say okay, just, generally speaking, you should be good at X when communicating to the CIO, so that it’s easy to communicate with the board? Or is everybody kind of a unique snowflake?
Ted:00:12:32I mean, everyone is unique in what their own structure is, and you’ll never really know that. What you do know is that the CIO will need to present the case to the board. So as the manager, one of the smartest things you can do is hand them the case.
So one of the things that’s always fun when I talk to managers, and you know I don’t do this that much anymore, but people like looking for advice raising money. Turns out everybody wants to raise money, no surprise. And of the thousands and thousands of pitch books I’ve seen, I can only think of two that I didn’t give the exact same first feedback, which was fewer words.
So what happens with money managers is, when they’re going to give a presentation, they try to tell their whole story. But there’s a difference between a deck if I’m sitting down with you going through it and writing down what the story is. So what I would always tell people split those two apart.
If you’re giving a presentation, you want a lot of pictures, you want to talk to you, you don’t want people getting stuck on the pages. But you can give them a leave behind, and that leave behind could be the script of what you just went through in your deck.
But it’s also the memo that the CIO and their team will need to deliver to an investment committee down the road. So that’s the one thing that any manager could do to get, help that person do their job really.
Mike:00:13:51Did you see a lot of that in your experience at Yale with Swenson in managing his investment committees and boards? He mentions that in his books, that he really worked on building the committee and the board to be sort of a reflection of maybe not; maybe his goals might be too strong a word.
But he seemed to build that or mentions building that in his image, if you will, so that he could have a chance to succeed and think differently. Was that your experience? And how did that compare to what you saw or what you’ve seen over the last four years in writing Capital Allocators and with your podcast?
Ted:00:14:35Yes. So it’s a bit of an evolution; when I joined David, he had only been there for seven years. And the committee wasn’t his committee, it was the committee that was there when he got there, and there’s some turnover.
So that’s what happens, right? The CIO walks into a committee, and the first step is how do you engender trust with that committee. And a lot of it sounds like common sense, and a lot of CIOs do it. Which is if you’re making an investment decision, keep them involved in the process. If you’re going to a committee meeting, they should know what’s coming up.
If someone’s a real estate expert on that board, you should talk to them about any real estate investment you’re making before you even go through the work, right? And he was very good at that, right? He was always in touch with every single individual member of that committee in between the board meetings.
What sometimes happens is you still do that, and then things go awry in a board meeting because decision-making bodies have all kinds of challenges to them. So it starts with that; it starts with getting that committee or each person on that committee to trust you as the CIO. Now, as time goes on, because he’s been there, he joined in 85, so 36 years.
At some point in time, and particularly the inflection point for him, was when he wrote his book in 2000. So you can imagine in the past, you had investment luminaries on the committee. And he was a CIO with a team coming to make decisions. He becomes the legend, and now the next person that comes into the committee is looking up to him.
He’s the only person with that dynamic, probably in the world. But even before then, he had a great relationship with the Yale Corporation and the president of Yale, and they were the ones who would make decisions about who to invite onto the committee, and it’s complicated, right? It’s a university.
They take in donations. The development office is going to want certain people. There’s always this, I wouldn’t say it was a legendary story, but we always knew. For whatever reason, I can’t tell you I know the reason. David never wanted Barton Biggs on the investment committee, the legendary strategist.
Barton desperately wanted to be on the committee. He never was on Yale’s investment committee, and I personally don’t know why. I wasn’t involved in those conversations. But there was something about him, or I don’t know what it was, but David didn’t want him on the committee, and he never made it on the committee. So wow, there’s something really interesting and over time.
Now over time, if you have the trust of the existing committee as people rotate off, then you get more and more of a say of what type of person comes on. And again, it all comes down to an interviewing process. So how do you know if the person you’re trying to bring on the committee will be a good committee member?
What does that mean? What does that mean in the context of any one committee? And for a place like Yale, they’re not voted on, right? It’s a subset of the Yale Corporation, and some of the members of the committee are voted on by the alumni community as members of the corporation.
But then there’s a good chunk of the committee are just, they don’t have a governance role, it’s kind of like an advisory committee. So they’re chosen by usually David and the president of Yale. So yes, that’s the process, right? People walk into a committee; they have to get trust in that committee.
The committee rotates over; they have to continually get trust with the new members. And then, over time, if they’re in the seat long enough, which is a whole nother question. The committee more and more takes shape in their image and functions as a better body.
Rodrigo:00:18:02So interviewing is a key aspect of Capital Allocators. And it seems that when you say interviewing with respect to that, you’re thinking interviewing managers. But in this case, we’re also seeing interviewing skills for your committee, your employees, the whole spectrum of interviews.
So do you think this is a skill to be learned? Or is it something that people are naturally good at? Like is Swenson somebody that has been able to teach you a thing or two about interviewing?
Ted:00:18:35So those are three questions; let me try to figure out which one I’m answering. …
Mike:00:18:39He didn’t read the book. Asking a three-part question, sacrilege. It’s highlighted in the book, actually.
Ted: 00:18:53Yes. I would say that there wasn’t anything in particular about the interviewing process that I learned at Yale. You do learn a lot by osmosis. So if you’re around people that ask good questions, and every person, every allocator has their own way of going about these interviews.
And so if you’re on that team, you’ll learn that person’s way. Just to give you a concrete example, at Yale, everybody goes through structural things, like what are you doing? What does your portfolio look like? There’s a bunch of data you have to collect. Yale would dive in deep on underlying positions.
And so other people don’t do that, other people care more about the temperament of the people, and they dive in on that. But I didn’t really learn anything about how to conduct a good interview until I was doing the podcast.
And I started kind of reading about good interviewers or listening to other podcasts from good interviewers. Reading about like Larry King or Cal Fussman and Tim Ferriss who’s quite a good interviewer. And so I did put some of the things I learned in the book, and some of it again is pretty; it sounds like common sense.
So if you walk through some of it, every time you’re doing an interview, the first thing you want to do is understand what the purpose of the interview is. That sounds like common sense, right? I’m an allocator; I’m going to interview a manager. The purpose of the interview should be for me to figure out if I want to invest; okay, yes. Within that, what I’m really trying to do is gather information from them so that I can make a decision. I’m not trying to make a decision in that meeting; I’m trying to gather information. Well, how do you gather information?
Do you do it by listening or talking? Sounds obvious; you probably should listen. Well, we’ve all been in manager meetings where the allocators decide the purpose of the meeting is for them to prove that they’re smart. They’re not going to learn much in the context of that meeting.
So just as an example, and then you could go through that from there, like one of the insights I got from thinking about the interviewing process that I had never done in my 20 years of institutional investing was that there’s a lot of information you gather in the process of deciding if you’re going to invest with a manager, right?
So there’s information about the team, there’s information about the fund, there’s information about the people, there’s information about competitors. It’s why most sort of allocators will have many meetings with the manager before they invest. What they don’t tend to do is to focus each particular interaction on one aspect of that process and going deep.
So you don’t often hear say, okay like we’re going to have a meeting with ReSolve? The only thing I’m going to ask questions about in this particular interview is how these people work together; that’s it. We’re not going to talk about their investment ideas, we’re not talking about anything.
And so let’s come up with 25 different questions that’ll help us understand how they work together. If you don’t have that as a premise, you won’t get in that kind of depth. You know someone will ask a question along the way, like, what do you guys do when you disagree? Okay, that’s part of it.
But to really focus the purpose on each individual interaction, and then you turn that over and say, well, it’s the same thing with money managers and management teams. I think sometimes the time that a money manager has with the management team is so limited that they’re forced to focus on what are they trying to get out of that meeting, and so you do get to that purpose.
But interviews are really a broad topic, like it’s not a conversation, right? A conversation is a two-way conversation where people are both exerting their opinions and going back and forth. An interview is really one person asking the questions and another one giving the answers.
So that’s just like the very first step of it is, what’s the purpose of the interview. So when I do podcasts now, I do think about like what is the particular story that I’m trying to get at, what’s the purpose of interviewing that person?
And how am I going to go about it? Not so much exactly for me what questions we’ll ask, but like what are the topics I want to cover? How do I want to get there? And then leave lots of room to go in different directions. So that’s one example of that whole interviewing process, that people just don’t think about much, and I didn’t either in all my years of investing.
Adam.:00:23:17In terms of just manager selection in general, I think we all agree that finding alpha sources is a really hard job, and the further along I go, I almost think that finding managers who are likely to be able to generate alpha is actually an order of magnitude harder.
Because just by virtue of the fact that you’re operating with less information than the manager is operating with about his own process, makes it very difficult to know the nuances and intricate details about whether that manager’s process is likely to yield fruit.
How do you sort of triangulate on the salient qualities of what a manager says that help you to close that gap and improve your chances that you’re going to actually find a group of managers that are actually going to deliver on what they have been assigned to do?
Ted:00:24:41Yes, it’s a funny dichotomy. And I think most of the people in the manager community share your sentiment, but part of that is because they’ve never sat in the seat of an allocator. So there’s a degree of pattern recognition that just comes with repetition. And if you’ve looked at the same strategy 25 times over, it oftentimes isn’t that hard to figure out which five of those do you think are better than the other 20. Because it’s going to be peeling layers of the onion, and at some point in time, one onion’s bare, and there are lots more layers than the other ones.
So there is a degree to which it comes from experience and pattern recognition. Doesn’t mean you get it right because there’s a lot of noise in markets, and we know that. But in terms of evaluating process, I think that’s absolutely true. Now the question is, what do you do with that instinct?
And there’s a fair amount of work that an allocator will do in the course of their decision that you’ll never see as the manager. Some of it you will, and some of it you don’t. So something as simple as reference checking, again starting with like what’s the purpose of that reference check, and how are you going to go about getting differential information in that.
But you can certainly paint the mosaic of a person and a firm and a strategy if you can talk to the people who are in the room with them as an example. So as a discipline in my years of protégé, and we could do this with slightly smaller funds. We spoke to every departing employee of every fund we invested in, every single one.
And if the manager wouldn’t let us, we usually would come out of the fund because you’d assume something was wrong. So there are ways over time that you can get access to, kind of what you’re trying to do, or my favorite reference check always was, who knows you on a day-to-day basis better than your administrative assistant?
The good, the bad, the ugly. Now it doesn’t help if someone doesn’t have an administrative assistant, but in a lot of instances, they do. And you can learn a lot, and it turns out who’s the best person to interview the administrative assistant? It’s not me. It might be my administrative assistant.
And by the way, in that interaction, that administrative assistants never had somebody do that before, so all you have to do is train your administrative assistant the littlest bit, to ask certain types of questions and do it in a really friendly way, so they’re hiding the fact that they’re trying to get information, right?
And that’s just one of probably a hundred different things that allocators can do. Now some don’t, but the good ones constantly are thinking about how do we learn the truth? You know I saw what I saw in these meetings, I like what I saw, how do I know it’s true. And so that’s their job, and they’re good at it.
And I think that if investing was a game with more skill and less luck than it is, and particularly you could differentiate public markets and private markets that way. I think performance would be even better from the allocator community because they are good at it.
And I think that’s why one of many reasons why there’s a lot of money gravitated to private equity because it is a more skilful practice than in many. On the skill luck perspective, private equity is more skilful than public equity.
Adam.:00:28:04I wanted to ask another question, but now I want to go down that rabbit hole.
Adam.:00:28:14So why do you say that?
Mike:00:28:16Ted said this, …
Ted:00:28:22Yes. So Michael Mobison, in The Success Equation, defined the difference between luck and skill in any game with this simple question which is, can you lose on purpose? So if you’re investing in the public markets, it’s very hard to outperform, and it’s almost equally hard to underperform.
It’d be very hard in good faith, you’re sort of going in buying stocks, you could trade a lot and just completely mess it up, but that’s easily identifiable. If you’re a private equity investor, all you have to do to mess up is go buy a company and tell them to turn off the lights and go home on vacation.
You’d lose all your money like that, right? So it’s much harder to mess up public investments than it is private investments. You have much more control in the private markets, there’s a lot more you can do. And if you’re really not good, you will harm companies, and that will come out in results.
Adam.:00:29:18Okay. So that actually dovetails perfectly with where I was going to go. Because it seems like a lot of the examples you gave, which are really good examples, by the way. But thematically, they seem to be in the category of seeking to avoid negative experiences, right?
And so if you can weed out the managers that have qualities that make it more likely that something that probably is not even related to the actual investment strategy is going to derail results, then you’re already well ahead of the pack who hasn’t done the research and eliminated those sort of standout negative managers, right?
So it’s more of a negative screening type approach than it is really driving towards whether someone in a certain space or with a certain type of strategy is likely, more likely than others in that category to deliver alpha, once you’ve eliminated the ones that have warts or hair on them in some respect, right?
And that seems to be sort of the same in private equity because, in private equity, the operating levers are more varied, and you have more direct control over the companies in your portfolio. More really negative things can go wrong, right? And therefore, you can rely on negative screens may be more effectively in private equity that even you can in public markets. Is that a fair assessment?
Ted:00:31:07Not sure I understand the question, but I think it’s only part of the equation, right? So in the process of trying to pick a great manager, one of the first things you want to do is get rid of your left tails, that’s how compounding works, right? But it’s not the case that you would just say, well, as long as we just get rid of the negative selection, we’ll just hire all the managers that meet that criteria, so you are trying to pick the best.
It’s just that I’ve said for a long time; I actually don’t think it is; given the right duration, I think it’s imminently achievable to pick top-quartile managers over time. I didn’t say it’s easy, but I think it’s imminently achievable. I think it’s very difficult oftentimes within the top quartile to figure out is it top decile or next decile because of the noise factor.
Doesn’t mean you’re not trying to pick the top one percent; you are. But most of what you can recognize are the things that you’re sort of screening out, because the whole business as an allocator, your business is saying no, that’s all you do. I even put these stats; I hadn’t even thought about these until I was writing the book.
Just getting a meeting with an allocator, just getting a single meeting based on the number of managers available and the amount of time allocators have, is six times harder than it is for a college senior to get into Yale or Harvard. Even with this year’s four percent acceptance rate instead of six percent.
They are just so many managers, and there’s a limited amount of time. So it’s a difficult practice, and as a result of that, when you’re sitting as an allocator, you have to create filters, right? You have to create filters to manage your time. And so some of those frustrate managers to no end, right?
Like Dave Swenson was known for saying he’s he’ll never invest in a fund sponsored by a bank or a financial services company that’s not independently owned. And that would frustrate the banks who had great products; I bet it frustrates Blackstone to no end.
And he’s fully aware that he’ll have some errors of omission from that, but he said you know what, he believes that having the proper alignment and having the economics you pay go directly to the managers is best for investment success. And so he’s perfectly willing to miss those errors of omission because he’s trying to narrow the filter to the ones that are more likely to be in that top half.
Adam.:00:33:33Okay, fair enough. So what are some of those sort of positive identifiers that, aside from let’s eliminate all the ones that have hair on them, in some qualitative respect or maybe some quantitative respects? And now you’ve got the top half of managers, how do you move from you’ve eliminated the ones with hair and warts and that you just kind of don’t want to touch. And then narrow it down to those that you genuinely have high confidence are going to be in the top quartile. So we’re moving to more of this positive screening.
Ted:00:34:09Yes, I mean, so it’s very easy to give you 25 different criteria, right? I could start throwing off the top of my head, alignment of interest, proper compensation incentives, a highly functioning team, great pedigrees, great backgrounds. They have a consistent investment philosophy, a sound process, on and on and on and on there’s nothing new in that, but all of those things matter.
At the end of it, it’s a judgment call, and it’s far more about people’s judgment, and then portfolio fit that you don’t really see as a manager than anything else, right? People have a portfolio, so the day you’ve walked in, they already have a group of managers. In some situations, in rare situations, but in some situations, they’ve shifted their asset allocation.
So they are looking for a manager to fill a gap. But most of the time, they have a portfolio in place, and so you are fighting an incumbent; how are you going to displace the incumbent, right? And that’s it.
So their biases should be and is to do nothing and in fact, if you do things like, let’s do it separately. Seth Alexander at MIT, who I worked with at Yale, who’s just doing a remarkable job. One of the things he did, was he’s made it incredibly onerous for the people on their team to bring a new recommendation to the group internally that makes a decision.
They have to go through multiple meetings; they have to write 50-page memos just to be able to recommend it because he wanted to create a bias towards less turnover. That’s the only way you can do it. Make it so it’s an obstacle for that investment office to actually make a new investment decision.
So as the manager, you’re on the other side of that, ultimately it’s a judgment call, and it comes from. And the hard part is, let me tell you, the hard part for managers; people are looking for the top one percent. That means that 99 out of 100 managers don’t fit, it’s a very difficult business to win capital because of that.
And it’s a perspective that the managers don’t really see and appreciate, that the allocators know a lot about what’s available and who the competition is, that’s what they do all day every day. And so you guys can recognize in ReSolve how difficult it is to mine for alpha.
And if someone senses huh, boy like Two Sigma seems to be doing it. They’ve got a budget that’s like 500 times yours, and they’re hiring all these people, maybe I’ll just invest over there, that’s an option that they have. And so that makes it very difficult for managers because I always say there’s nothing unique. Every strategy you could find, there’s a hundred managers doing exactly the same strategy. And if someone’s looking for that strategy, they’re only going to pick one.
Mike:00:37:03I’m really depressed now.
Adam.:00:37:05Yes, that is what is funny, because I keep driving.
Ted:00:37:08Yes, I’m happy that I don’t do this anymore.
Adam.:00:37:11I keep driving because we’re obviously systems thinkers, right? Like we’re systematic thinking in every conceivable dimension of the business to the maximum extent possible. And so the least satisfying answer is it’s a judgment call, right? Like what are the inputs of the judgment, how do we measure the weighted salience of the qualities that are going into the process? How do we measure success? How do we filter out the noise?
Ted:00:37:52So there’s another perspective I could bring that that might be helpful in thinking about it, which is the following. There’s a reason why it’s a qualitative decision for the allocator, and there’s a reason why despite the proliferation of data that’s available, that statistics don’t really drive their decisions that much.
And that is that they are layers of layers removed from the real economic data that matters. So think about the data that Amazon is using to track, to sales, whatever it is. There’s an incredible amount of data that an individual company can use to understand their customers and make better decisions.
As an investment manager, there is data you can use about companies, but it’s not close to the amount of data that the companies have about their customers, right? You can use financial data; you could use technical data in the markets. Now you’re at the allocator level; the only real data is performance.
Maybe they can get access to your data, right? But the only new independent data is performance, there’s no data that will tell you how do the three of you work together when you’re creating a systematic process. What is that data set? So it’s actually right that when you get to the allocator level, it shouldn’t be a quantitative-based decision because there’s not enough data to do anything robust.
And if the managers want to really get frustrated, then talk about the allocators that do use the available data, which is performance track records, and we all know that those aren’t statistically significant in almost anyone’s lifetime.
So it’s actually maybe frustrating from a systems perspective, but it is the right answer because those aren’t, there isn’t really a body of data that anyone knows about that goes into determining future investment performance in any of these asset classes.
Adam.:00:39:49Well, the funny thing is, I mean actually, we don’t disagree. It’s just that I think there is an opportunity. And I know that there have been academic studies that have tried to sort of codify, right? What are the qualitative categorical variables, for example, that are more likely to identify managers with, that will outperform, right?
So it doesn’t need to be just examining the sort of performance data; it can also just be there is a formula, there have been lots of cross-sectional analysis that identify these variables as having a large amount of weight in terms of identifying strong managers, and now you’ve got some sort of statistical robustness to the decision making process. That is not just I’ve been doing this a long time, and my radar is good, right?
Ted:00:40:43There is, I mean let me share with you what that data is, from very smart professors. So let’s start with the fact, particularly in the hedge fund space, let’s start with the fact that the databases aren’t good, they’re not cleaned well.
They are not capitalization-weighted, so they’re not the investor’s experience, which means that Bridgewater accounts as much as a 25 million dollar hedge fund that nobody really cares about. And within that, after here’s what you learn, managers who drive Ferraris take more risk than other managers, right?
Okay, managers who go through divorce, by the way, tend to have weak performance in the period of time of stress and very strong performance after; I totally buy that, right? Now let me ask you a question, do you know when they’re going through the divorce and having a period of stress?
Usually, by the time you know about the divorce, they’re on the upswing. So how are they measuring that data? So every time you’ve seen some interesting data set that would tell you if a manager is likely to be a risk-taker, not a risk-taker, good at what they do, not good at what they do, it’s so peripheral that if you have a list of 100 things that might matter in the decision, that’s now 101.
Not that you won’t incorporate it. And so then where else, I mean, I’d love to know what you’re referring to, because outside of performance, and yes, you could scrutinize performance in a lot of ways, and there’s really good granular ways to cross-section performance if you have the data. Like I just have full transparency on the managers, we see that we knew a lot about what was driving returns. I’ve yet to see a situation where what was driving returns in the past ended up driving returns in the future. It’s very rare, yes.
Adam.:00:42:24No, we’re completely aligned on that, I think, all four of us yes. And I agree with you, I think a lot of that data, and we don’t need to belabor this, and I think we’re mostly in violent agreement here. But I just think it’s absolutely a lot of these this qualitative information that you use to triangulate and try to make good decisions need to be derived through the interview process, right? They need to be derived through conversation.
And the question really is once you’ve got a list of information that you’d like to know about, and you go about getting that information, using a mosaic of methods. Most of which involves interviews then.
Is there a way to sort of now we’re going to take the information that we got through the interview process, and we’re going to put it through more of a formal codified framework to help us with the decision making?
Ted:00:43:14Oh sure, yes and there’s a lot of allocators do that. Like they’ll have a scoring rubric, and they’ll weight things. I’m not sure that they make this decision based on the manager that reaches a 27 out of 30, compared to a 26 and a half that they liked better. But there are ways that people score it, for sure.
Adam.:00:43:32How do you overcome that? Go ahead, Mike, sorry, man.
Mike:00:43:36Well, I just found that this is complicated also by the fact that on the other side is the allocator, who is a flawed human or a flawed board of humans. And so we’re aspiring to give me the freaking code that you make decisions with. And on the other side of that is this messy human that doesn’t have a code, …
Adam.:00:44:09I agree, right? But then you’ve got the Annie Duke example, right? Like you’ve got, you’ve got Mobison, and you’ve got Annie Duke, and you’ve got Kahneman, you’ve got other people who are constantly highlighting research that shows that a lot of the inputs that drive us to make decisions come down to familiarity, kin identification. Like there’s all these sort of soft things just social chemistry, did you have the same, are you alumni of the same school?
Mike:00:44:44There’s tribalism, there’s lots of tribalism through the whole thing. And this is what I’m trying to add.
Adam.:00:44:50So you want to sort of, yes, how do you codify in order to drive away from those biases.
Mike:00:44:55So there’s allocators trying to do that math on their side, which they’re not doing very well. I think that this is actually great; Ted, if you could highlight some of the behavioral finance stuff that you found on the boards, the variants of how they approached these things, and the mistakes that were commonalities across the board, I think would be amazing.
Behavioral Finance and Boards
Ted:00:45:15Yes. Well, I think the mistakes are the same as any mistakes we know about, right? So performance chasing is a big one, and I love using this example. So I’ll ask you guys, I will ask any CIO. If you take the spectrum of decisions of, it could be entering or exiting managers.
I haven’t come across an allocator yet who invested with a manager, who watched that manager deliver just outstanding returns. And maybe they grew, but they didn’t grow like crazy; they did everything they were supposed to do. The returns were incredible, and therefore they fired them. That’s happened exactly never, right?
Mike:00:46:01Counting all the times that that’s happening.
Ted:00:46:06It’s exactly never. So we know returns mean revert, but that’s kind of interesting, right? Like no one’s taken a risk to say, maybe we should fire all the managers that have done just exceptionally well because it can’t continue. The other side of it we know happens all the time.
And this is where I think things have gotten interesting and more subtle. So if you went back 15-20 years ago before the knowledge of kind of behavioral finance was prevalent, people would make these, a manager would underperform, and an allocator would fire the manager, and they would make that decision without being aware of the kind of chasing performance data or behavioral bias and loss aversion, whatever it is.
Now people are aware of it, but they do it anyway. And so the question is like how does that happen and why, right? Because they are, people are much smarter than they were. And this probably goes back ten years, but I remember this vividly in two ways in my old firm.
So one was that to get away from that, what we decided we would do is whenever we invested with a manager, we would lay out a thesis and a set of risks, and all of that had to be disprovable with data. So we wouldn’t say as a thesis we think the manager is really smart, I said that’s a valid thesis, as long as we’re testing their IQ scores, and we will fire them when the IQ score deteriorates, right?
So you might have a thesis that says, like I think ReSolve has great models, and those models will be refreshed with new insights over time. And if you go three years and there are no new insights, you say okay, that might be a problem, right? So you could have thesis, and by the way, that has nothing to do with performance, performance could be good, and your models could be the same.
And people could determine well; if you’re not refreshing your models, my thesis is you have to do that to continue to perform, right? So you’d lay this out in such a way that it was, you wouldn’t look at performance, the first thing we would do in our quarterly reviews would say let’s review our thesis and risks, you might know, but you’re not looking at performance when you do that, it’s fine. So what happens? Well, you then go through your review, and the managers who had weak performance, people would say aha, we knew that was a risk, the manager isn’t as good as we thought they were.
Rodrigo:00:48:30Right. In our framework that had nothing to do with data, now.
Ted:00:48:34You still get the same answer because you’re influenced by it.
Rodrigo:00:48:37You’re just creating a narrative around why.
Ted:00:48:39It’s exactly right.
Rodrigo:00:48:40Your framework fits that they should be fired because you can’t disaggregate the performance from your original model.
Ted:00:48:47You don’t know. And you can’t help that because it’s behavior, right?
Rodrigo:00:48:50So with Swenson’s book, in some of his writings, he often talks about having a relationship with a manager long term, and focusing on process. Now I don’t know how much of these articles are true or not, but how true is that, where he seems to be a person that really is focused on process, less on performance and is able to keep long-term relationships?
Mike:00:49:14Well, also, how important is that in your experience with other managers too? Is that what you should do?
Ted: 00:49:21So let’s differentiate what market you’re in, right? Because in private equity, it’s one decision, and it’s 13 years later, right? So by definition, everything is long-term. But in the public markets or hedge funds where you can make regular decisions, I don’t know their data today.
I know that when David had been there for 25 years, the average length of the manager relationship was about 16, 15, and 16 years. And I know from being there that the one systematic bias that Yale makes mistakes time and time again, is overstaying their welcome.
So they have lots of examples of managers that had not been performing well, that things did not look good, and it didn’t get better, but they stayed around till the end. What I also saw was that’s incredibly valuable, because if your bias is to look through that, you are not running for the hills when things are bad. And you do that over and over again; it does add to performance. So I think that is, so I think that is a great way to invest.
Rodrigo:00:50:34That’s valuable because sometimes you stick to a manager that does recover.
Ted:00:50:39More often than not, yes.
Mike:00:50:42Which I guess is the primary objective of the earlier individual you mentioned, who made it very difficult to replace managers.
Ted:00:50:53Yes, right exactly. So one of the things that I had to learn, because I got lucky to start at Yale, and then at a place like Protégé, you don’t have an investment committee. So the long term doesn’t exist; the long term that investors aspire to does not exist. It does for Yale, it might for MIT, and it might for 20 or 30 institutions around the world. But for everybody else, it’s really three to five years.
Ted:00:51:28Right? So because of that, one of the things I’ve been preaching for years is for allocators to separate their decision about whether they want to invest with a manager from when they want to invest with the manager, on both sides.
Because if it’s only three to five years, you could look at almost any manager’s track record and find three years that were great, and find three years that were lousy, and it doesn’t even, doesn’t matter if it’s Warren Buffett, it doesn’t matter who the manager is. So ideally, you’d like to change that three to five-year horizon, but that’s what exists, and we know that that’s what exists.
So, as a result of that, you just need to be a lot more sensitive to your endpoints and to have a better experience. And then maybe that helps you, if you’re having a better experience, maybe that helps you stay around for longer which then contributes to long-term returns.
Adam.:00:52:25So, did you review the success of institutions in general? I mean, I know there are some standouts, right? Yale being obviously one. And I know that there are a handful of others. There’s also lots of research that suggests that while there are, I’m sure, a fairly large number of vigilant and hardworking and intelligent and thoughtful allocators that, for whatever reason, the vast majority of institutions just don’t generate the alpha that they hope. Are there institutional barriers that that get in the way here? Or is it just lousy practises? Or how do you sort of diagnose that challenge?
Ted:00:53:22So let me start with the premise; I haven’t looked at the data, I don’t much care. And to give you a sense, it was only six years ago that I left managing money on my own, so I wasn’t paying any attention to it. And if I was going to measure it over six years, it’s way too short a period of time to have any real conclusions.
Ted:00:53:45So I’m not sure that the premise is correct, and the reason is that if you go back to purpose, like what are the purposes of these pools of capital? It is not to beat a market. I don’t know Richard Ennis from the retired founder of Ennisknupp, who’s going around now telling everybody they should index; they should have much more money passive management.
But everything he writes is talking about, oh, these institutions have underperformed their benchmark by 1, 2 percent over the last ten years. I was like, that may be the case, but I think they’ve all met their spending objectives. Their purpose is not to outperform a benchmark that he ascribes that they should be outperforming.
Now you could say their job is to do better than, and that’s fine, and we could talk about that. But let’s start with the point that if capital markets are going up, everybody wins. Like you can fine-tune the difference and say we should have won by more, or maybe we should have won by more, and then that would have saved us.
But everybody’s winning, that’s good, right? So the problem with saying these people are underperforming is you’re presuming that we know in a statistical and data-sensitive way exactly what they’re trying to do.
And what the relevant benchmark is for them, and what they’re doing. Instead, what we get is reams of data that claims that across the public equity markets, active management as a whole, underperforms. And you know what? That’s been true, and now it’s been true for like 12 years.
And it’s been true because we’ve had a revolution in the way technology has changed the economy, and if you didn’t own enough Google and Amazon and Facebook, you underperformed. People don’t talk about that in Korea when Samsung was 40% of the index, right?
Because it’s like, well, that’s not what you’re trying to capture. And we’re getting there in the U.S. especially, we’re getting there. So if the index gets more and more skewed towards a couple of winners, the purpose of investing in the S&P500 is not going to be the same thing that it was, so let’s start with that premise.
Now let me address your question, which is I do think that generally, speaking institutions do poorly. In fact, David Swenson’s book 20 years ago talked about investment success demands un-institutional behavior from institutions.
And so what is it about that? It’s exactly what we talked about. It’s sort of people want Margaret Chen from Cambridge Associates had this great quote on my show, which is “people want to be different and the same”, right?
Whether it’s kind of go all the way back to kind of classic job risk, or it’s just human nature, right? These boards want to ask what Yale’s doing; they want to be more like somebody else. They’re not really thinking about it in the context of what’s right for us. And so all of that, that’s a high-level way of saying like the institution itself makes investment success very challenging.
Because you just have to do things that are different from everybody else, in that if you were measuring things properly, and if you were trying to beat whatever you could get and access readily in index funds or low-cost investing. People have still fallen short only in the public markets, not in the private markets.
The private market index has worked for everybody, that’s been a place. If you were investing in private equity, you won over the last ten years. If you’re investing in hedge funds like when I was at Yale, you won over those ten years. It almost didn’t even matter which managers you’re in. So being early, being a first mover, being on the leading edge of what is working is sort of its own type of beta that wins over time, and that’s what a lot of these people are trying to do.
Mike:00:57:30In a structure that doesn’t really allow them to do it.
Ted:00:57:33Some of them, they’re not homogeneous structures, right? So everyone’s a little bit different.
Adam.:00:57:40Well, you won’t find a group of people that are more supportive of the view that marking managers against some kind of U.S. 60/40 benchmark is absurd, right? So completely agree with that. I think the analysis that maybe is a little more relevant relates to performance relative to their own policy portfolios, right?
So I think that probably has a more interesting; I mean, we can certainly have a conversation about whether the policy portfolios make sense. But I think we can benchmark whatever the public equity, U.S. public equity against U.S. public equity passive, emerging equity versus emerging passive, that sort of thing is a reasonable proxy.
And I think some of the research suggests that it’s just a really hard game when you market using the right criteria. But I’m sure that people can structure the institutions, structure organizations to improve their odds of success.
Rodrigo: Speaking of improving your chance of success, I know Ted that you like a lot of Annie Duke’s work and the idea of decision-making frameworks. From your interviews with her, and I know she’s affected you personally.
What did you come out with in your book? And what would you write in your book that would help allocators use her framework or her way of thinking in order to improve things?
Annie Duke and Decision Making
Ted:00:59:12Yes. And Rodrigo, you’re right, like I’ve learned a lot from Annie. She’s become a good friend, and fortunately, I can like tap into her from time to time when important decisions come up because she really understands this stuff incredibly deeply.
So from the institutional allocator perspective, most of these decisions are made in groups. And so a lot of Annie’s work starts with the problems that we have, starts with the problems we have as individuals in making good decisions, right? It starts with to get the feedback loop right, you have to have like good, clean data, and that’s actually not that easy because of hindsight bias and all these kinds of things.
And the way the brain is wired at Danny Kahneman, system one and system two thinking, and it just gets more complicated when you get in a group. So when you get in a group, there’s really three, it’s really Annie and Michael Mobison, and Gary Klein are the three people I drew on the most, three different features.
The first is sort of what’s the structure of the team; the second is how does the team conduct themselves. And the last is sort of what are they thinking in the underlying decision thought. So structure of the team, fairly simple, four to six people is optimal. I don’t know the research.
Michael knows the research; he talks about it. It’s not 12; we know that, right? It’s not one or two because if you have a few more people, you’ll be able to really unearth other potential outcomes, usually risks that you might miss if it’s just one or two. Within that, cognitive diversity is important.
I like to highlight not social diversity. Social diversity is usually correlated with cognitive diversity, but what you want is people who think differently. You don’t want people who look different but think the same, so just to make that clear. Those two things are often correlated, yes, exactly.
And so that kind of gets into putting the team together, having a group, and then there are things like intellectual honesty within that, right? So the idea of that group is to try to seek objective truth, not to be right with your own opinion. So that’s kind of you form the group, then you get into how does that group conduct themselves. And that all starts with Annie has this great framework of infecting beliefs.
So the way the brain works if you hear something you believe it’s true, system one thinking, and then you later might process whether you actually think it’s true or not, and that takes work, and the brain is lazy. Which also means that if you’re in a group with a leader, and the leader comes in and expresses their view before anybody else talks, everyone else, because of human nature and tribalism, will just fall into line. So you want to structure the group so. Usually, the most junior person or the least informed person sort of speaks first and has their opinion heard, and then it works its way up.
You want to draw out the introverts and quiet down the extroverts. So everyone’s on equal footing. And that allows you to have independence of thought. The other part of it that’s incredibly important is cognitive safety, so if you have a team where people are punished, either implicitly or explicitly, for expressing views that are different from the leader of the group, they will not feel free to express dissenting opinions.
And that’s really what you’re trying to get at; what you’re trying to get at is all the different possibilities that could happen in any decision. Ultimately, the leader or the key decision-maker will make a decision. Consensus decisions are harder, but that’s what you’re trying to get to. And then the last part is okay within that structure, that team, that structure, how are they thinking? And that’s you know Annie’s great line “wanna bet?”, which is thinking probabilities, not absolutes. And they all weave together because if the head of the group comes in and says, hopefully, doesn’t, but he says I think we should make this investment, and I’m 75% sure, that is totally different, in the tone that sets from I think we should make that investment.
Because if they end there, everyone in the group thinks they’re 100% sure. They’re not allowing themselves to tell the group that there’s uncertainty in the room. So all those things weave together; if they express themselves in probabilities, they are allowing other people to express their opinions, they’re expressing doubt, they’re welcoming other opinions, all those kinds of things.
Then you get into base rates inside view, outside view. Michael Mobison’s done a lot of great work about this. So most people are focused on the inside view; they ignore the outside view, you want to consider both, and then the last piece is risk assessments. So everybody loves post-mortems, and Gary Klein created the pre-mortem analysis, and he did it with fighter pilots, and he said the problem with the post-mortem is the pilot’s already dead, we’re trying to keep them alive.
So there’s a whole methodology for how you conduct an effective pre-mortem, and it’s an incredibly powerful tool because if it’s done well, it takes like 15 minutes and has a really elegant way of unearthing lots of different possibilities, and also reducing overconfidence was one of the key biases you’re trying to get rid of. And there’s other all kinds of other risk assessments, right? People use red teams and blue teams, devil’s advocates, even just pro and con list if it’s an individual is better than doing nothing. So those are just a couple of the key kinds of lenses that I’ve taken out of mostly Annie’s work, but also Michael and Gary’s.
Rodrigo:01:04:36That’s very insightful. Yes, and I think we certainly have seen those dynamics internally play out, and cognitive diversity is absolutely important. Because you know within the quantitative team, people with PhDs and mathematics background without a little bit of knowledge of management or sales or distribution, and everybody participating in the discussion, it can become the loudest, most confident, and most accredited person that dominates the group. So managing that balance, adding diversity, it has certainly been something we’ve seen add a ton of value.
Mike:01:05:19Reminds me of the conversation we had with Michelle Wucker, who was author of “The Grey Rhino”, and “You Are What You Risk” is her current book, and she talked about board diversity, specifically from the perspectives that you mentioned Ted, which is diversity of thinking. Which is slightly different and controversial to some degree because sometimes gender diversity would bring that, and sometimes it may not bring that. And so I also thought the RQ was something that you mentioned too, was that go ahead and just elaborate on that a little bit.
EQ, IQ and RQ
Ted:01:05:57So there’s EQ, right? There’s EQ, which is sort of how you relate to people and IQ, is your intelligence. RQ is something I don’t know a whole lot about it, so the rationality quotient, so that’s a metric of how rational people are in their thoughts.
So the question that comes up with cognitive diversity is if people naturally think differently from one another, it’s also naturally hard for them to get along. So how do you have both cognitive diversity and a cohesive team?
And what Michael Mobison talks about is there’s something called the Rationality Quotient, so you want people that are both cognitively diverse and to think rationally, because if they are high on the rationality quotient, they then can see their differences for what they are and not for the emotional triggers that will inevitably come up when you have people who sort of process things differently.
Mike:01:06:53And you shared some actually advice on how to frame that actually, in discussions on the board, which I thought was insightful. Anyway, sorry, Rod, go ahead.
Rodrigo:01:07:00No, I was just going to say that kind of ties into one of the questions from our audience that Brian Moriarty asks. How important is the relationship between a PM and the allocator versus the strength of the process? That is, the two parties dislike each other, but it’s a great portfolio fit.
Ted:01:07:18I love that question. I think it’s different for different people. There are money managers that are phenomenal that I personally would never invest in because I wasn’t comfortable with them as partners.
But I had clients, Protégé that from other countries, who didn’t value personal relationships at all; they just cared about numbers. And if they saw someone who’s performing, that was what served their purpose. I don’t think there’s one answer to that, and it also depends on what the manager wants, right? Some managers naturally want their clients to deeply understand what they do as a personality characteristic, not as a business strength. Everyone wants their clients to just shut up and stay put, right?
But there are some managers that naturally don’t like people, and they prefer to have clients who just want to evaluate them based on the results. So people are different, and it really is at its core a people business, there’s no one way to do it.
Mike:01:08:22Very cool. So what’s the better book, Pioneering Portfolio Management or Unconventional Success? Let’s get down to the real brass tacks here.
Ted:01:08:31Oh, I mean so Pioneering Portfolio Management, let’s talk about Unconventional Success, David’s second book. When he wrote the book, I read it, and I said, uh-oh, for two reasons. One, so David is a black and white thinker, and he it’s one of his gifts as it is with many money managers.
But when he wrote Unconventional Success, he really alienated everyone that he wrote about. And as a result of that, there wasn’t a natural audience for the book. So for those who don’t know, Unconventional Success is David’s second book, where he wrote about personal investing, and he basically said you should invest in index funds. But he’s a very dense writer, and he uses lots of data.
And he talked about all these different anecdotes, pretty damning anecdotes about different money management organizations. And I just looked at that book and said he’s trying to preach like Jack Bogle, but the only people who will understand the book are the money managers that he’s alienating. He doesn’t care about that, but so yes, I don’t think that book sold as well. It’s perfectly good, but it didn’t sell as well.
Mike:01:09:46Love it. Probably better then.
Ted:01:09:50Yes. I mean, I have one or two stories in my mind of things he picked out that I actually, for a bunch of reasons, knew the organizations he was writing about better than he did. And I was like; I can’t believe he like, you could go after lots of different people for lots of different things, he chose a few that were questionable choices.
Mike:01:10:10Yes. And I wonder also we had a question about what have you found are the best compensation structures that are aligned for the long term for the stewardship between allocators and portfolio managers, which I think is a really hard question to answer.
But I’d love you to share your thoughts on how you can do that. Given short term results are so random, and you want a long term partnership. And so, how do you structure a thoughtful compensation arrangement for all the parties concerned?
Ted:01:10:42Yes. Let’s start with the fact that most people can’t, right? Most people are, to some degree, price takers, right? And what is ideal in theory is often difficult in practice. So what you really want is a management fee that comfortably pays for the business, that people cannot be worried about their lives in their business, but don’t get really rich off of.
And then you want incentive compensation that rewards them for outperformance over a long period of time. So when you get down to brass tacks of what that means, like ideally, you’re not measuring, say, a hedge fund annually and paying incentive compensation. And so some people have, there are some share classes that lock up for long periods of time.
But when you get down to that in practice, what happens is there’s a tax bill, particularly say a U.S. one for that the U.S. government charges every year; they don’t care if the manager is paid or not. So you could have situations where there’s a big tax bill that comes due even if the manager isn’t taking the compensation out. So you say okay, well let’s do a longer-term incentive pay out, or we’ll pay it, and then we’ll claw back the after-tax.
Well, that’s great, but now you’ve had this like, you’ve lost the compounding on the amount that’s kind of going to that effectively to the government. So in the public markets, it’s harder to do that. But when you do have some situations where you have some investors that their pools are big enough that they can structure their own compensation, and that’s what you see. But if their own compensation is not driving the business, it’s just effectively additional compensation for the manager; they can structure long-term compensation. They can lock up their capital for a long period of time.
And somewhat like in private equity, where the managers really don’t get paid until the end. It’s not quite the end, but they don’t get paid until that cumulative compounded hurdle rate is achieved. And so that’s ideally what you would want, it’s very difficult to pull off in the public markets.
Mike:01:12:48Very interesting. All right, so I’m going to, while we think about other stuff that’s really sophisticated to talk about, I’m going to lob in now. What’s the favorite podcast? Yes, you got to pick one.
Ted:01:13:01200 kids, right? My favorite podcast is almost always next week’s show. …
Mike:01:13:10Okay. That was a nice dodge, and I’m not accepting that. So of the 200 that are in the can, give me a couple that you can go by, maybe a couple of subject matters too. Because your subject matter is a little bit varied, obviously Annie Duke is in there, so yes. It’ll also give people who may not have listened to your Capital Allocator’s show; it’ll give them a place to start.
Ted:01:13:50So the most listened to so far, I’ll say the two most listened to because one is recent and one is not. The most listened to right now is the one I did earlier this year, late last year with Chamath Palihapitia. He’s popular wherever he goes. We talked about his new hedge fund seeding business, and so that was a little bit of a different line of thinking. Currently, the second most popular is someone that most people won’t know. But he is a former a guy named Michael Schwimmer.
Rodrigo:01:14:14I love that episode.
Ted:01:14:18So Schwimmer was a minor league baseball player, actually made the majors in major league baseball as a pitcher. And he knew how bad life was as a minor leaguer, and he created a private equity fund that was effectively income-sharing agreements with minor league players.
And he walks through in the show both the experience of a minor leaguer, and how he used statistical analysis to apply it to the minor leagues. And it’s been a remarkable success story. And it recently became public because one of his signees is Fernando Tatis Jr., who just signed this like mega-contract as a 23-year-old.
So those are two different ones. On the CIO side, there are a couple that have been a little more popular than others. One was Scott Malpass, who recently retired after 30 years as the CIO at Notre Dame University, that was a relatively early one, and slightly more recently, I did one with Steve Rattner, who’s the chairman of Michael Bloomberg’s family office, Willett Advisors that was really interesting as well.
And there are a lot; I’ve just re-launched a website, so it’s now called Capitalallocators.com, it used to be Capitalallocatorspodcast.com. And for the first time we have a little bit, it’s going to get better, but we have a little bit of search functionality so people can go in and search on hedge funds or crypto or allocators and kind of weed through what’s there.
Mike:01:15:52Well, yes, you said the word now. So we got to pull on that thread, so where’s crypto in the space of institutional allocation?
Ted:01:16:00Yes. It’s still kind of in the venture capital ecosystem. So this year, for the first time, the leading thinkers of institutional CIOs are looking seriously at, and I would even say broadly a crypto, I would say kind of a Bitcoin and maybe to a lesser extent Ethereum. It started in 2017, but back in 2017, what they did was they made a venture capital investment in a very small number.
So like Yale was in the news for saying Yale’s investing in crypto, they weren’t investing in crypto, they invested with Chris Dixon at Andreessen Horowitz and his crypto fund, and for them, that’s just another venture capital investment. All of it looks like venture capital to them, but people are really scratching their heads on Bitcoin.
I mean what’s been interesting about Bitcoin is the institutional adoption has started on corporate treasury balance sheets. So I just read the head of Aker in I guess it’s Norway, Aker Solutions all those businesses is sort of the wealthiest guy in Norway, just wrote an incredible paper on a new business they’re creating in the crypto blockchain ecosystem, and the person who sent it to me, who is in the inner circle, told me that there’s about to be a big announcement out of Silicon Valley. Public company, so he won’t tell me who it is, of another presumably Bitcoin purchase.
So they’re paying attention. I have talked to a couple of CIOs who, as they were paying attention, the first thing they said is, well, let me actually see what I own and looked through their managers and said, well, we have two or three percent exposure to crypto already. And so that’s all, they’re comfortable with that, they don’t need to do more. So there are some situations like that, but it’s early stages on institutional adoption, but it’s happening.
Rodrigo:01:17:50Well, if you think about what is, one of our quants, ran a software development company and sold it at a nice valuation. But he was saying that all this, this is nothing new; these are a bunch of venture capital firms. This is new technology, especially the stuff coming out of the Ethereum network, right? So we like to call it crypto, but what they’re doing is investing in thoughtful companies that are doing creative things that are having to use a particular crypto chain in order to be able to deliver that value. So I thought that was an interesting view. It is a VC; it is venture for the most part. Bitcoin is its own beast, but everything else seems to be just more companies doing innovative things.
Ted:01:18:46It’s amazing to see that like that phrase makes you think, it’s amazing.
Rodrigo:01:18:56Look, I wonder there’s Bitcoin; what you were saying is that they’re buying it in the corporate treasury. Is that what you’re saying like similar to Tesla, where they’re putting it into their balance sheet?
Mike:01:19:06Well, Michael Saylor is the leader at MicroStrategy.
Rodrigo:01:19:10Well, he’s levered his whole firm in that one bet which I find.
Mike:01:19:15Well, no, it’s not quite the whole firm, it’s not quite the whole firm. But they did a great bond offering where they went private shares. You get upset? Well, no, it sort of got a conversion, it’s got a conversion in it where if MicroStrategy goes up a lot because Bitcoin goes up a lot, or because of whatever MicroStrategy is doing that, the bondholders actually participate in the equity side of the raise beyond.
So I think MicroStrategy may have had a double or whatever it was, but anyway, it was a brilliantly orchestrated offering, and it’s not the whole treasury there, it’s not. But again, it’s one of the leaders, and we have also heard of other public firms that we cannot talk about, who have started to get worried about the DeFi opportunity and influence and changing, and they’re looking to make initial investments. So your experience Ted is congruent with our experience; it’s happening, it seems, and the network effect is growing, and the adoption rate is growing, and it’s a thing, I don’t know.
Ted:01:20:21Yes. I mean, look, the blockchain technology is different, and in our world, I mean I like to give this example because it’s such a no-brainer, but there are so many no-brainer examples. Which is based on what we saw with GameStop; you know, a month or two ago, in the public domain, the stock had 140 percent short interest. And we know how that can happen, right? You can re-lend shares. But the system isn’t really designed to be able to re-lend shares. So would it be that surprising if sometime in the next couple years, five years, ten years, every stock that’s purchased is tagged on the blockchain? And so when you go to lend a share, you’re not lending a generic share, you’re lending a particular share. And once it’s lent once, you can’t lend it again. Yes, that will happen. I don’t know when, but of course, that will happen.
Rodrigo:01:21:14It better happens slowly. The amount of leverage that exists in the system today on re-hypothecated stuff is going to be astounding if we were to do a wholesale change. Like it would just be massive deflation, right?
Mike:01:21:29It’s options market makers that can do naked shorts as well that provide a lot of this. And really it is important to explain, and I’m sure most people who are listening to this are going to understand.
But like if once you pass 50%, never mind 140%, once you pass 50% of short interest, you no longer have enough shares to deliver to the shorts. Like you can’t do it. Like you have too many shares, so let’s say I’m going to go buy all the shares, and we’re at 52 percent, that I’m going to buy them all and I’m going to deliver them, it still leaves two percent short, like they’re still existing shares.
So once you get past 50%, you have this weird thing that’s going on, and that was a hundred and fifty percent. So just to get that in, like it’s just not possible.
Rodrigo:01:22:24This idea is nice. I think the idea of like being able to tag and all that is nice. But we’re already seeing the layering on top of Bitcoin, and that was the first thing that starts happening. You find opportunities to find yield in Bitcoin and crypto, where you’re lending it out and who’s lending it out, an exchange is lending it out.
And it’s promising that it owns the thing, but now it’s a centralized trust system. Like this is where the Bitcoin maximalists will own their Bitcoin in like their head, right? Or like a piece of paper under the mattress are seeing this and saying it’s just … like they’ve taken over again, the world is taking over again that’s where my paper is. Under my bed.
Ted:01:23:12I’m going to sit back and let you guys have at it.
Rodrigo:01:23:15So I don’t know; I think it’ll be an interesting development, how the old finance world eats Bitcoin and not the other way around, right? Like it’s just going to do the same thing with the new technology. What do we call it the technical debt, right? This is what I was thinking about. I was thinking about how you have, the old system just has a lot of technical debt.
It’s old infrastructure that is really tough to stop everything rewrite, admit, and so cryptos come in with this brand new technology, it’s better, faster. And so it’s just easier to slowly adopt that. But ultimately, it’ll look the same anyway. And when it starts looking the same as what all the capital allocators will be …
Mike:01:23:55That’s a great insight, it’s a great insight. I mean, it already is, there’s already options, there’s futures, there’s re-hypothecation going on already to some degree, I’m sure.
Capital Allocators – the Book
Rodrigo:01:24:07Anyway, so Ted, your book is called Capital Allocators, How the World’s Elite Money Managers Lead and Invest. Who’s it for? Who should be reading this book?
Ted:01:24:24It was mostly for me because after writing a book the first time, hopefully for other people, you realize it’s not really a good use of time. I really did write the book in large part because I wanted to distil all these lessons that I had learned. And my thought was that it could help anyone who’s allocating capital.
So you know any CIO, private wealth manager, money manager, individual even. And particularly the first part of the book that tool kit, that are these non-investment disciplines that apply to investing. I repeatedly had people tell me that they learned stuff from that, even though they’re not.
Mike:01:25:02Yes. Drop a sound bite on those, if you will.
Ted:01:25:05Yes. So these are some of the things we talked about earlier. There’s a chapter on interviewing, a chapter on decision making, negotiations, leadership, and management. And they’re not the definitive body of knowledge of any of these.
They’re really the body of knowledge that I distilled from the people I’ve interviewed on the show. So there’s a lot of anecdotes from those guests, and then it’s sort of framed out as a set of principles that really constitute the core body of knowledge in each of those disciplines.
Rodrigo:01:25:39So this should be accessible to anybody really that cares about managing their own money. Hiring managers, for their own wealth, allocate advisors, institutions, anyway. It’s a good framework to then choose to start getting better at those different sections, …
Mike:01:26:02Right. Well, I think it dovetailed well with some of our Master Class Series, and you nailed it earlier, Ted. Like with a hammer, dead nailed, I forget the quote, so I want you to re-drop it.
But basically, the whole idea of very long-lived assets and managing long-lived assets. that’s not what everyone’s doing. They’re managing the three to five years. And I forget you said the quote, but what did they say, like there’s no, I can’t remember.
Ted:01:26:27I don’t remember.
Mike:01:26:29We’ll look at the tape.
Ted:01:26:31So the other thing I will say is like that the last section of the book is called Nuggets of Wisdom. So there’s 161 quotes.
Mike:01:26:38Yes, which one’s your favorite?
Ted: 01:26:40Well, I have a top ten list.
Mike:01:26:42There you go. Well, give us three of the top ten that will make people buy away. Don’t give them number one.
Ted:01:26:45Don’t give them number one?
Mike:01:26:50No, because they have to buy the book to get number one.
Ted:01:26:55Yes, one of them I mentioned was Margaret Chen from Cambridge Associates said that clients want to be different and the same.
Ted:01:27:04One of the ones that goes right to what we were talking about that I love, that’s probably the one that for whatever reason has come up the most when I’ve been talking to people about the book is from Andy Golden at Princeton. He’s the long time chief investment officer at Princeton.
And he said to finish first, you first have to finish. And that goes to this idea that styles can go out of favor for longer than you’re going to stay in the game. And then there’s some really fun ones. There was one story from Jim Dunn at Verger Management; he manages the Wake Forest University endowment and an outsourced CIO. And I don’t remember the exact quote, but he told this story about a woman who sent him a one red stiletto in the mail with a note that said I got my foot in the door, can I come get my shoe.
Mike:01:27:52I’m going to use that in my next job application. Actually, if I don’t get a red shoe from somebody in the job, I’m just going to tell them no thanks.
Rodrigo:01:28:02That’s a good one; I love it.
Mike:01:28:04Someone calls us says I want a job; I didn’t get a red shoe, brilliant.
Rodrigo:01:28:10So Ted, are you, if things die down here, everybody gets vaccinated up, you’re planning on going to the March for the Fallen? Joining us again?
Ted:01:28:18Yes, I haven’t even thought about it. I haven’t done it in a couple of years, we’ll see. We’ll see, that was a lot of fun. How many years have you done it?
Rodrigo:01:28:28I did it two times; the two times you went is the two times I went. And I remember spending an hour on Michael Schwimmer. And I went like that; I just went all the way down the rabbit hole.
Once that was done, that was the first podcast I listened to. Anybody who hasn’t listened to that podcast, it’s just so, it’s so wildly creative and out there in our business, and he’s a charismatic guy. Great idea that is now proven to be quite; I wonder, have there been replicators of other people?
Ted:01:28:54Yes, but none with the success in terms of sort of, I don’t know if you call it market share, I mean they’ve really done a great job.
Rodrigo:01:29:07Yes, awesome. All right, Ted, well, thanks so much for your time, man.
Ted:01:29:13Pleasure. Great to see you guys.
Rodrigo:01:29:14We appreciate you coming on, and hopefully, we’ll see each other again at the next March.
Ted: 01:29:16Sounds great.
Adam.:01:29:19Best of luck with the new book, and I can’t wait to read it.
Mike:01:29:23Yes, number one. Number one new release, baby.
Adam.: 01:29:26 Love it.
Ted:01:29:27Available on Amazon.
Rodrigo:01:29:28All right, thanks a lot.
Ted:01:29:30Thank you, take care.
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