This is “ReSolve’s Riffs” – live on Youtube every Friday afternoon to debate the most relevant investment topics of the day.
Despite the common understanding – and ubiquitous disclaimers – that past performance is not indicative of future returns, it is well documented that performance chasing can be almost considered a fundamental law of capital allocation among institutional and retail investors alike. It is also an open secret in the industry that well-connected managers are much more likely to receive institutional allocations than obscure ones.
To discuss and shed some light on a recent whitepaper that explores these topics, we invited our good friend Brian Portnoy to bring his vast experience as a hedge fund analyst and allocator to bear. Throughout the conversation we cover:
- How to determine whether a manager has skill
- The evolution of alpha through time
- Many ways of defining alpha
- The role played by familiarity bias
- Principal-agent problem in capital allocation
It was a far reaching discussion with many layers, and once again much improved by the many questions and comments we received throughout the live stream. Keep ‘em coming!
Thank you for watching and listening. See you next week.
Brian Portnoy, Ph.D., CFA
Founder, Shaping Wealth
Brian Portnoy, Ph.D., CFA, is an expert at simplifying the complex world of money. He is an investor, educator, writer, and entrepreneur. As the founder of Shaping Wealth, Brian speaks on and coaches financial wellness throughout the US, Europe, and Asia. In his two books, The Investor’s Paradox and The Geometry of Wealth, he tackles the challenges of not only making better investment decisions but also how money figures in to a joyful life.
Brian has worked in the hedge fund and mutual fund industries for more than two decades. He is a CFA charter holder and earned his doctorate at the University of Chicago. For mor information visit www.shapingwealth.com.
Mike: 00:00:03 All right. We’re live. Gentlemen, welcome to another ReSolve Riffs Happy Hour.
Adam: 00:00:11 Good to be here.
Mike: 00:00:13 Cheers everybody. I’m having nice Caribbean rum. Today what do you guys enjoy?
Brian: 00:00:20 Straight bourbon whiskey.
Richard: 00:00:23 Having a good time, IPA.
Adam: 00:00:25 Nice. Everyone’s in character.
Mike: 00:00:27 Everyone get in character, please, if you don’t mind.
Richard: 00:00:33 I’m not sure what a character is.
Mike: 00:00:33 Before we get started I just do want to remind everybody out there that these ReSolve Riffs are for entertainment purposes if you’re going to be pursuing investment advice of any kind get that from a professional, not from the scallywags on this particular show. And enjoy. Enjoy. I’m going to turn it over to Adam Butler to do the intros etcetera and away we go.
Adam: 00:00:58 Great. I mean, I’m going to lean on Brian to introduce or at least give us some background. But today we’ve got Brian Portnoy, our friend from our esteemed Dungeons and Dragons group, but also an expert in a field that we wanted to highlight today, which was the idea of manager selection, manager evaluation and selection and just kind of dovetailing off a recently published paper by Goyle and Wahal who’ve published lots of literature in this area. And Brian’s background, we thought made him uniquely qualified to weigh in on this discussion. So maybe Brian, just give us the two or three minute overview on why you might have something intelligent to say on this topic.
Brian: 00:01:49 Well, it was a good question until you loaded it with intelligent. So my background that’s relevant here is that for most of my time in finance going back to the late 90s, early 2000s was in manager selection. I do a lot of stuff now with behavioral finance and social psychology and fun stuff like that. But I started as a mutual fund analyst, Portfolio Manager Evaluator at Morningstar in 2000. And some of the luminaries from that group, Christine Benz, and Jeff Petak, and the current CEO Kunal Kapoor, we all sat three feet from each other. And I learned a tonne from those guys and many others, and I went from there, which was just sort of arm’s length analysis into the world of actual client capital allocation. I was sharing with you guys before we hit record that back in the late 90s, early 2000s Chicago was the global hub for funded hedge funds investing. There was like 80 billion in capital, funded funds capital within like five blocks of each other. So the foot traffic of people coming through town, the managers that you would see, the access to the prime brokers and cap intro it was pretty spectacular. And I was at a firm that no longer exists, which we can get into why in terms of the value of manager selection, but a firm called Mesirow Advanced Strategies. And at peak, I think we had 14 or 16 billion in assets, almost all pension fund, pension insurance, split 50-50 between US and international investors. So sovereign wealth funds in Asia and Europe, pension funds from all over the world and for a period of time, I was head of hedge fund manager of research for them.
I had a team of like 20 or 22 analysts that I oversaw, we had a portfolio of our diversified fund of funds had 60 or 65 positions. We had a team that was devoted to ongoing manager due diligence as well as a team that was devoted to sourcing new ideas for the portfolio based on our own asset allocation needs, what just sort of from a supply side who was coming down the pike. So for a long period of time all I did 24/7 was evaluate managers and then tie a bow around that. I wrote a book in 2014, called The Investor’s Paradox which kind of applied some of my early connections in behavioral finance to what’s involved with picking good fund managers. And that book was the beginning of the beginning of the next phase of my career, which is as you guys know now like very different than when I’m not sitting at an investment firm, allocating client capital. I’m doing more on the decision making and wealth management front.
Adam: 00:05:07 Nice. So I assume that the lessons learned from your time at Morningstar are directly applicable to your experience at Mesirow. Or what was the evolution of thought in terms of measure evaluation selection from that journey?
Lessons From the Journey
Brian: 00:05:24 Yeah. It’s funny, I hadn’t thought about this for a while, but the question creates a good opening for an important topic which is sort of at the time, there was this bright line drawn between mutual funds and hedge funds. So you had the mutual fund world that was style box oriented. Keep in mind style box wasn’t invented until 1993-1994. And Morningstar’s offices in Hyde Park are about seven miles away from each other, and the creation of Fama-French in the style box, not the creation box, the classic papers from the late 80s and early 90s that they wrote. The opposite of a coincidence with the creation of the style box, big cap, small cap growth value. Because prior to 92, or 93, Morningstar had a category called equities. And they had another category called fixed income. And so prior to 92 or so, if you had a large cap growth fund and a small cap value fund that were, you know, doing completely different things and opposite ends of the market, they would still get their quote-unquote star rating based on their performance risk adjusted performance relative to that entire universe. And so there was sort of a Heisenberg event in the early to mid 90s with Morningstar, picking up the academic research creating the style box which in turn created a whole new production engine at the mutual fund factories which created all these style based investment products.
Fast forward for me 10-ish years, going from mutual funds to hedge funds, there were some question as to okay, those are totally different asset classes and what occurred to me like really early on is that they were actually just everyone’s taking the same risk within stock and bond markets primarily but other asset classes, whether it be currencies or commodities, it’s just that in the alternative space or hedge fund space, the liberty or freedom to go in a lot of different directions was much bigger. So, you can be long or short, you can be highly levered, you can be underleveraged and been sitting in a bunch of cash, you can be straight cash securities, or you can own a whole variety of derivatives or invest in nothing but derivatives, and so on and so forth. But what occurred to me and it was really the one of the main points I tried to make in The Investor’s Paradox, which I wrote at this point eight plus years ago is that it’s really just spectrums of risk that any portfolio manager or risk taker is taking, and you need to evaluate them on their own terms. So for me, the transition was pretty seamless, cosmetically there were some eyebrows raised as to, wait mutual funds and hedge funds, you can’t do both, those are different and they’re just the opposite of different, exactly the same.
Does Alpha Become Beta?
Adam: 00:08:39 So a framework that I’ve been developing, and it’s not particularly novel, but I think it’s useful is that alpha eventually becomes beta. And so you’ve got this, you start at Morningstar, it’s not even style boxes, and let’s set aside some whatever discussion about whether the all boxes reflect the research from Fama-French, but you’ve got style boxes so you now sort of theoretically decompose the equity universe especially into risk from different categories. So growth and value, large, small and mid or core. So I don’t know if that’s not really alpha, like exposure to growth or VAT, maybe value at some point was considered alpha and I think now there’s a lot more debate about whether sort of traditional value is considered alpha or subsumed by some kind of systematic value factor. But the evolution of adding more explanatory variables or factors to the zoo, all of a sudden you’re able to explain retrospectively, a larger proportion of the variance in returns for months. So, was that a direct experience that you had that over time you added more dimensions of explanatory power, more factors or whatever. And so what was alpha in 2008, was much more sort of beta in 2012 or that that trajectory generally played out.
Brian: 00:10:30 I actually have receipts, I’m not going to show people my actual scribbles. But what I wrote down before the call as I was reading this Goyle and Wahal paper, the relevance of manners to your selection in the twilight of manager alpha and the dawn of the factors zoo. I was-
Adam: 00:10:49 That’s where you were, or that’s where were when-
Brian: 00:10:52 That’s where we are now. Look, starting in 2000, I didn’t know my ass from an elbow as it related to mutual funds and how to do any of this and hopefully I got trained up pretty good to ask some good questions. But, at least a comment on my career before we can talk about the industry. For me, it was just learning the ropes. It’s like, oh, you’ve got…I didn’t have a good sense of market history or I should say investment strategy history as it related to the style boxes when I first got going at Morningstar for the four years that I was there. And then going from there to Mesirow into the hedge fund space generally, I recall sharing with someone once that was like going from that tiny room, in the Willy Wonka movie, that tiny room when they first walk in to the Chocolate Factory to when he opens the little door, that’s actually a massive door to the room with the lollipop trees in the chocolate river. I mean, just like massive variety of stuff. So it was pretty easy and comfortable to think about alpha because there were so many moving pieces. I think one of the…and I really want to get your guys thoughts as well. But when I fast forward from that period 2004-2005 when things were just ripping, we were bringing in $200 million a month from pension funds to build portfolios of hedge funds.
Adam: 00:12:24 Yeah. Those were the glory days a fund of hedge funds, right?
Brian: 00:12:26 Oh my god, it was out of control. And then you throw in the elixir of the prime brokers and cap intro groups with unlimited budgets, and those are dangerous times. But what occurred to me and it probably, not probably, it does explain in part why I’ve moved my career in the way that I have over the last five or six years is that a lot of that wasn’t alpha. A lot of that was in fact factor selection or some sort of exposure management that if you could quantify and codify, you are recognizing that beta turns into alpha. So if you take ’08 or ’11 that AQR put out the piece that alpha is just beta waiting to be discovered. I think that’s one of the most important pieces ever written on investment strategy history. And then when I was at Macintyre more recently we wrote a white paper that took part of that core idea and did a lot more with it. But if you look at the forms of market risk that investors have taken going back a century, even to the creation of treasury bonds, and the quote unquote risk free rates, over time that unique and interesting form of exposure, which you could refer to in a lot of cases, it’s manager skill. It’s actually just something that hasn’t been fully extracted and amplified yet, because once it does, then it does move more from skill per se to beta. And now where I think we’re at in 2020 is we’ve thin sliced things to the point where it’s really hard to talk about alpha per se, especially in the context of manager selection.
And so I think coming full circle on my old world of funds of funds that world has not disappeared, but it has dried up. There’s a handful of really big firms, Blackstone, Grove, few others that have massive portfolios of underlying hedge funds, but a lot of the old Chicago shops have literally gone out of business. A lot of other firms are a fraction of the size that they were and to the extent that they’re still in business, they have crap fees and that’s because the ability to select manager skill isn’t really a thing anymore, because it might be the case that managers don’t deliver skill, what they do is deliver certain well-articulated factor exposures consistently and at scale. In some ways, those are the same thing. But in another way from a commercial venture point of view, they’re totally different.
Adam: 00:15:20 Yeah. Well, I think alpha can reasonably be described as sources of return that you can’t access cheaply. So if you’re a sophisticated hedge fund with either domain experts, if the alpha happens to be low capacity or opportunistic, like you’ve got a mortgage desk which has got better connections in the mortgage markets where the liquidity is, where the fore sellers are, and you can eke out alpha in the mortgage space or whatever, some other-
Richard: 00:16:05 MBS’s.
Adam: 00:16:06 Yeah. Then that is something that not everybody can access because you’ve got whatever it is, an informational edge or experiential edge or flows edge or something. But in terms of like scalable liquid alpha I’m sympathetic to the fact that until very recently, even though academically some of these anomalies had been published, the underlying mechanics were out in the open for anyone to see. The vast majority of investors could not access those sources of return with liquidity and at reasonable economics. And so, until a Vanguard or an IShares or the ETF industry or some sort of index mutual fund group decides that they’re going to offer these systematic sources of return, these factor returns more cheaply and with appropriate liquidity or in a vehicle that an average investor can access, then for an average investor, those sources of return are actually alpha because they can’t access it cheaply themselves. Some of it’s just like structural. Some of the rules around 40 ac products have changed over time and allowed for different types of strategies to be offered to retail. Obviously, the indexing movement has made a real difference especially when paired with the ETF structure. So a lot of it was that the structures themselves changed to provide access to what was previously considered alpha to smaller investors. And so part of it’s what’s published and what people know about but the other part is, what’s accessible or what you can get access to for cheap.
Brian: 00:18:00 I generally agree and Mauboussin wrote a great article or white paper on this a few months ago in terms of the different types of alpha or skill that are available generally and what the trends have been. And if I recall correctly on it, read it when it came out, but I think the era of having an informational edge such that you understand what Google’s profits are going to be, or whether a food company is going to sell more cereal than they did in the past or something like that. Hard to point to that as we used to not that long ago as pure alpha, having an informational edge. I do think that what you’re talking about in terms of structural alpha, whether it be access, or just understanding how these complex structures might work, whether something in the NBS stack, or something in real life, something else in real estate world. There is and will remain many interesting things to do. And Adam, if you’re defining that as alpha, there’s still plenty of alpha to be had. The question that you’d want to bolt on, or I’d want to bolt on as a private investor now is what premium am I getting from that combination of complexity and illiquidity? And that’s where the due diligence comes in. And so there’s still a lot of good work to be done there. But it’s not like it used to be five let alone 10 or 15 years ago when that nature of due diligence and that search for alpha felt very different than the way it feels right now.
Adam: 00:19:54 Yeah, agreed. By the way, for those who don’t know, Richard has a bit of a background in manager selection. At least touched on it for a while there with your pension career, Richard maybe just 30 seconds on that and any takeaways that you had or in giving some thought before this conversation. Lessons learned.
Richard: 00:20:13 Yeah. For sure. I had a previous life still back in Brazil, I was a portfolio manager managing basically local equities portfolio. But we did have an opportunity to outsource part of that AUM towards third party managers for a number of reasons. And we did begin something of it. It was mostly a quantitative screening process with some qualitative aspects to it. And when you sent me that paper to start reading up and the two themes, one is pretty obvious. Stands to reason that as much as we say past performance isn’t indicative of future returns. Everybody looks at past performance and hopes that there’s some consistency there. But the second aspect to it, which is who you know, and the connections and how those might play a role reminded me of an anecdote of deciding across some of these managers. And we knew that there was one manager that was supposed to be front runner because of good connections. And after going through the process because of the criteria, which is decided that it wasn’t a good fit, and we went with, I believe two or three other managers, but then the analyst in the team, I think a couple of days later we just received the form with the well-connected manager for an allocation on his desk. And that was pretty telling of where we were supposed to lean there. So it’s quite interesting.
Adam: 00:21:57 It was a message, right?
Richard: 00:21:58 Yeah. I think all of us know to some degree that it’s not very surprising some of the finding even though as Brian was pointing out earlier when we were offline that the connection criteria that they use is quite thin. But I think we all know that it does play some role, sometimes it can be quite dramatic, but at least some sort of…and it stands to reason if everything else is equal, if you know the manager, however misplaced that knowledge might be in terms of it not translating into a knowledge of the process, but human behavior kind of leads us toward, I know the guy, he’s-
Adam: 00:22:45 Well, familiarity breeds trust,. So if you know that person and you’ve heard their story and you know their background, even though you haven’t maybe given equal credence to the stories and backgrounds of other people who are bidding for this business or other firms that are bidding for this business. You’re going to prefer the person that you know well. And I think just again, like we’re referring to this paper called, what is it? Choosing Investment Managers. And so Goyle and Wahal, they studied the factors that explain manager selection across how many different plan sponsors was it?
Brian: 00:23:38 Quite a lot.
Mike: 00:23:40 It was like 1.6 trillion in assets between 2002 and 2017.
Richard: 00:23:45 Plan sponsors.
Adam: 00:23:47 Yeah, plan sponsors. So, pretty large sample.
Brian: 00:23:49 7000 decisions made by 2000 plan sponsors covering 1.6 trillion in assets allocated to 775 unique managers.
Richard: 00:24:01 That was 15 years from 2000.
Adam: 00:24:03 Yeah, 2015. So it’s-
Adam: 00:24:06 Quite a sample.
Brian: 00:24:07 It’s rare to find anything good on manager selection in the academic literature. I remember when I was writing The Investor’s Paradox, there just wasn’t a lot to hang your hat on. So when these guys published something new, it’s always noteworthy because they’ve been pretty sensible in the past.
Adam: 00:24:28 Well, what was it? Maybe I think it was 2008 where they published a study on the performance persistence among manager selection for plan sponsors. And that there’s that famous chart where they showed the three year performance of managers before they were selected for investment and the three years of performance subsequent to being selected for investment and the performance in the three years prior to being selected for an investment was above average, or average, and then the performance in the three years subsequent to investment were below average, and were worse than if they hit simply stuck with the managers that they had in those sleeves before. So I guess going on … have not over the years been kind to the process of your selection at plan sponsors, certainly. So what was new in this paper that you that you took out of it, Brian?
Brian: 00:25:32 They did to two things. So first of all that 2008 paper was just brutal. And the funny thing is that you don’t see a lot of countervailing arguments. You see puff pieces from consultants about their prowess in choosing managers, but there’s no evidence. You’d think that somebody would sponsor some sort of research to some academic who can at least put something out there that says that somebody’s good at picking managers, there’s really nothing. So the 2008 piece was pretty brutal. In this one, they did two interesting things but I find one of them compelling. So the first thing they did was to engage the counterfactual, which is always a tricky thing from a causal-logic point of view, like, what could it have been if you hadn’t chose this? And I read the methodology on that. Very large sample, they looked at a lot of decisions and they were able to collect data on RFP’s for particular mandates, and then they can see that an asset owner chose manager X but not Y, Z, A, B, and C. I think most of the data that they’re looking at is in the public space, it’s public equity, public fixed income, they’re able to measure manager X versus the five others that were in the beauty pageant. Because you have the funnel, you’ve got a ton. And then you get to the finals and they can pick, they can see how people did on a post hire basis.
Adam: 00:27:18 That’s because they’re public sponsors or public plans. They need to go out with a formal RFP. There’s response proposals that are sent in response to the RFP. So we know who responded because it records of who responded and what their proposals were and so we can identify what other managers were available to the plan sponsors at the time for them to select from. Is that right? So that’s why we are able to have the counterfactual because we’re able to see all of the other options that were available at the time in relation to that RFP and see the decisions that they made, right?
Brian: 00:27:52 Yeah. Them even trying to do the counterfactual exercise they get kudos for. I’m guessing when you dig into the methodology and I see in the chat that our friend, Jeremy, here is here, and I think he’s one of the smarter institutional allocators. So I hope he’s going to chime in on the chat with more questions and comments. But on this first of two topics, on this topic of counterfactuals which is part B to the part A that they did in 2008. What they found was that people, I should say asset owners or allocators did not choose funds that outperformed the others that they passed on. So that in itself is interesting, and whether or not the three year time period that they looked at or whatever the time period they looked at is right. That does to me count as research progress, because I hadn’t really seen it done with this methodology before. And it might have been done. To be perfectly fair and transparent, I’m not looking at this literature all that much anymore. The second thing that they looked at is the relevance of connection. So what Richard was talking about with network, and I can tell many above and below board stories about what was involved with hedge fund due diligence and saw some things that probably made my hair curl a little bit.
But what they wanted to do was see whether asset owners would allocate to people with whom they had some formal connection with, and on this one I think they fall pretty flat. I think the question is valuable to answer on these guys who are in the world of quantitative finance, they’re not going to really find data, I would suspect that’s going to be able to evidence these claims very well no matter what they do. They were looking at…And I forget, Richard, if you saw that sort of formal. Yeah, the relationship science database is based on publicly verifiable data sources, including SEC records, court records, financial statements and other such hard records, notably absent are self-reported linkages and social network mediums such as LinkedIn. I don’t really think they have much of a leg to stand on and there’s nothing untoward about people doing business with those they have met before. I mean, the idea that you would hire a lawyer or an accountant or a consultant, or almost anything else in the world of services without having in some ways having a connection to them, not knowing that they might be trustworthy, all that kind of stuff. So the fact that you’re investing with people that you’re more connected to, I’m actually surprised that the number is not higher, I think there was sort of a 30% bump in connected. But it’s not like you get a laminated menu, or you go to a train station and there’s just one of those big boards, and you just pick what you want based on your due diligence. This is complicated, it requires asking a lot of questions and it makes sense that the people that you would be connected to would be the ones that you would feel most comfortable receiving those answers and ultimately allocating other people’s money to. On the first point, I think they’re onto something because it resonates on the second point to the extent that academics can be a little bit naive about investment management. I think this is them showing that.
Adam: 00:31:52 So that’s fair, and they did acknowledge that most of the betas to some of the relationship variables were meaningful but not statistically significant. They did show that they were explanatory. They explained 15 to 30% of subsequent return variation. They tried three different methods. One of them was, this made stronger assumptions than the two others, the one that made stronger assumptions was more explanatory, but the assumptions were more questionable. So, I think they took a took a stab at it, but like you say, it’s just a really difficult thing to evaluate. Anecdotally, Richard shared an anecdote that leaned heavily in that direction, but in your experience we’ve got Mike and I have anecdotes too. It certainly resonates to me, or with me that networking with consultants, networking with the managers that select managers for RFPs, et cetera is a highly productive activity for investment managers. In your experience, is this legit? Without being overly critical and without the relevant caveats that you’ve already mentioned.
Brian: 00:33:24 Yeah. Look, the thing about investment managers, and there are 10s of thousands of them is that they have a craft which they work on every single day. And they’re trying to do something that they perceive to be valuable. It could be return, it could be risk adjusted return, it could be diversified exposure, it’s any number of things. And then you need to tell that story to somebody because the search costs are pretty high, or the discovery costs can be very high is a better way of putting it. So there’s nothing, there’s no nepotism, there’s nothing untoward about someone who is devoted to their craft wanting to share with others that what they’re doing is valuable. And this is documented in The Investor’s Paradox I did over the course of 14 years, I interviewed something slightly north of 4000 distinct fund managers and made with whatever evidence would be available after the fact some of those were quote-unquote good decisions based on the fact that they made good returns and fit into the portfolio well, and others were terrible, because I was responsible for global research I remember in ’06, ’07 one when the world seemed to be getting just a little bit punky just as things begin to feel weird. And we were seeing kind of green shoots or black shoots of just not good things. And we were generally conservative in the way we positioned ourselves with the pension funds.
Anyway, I was responsible for our Asian investments. So we had zero Asian investments before I joined the firm in ’03 and then we built out a book of probably eight or nine managers over the next five or six years. And I found there was a group called Atradis, I don’t know if you met those guys way back when. But they were sort of a long vol slash vol ARB manager. We spent a lot of time with Sock Jen and Goldman and others understanding what the listed and unlisted derivative market was like. So we triangulated from that direction. We spent an enormous amount of time with the Atradis guys, Australian, born and raised move to Singapore ran their long Vol firm from there. And both from a skill point of view as well as and we did a bunch of custom quantum analytics on their portfolio and their return stream got to know them well. Were introduced by every cap intro group on the planet and spent probably eight to nine months getting to know them. And at minimum thought, there was just a tonne of convexity in the trade and it would be a good fit and in a way they were up like 80 or 90%. And so like on an asset weighted basis, our Asian Book in ’08 was up. Okay. Good for me. Europe, like a disaster. There were so many people in Europe in ’05, ’06, ’07 who made this pitch about, hey, we take a private equity approach to public equity markets. We do deeper due diligence and I loved these guys, super concentrated 15 to 20% in a position plus their lever running 80 to 90% long run, 200 gross. Jacked up stuff. They would produce you remember the you know what Ackman and those guys used to do with their research reports like 200 pages, like, they knew the flavor of the chewing gum that the CFO liked. There wasn’t anything they didn’t know. It’s like, well, how could these guys be wrong? They all lost like 20 to 40% in ‘08. And alpha be damned. It’s just like, well, they’re long and levered in a down market, they’re going to get crushed. There’s so many stories about you get access to these guys, and your do your due diligence, but it’s-
Mike: 00:37:51 Doesn’t this fall into the camp, not surprised? Like you have a principal agency issue here and the asset owners have one goal. And the consulting firms and those in power have a totally different set of goals. And their goal is to put together, it’s probably the oldest trick in finance. Here’s the portfolio that I would have provided you over the last five years and the return looks lovely. And there’s the portfolio you had in actual execution. Had you had that person five years ago consulting, there’s no way they would have had that portfolio. I mean, this is the oldest bait and switch situation and it’s pervasive, it’s in retail, it’s an institutional and it speaks to the bias of the person responsible for the OPM, other people’s money. You have a different set of goals that does not align perfectly with the asset owner. And if we want to talk about success stories, or let me pause it, I think Swenson is in it. When he talks about in his books, how he allocates to different strategies and firms he looks for, what does he call it? Non-profit maximising motives. So he’s looking for firms that are willing or looking to cap their strategies because they see a limit to the amount of alpha that they may be able to generate. He’s looking for them to not be prioritizing, sort of capacity in the way they might think about the markets. He’s looking for a very unique thought methodologies that are a little bit different. Now, this is granted, he explained in his books, he’s one of the more successful guys who’s done this. I’m just wondering, is there any solution other than, this is the game that everyone just plays? Is this the-
Brian: 00:39:49 Yeah, well, to quote Lloyd Benson, like I know David Swensen and I’m no David Swensen.
Adam: 00:39:57 But what are some positive takeaways. Like what are some and wide open to people on the comments who do this for a living and in this space and have had successes, but I mean, what are some positive takeaways here for those who, advisors and plan sponsors and CIOs and their teams and endowments. A lot of people need to make these types of decisions. What are some best practices and how have those best practices evolved over time?
Brian: 00:40:27 And as people try it, Mike’s point about the principal agent problem is just spot on in terms of like, it’s just super relevant. And when you’re, I was at fund of funds so you have a multi layered, you have multiple principals or multiple agents depending on how you want to define everybody that’s in the food chain because at its most extreme but not uncommon, you would have a pension fund, hire a consultant to hire a fund to funds to hire managers in a portfolio for their and clients pensions. So I don’t know whose principal and agent but there’s like a pretty, the tin cans and string telephone game gets pretty stretched there. There was no doubt that when I think about mistakes that I made, I’m not really understanding in any deep way what a trader’s option was all about. Some of the guys that I advocated for that I push to get into the portfolio, they could just run and gun it, they could be long and levered, they could have these super well researched 200 page books on like what this stock is all about. And either works out or it doesn’t. And if it works out they get the big and if it doesn’t, they shut down and start again or go to a different shop. I can say 20 years ago I didn’t understand that in any deep level.
The positive takeaway, and it’s why I wrote The Investors Paradox, but it’s also why I quit the manager selection business for the most part is that you can be very careful in the expectations that you set for what the manager can and should provide you over time, and the ability to work with a manager to understand what they’re going to be able to do, what they’re going to want to do over different types of market environments. It’s right there like in front of you like to be done. I think I became better with that over time. But tying back to the conversation we had a few minutes ago, as alpha grows into beta over time as we thin slice these markets from equity to the nine style box and then each of the style boxes has tilts, all of a sudden there’s no alpha, there’s only exposure. I think there is a legitimate question today as to what is the nature of manager due diligence, at least in large public markets, we can leave aside some of the structural inefficiencies, Adam that you referred to, which are always interesting. But in large public markets, like what are we doing? Are we simply sourcing exposures and the ability to be consistent to or show fidelity to that exposure? And if so, why wouldn’t we just buy an ETF? I think those should be front and centres for allocators now.
Mike: 00:43:43 I think that’s great. Okay, go ahead. Well, I’m just going to jump in with, there was some great comments from Jeremy and the crowd here that if someone is only listening they’re not going to get these if they don’t have a chance to see them. But alignment is most important. That’s what Swenson is talking about. Bait and Switch ploy, Swensen says that’s something that is pervasive, it happens. So if you’re an allocator, you’ve got to watch for that. You’ve got to really think about is this real? And Adam, we’ve got that story where you come in with the three allocators, and the allocator wanted, or that the investor wanted, like was it five real plus five unreal?
Adam: 00:44:20 Yeah.
Mike: 00:44:20 And three managers said, can’t be done. That fourth manager said it can be done got the money. So that’s something else. As an allocator you got to be thinking along that those lines and just delicate balance between capacity, certainly if you’re an allocator you want capacity so that you can continue to add, because you don’t want too much capacity. Again, we come into these yin and yang situations and those are the types of a well design-
Adam: 00:44:49 These are important, right? And I get that there’s not to be too cynical, as perhaps my bent but there’s certainly a role for consultants in this which is not profit motive, or there’s not really a profit motive by the plan sponsor. It’s more trying to defray liability for decision making.
Mike: 00:45:08 Correct. Exactly right. How could you invest in this five year portfolio? We know that if you go through asset classes and look at mean reversion five years sort of mean reversion and say, what you should be looking through is the managers over the last five years that have done the worst, and you should pick randomly from that group. And that would probably give you the opportunity. Now you can imagine you go in as a consultant and say, here’s how I built your portfolio.
Richard: 00:45:38 Yeah, I think addresses this point, specifically and it talks about how one of the reasons why people may performance chase in the institutional sides is the defensibility. It’s the careerist. These are things that we’re well aware of and however anecdotal our knowledge of that is and we know that that doesn’t translate to parole data, but we know that everyone is process driven when you’re doing well. And so everybody needs to find some justification to invest in something. And so you’re doing well, you have a process that resonates with the allocator. The allocator is going to be definitely more inclined. But I wanted to kind of circle back on a point that both Adam and Brian were making about alpha. So perhaps if you’re on the retail side and you find these systematic sources of alpha, which technically are beta but you’re able to provide to them and they can’t do it on their own. So that becomes alpha to them. But as you go down this rabbit hole and layers deep at the ultimate level, if alpha as we’re describing here is just beta, then what is alpha at the ultimate level? Is it timing? Because we’ve talked about this, timing can be a source of alpha as well. So how do you find alpha at that last layer of sophistication for an investor?
Adam: 00:47:00 Well, yeah, again, alpha is kind of what you can’t access yourself cheaply. So it’s going to be different for participants in the markets at different levels of sophistication and access and size. So for an institutional allocator with their own internal factor desk that can replicate the vast majority and it’s a good factor desk, and they’ve got craftsmen in the chairs, and they’re doing a reasonable job. The hurdle to demonstrate alpha is going to be larger than for maybe some advisors or some retail investors who have neither the size, nor the access nor the sophistication, to be able to identify how to get access to those sources of return more cheaply. So it’s like alpha’s going to be different for people at different levels of the food chain. I did want to come back to this because I know for sure there’s a principal agent problem. But let’s just take that out of the equation for a second. And you know, Jeremy’s been harping on alignment of interests, which I think you can’t debate it. I think that’s almost self-evident, although not well executed. So it’s a good idea.
Mike: 00:48:26 How do you determine it? Well it is self-evident. If I would like to lose weight, it’s self-evident that I should eat less.
Adam: 00:48:33 Totally. Yeah. It’s self-evident. But let’s assume even notwithstanding that, you’ve got this issue where very few if any managers are coming to plan sponsors with proposals where they don’t genuinely believe they have an edge. They don’t believe that they have something special to offer. So you want to have alignment, great. You’ve got a manager who you’ve set up the structure so that you’ve got special access that they’ve got limitations on external assets. You’ve got great alignment policy in place. The manager tells a good story, but how do you determine whether that manager has genuine skill? I think there are government’s policies that are really good to talk about important but in the end-
Brian: 00:49:37 I haven’t come up with a good answer.
Mike: 00:49:40 We’ve got skin in the game.
Richard: 00:49:46 It’s not a guarantee.
Mike: 00:49:48 It’s not a guarantee.
Adam: 00:49:50 The point is these guys fundamentally believe they have skill. If they fundamentally believe they have skill, they’re not going to mind having skin in the game. But their belief that they have skill doesn’t mean they have skill. So how do you overcome the Goldman Sachs pedigree? So much of this is-
Mike: 00:50:14 It’s such a huge assumption that you want it. So Wow, you’re really blowing my mind here because I have to assume away so many of the behavioral mistakes that are nine tenths of the issue.
Adam: 00:50:24 I could hear some people saying, well, no, our governance structure addresses these issues.
Mike: 00:50:31 Sure. What we would look for is if that’s the case, we would take the number of allocators as of size and ability of known, compare whatever their relative skill would be on some sense and then say, just not by assets by number of allocations. Did you make allocations to advisors? Like did you go to all Goldman Sachs and those large managers or did you actually allocate to some smaller less known, not known managers in your database? How many of those did you allocate to-
Adam: 00:51:07 You make your point, so Brian we know that emerged or okay….The research I’ve seen strongly implies that emerging small emerging managers is actually legitimate. There’s an edge there. Is that harvested in practice?
Brian: 00:51:25 No. And I’m not convinced and I’m in the small minority in the allocate – well, former allocators world. I’ve never really been convinced that those small emerging managers had any sort of advantage. There’s evidence to suggest that they do but I think it’s as you know, when you go asset or sub asset class by sub asset class, when you go into the world of credit, go into the world of moving along large complex capital structures. I don’t think small guys have any advantage there. In fact, they have a disadvantage because it’s the big players. It’s the Angelo Gordon’s, it’s the Blackstone’s. It’s the Marathons. I mean, these are the names that I used to trump in. It’s all the old Goldman Sachs prop credit guys, the Grey Wolf’s and Silver Points and such that had access to deal flow. And so the notion that as an emerging manager you have access to those capital stacks is a joke, like you simply wouldn’t.
Adam: 00:52:39 Yeah. I think the assertion that small emerging managers can access edges with that just have less capacity, like if you’re trading-
Brian: 00:52:48 But I’m going to push you back. I never saw that. It’s not like the small managers were investing primarily in micro caps or smaller small caps and finding edges and scalability that allowed them to do really great things, like most small managers at lowest were in normal small caps or small to mid-caps and, sure, a TPG Axon or an SAC, although SAC is a terrible example. Well, no, I don’t mean it from an illicit point of view. I mean it because, if there’s 100 traders and everybody has their own $50 million book, there’s actually a ton of flexibility that’s built into that where you can’t so I just never and Jeremy I think it’s off the call. But he wrote in the chat, the plural of anecdote is not data which-
… I think you get to my point earlier. He-
Brian: 00:53:53 I just haven’t seen that small manager effect really take place because they’re not in markets where whatever that size is logically makes any sort of difference. I’m not sure if that’s the point that you wanted to hammer on.
Adam: 00:54:09 I don’t know either. I can’t say that. Again I can point to lots of anecdotes where, for example, there’s maybe a double handful of firms that operate exclusively in the Canadian small cap space that have just been killing it. Maybe they’ve got a capacity of 40 or 50 million, tops. Because they’re just dealing in a space that doesn’t have enough liquidity for them to play larger. I know some Muni managers in Cleveland that are just crushing it. I remember after 2008 there was a huge run on asset backed securities, especially in Canada guys raise whatever, 50, a hundred million dollars, and then they bought a bunch of asset backeds that they bought on fire sale. They ran the portfolio down over five years. There’s lots of opportunistic funds run by specialists with real nice specialisations that happen to be in the right place at the right time and if you’ve got access to that raise then that’s a legit source of alpha but it’s more like, you’ve got a group of specialists with a market dislocation that are raising capital and they’re going to, or you’ve just got like a perpetually inefficient market like Canadian small caps that seek resource-
Mike: 00:55:31 The resource cap. The resource stocks in Canada are famous for this. A good resource manager is going to be connected to the deals, he’s going to get early seed deals. He doesn’t have to be large do that. In fact, oftentimes, they start a fund at the beginning of the bull market that’s brand new and small.
Adam: 00:55:49 Yeah. And they get involved in the syndicate. And there’s a syndicate of firms that run the prices up before they get off their shares. Like there’s a whole racket there.
Richard: 00:55:56 But how about outside the security selection space because all the examples so far that you guys are giving are strictly in the security selection space, which plays a lot to Brian’s point. But how about plays that are dealing more in the asset allocation space? Your futures, your global macro.
Mike: 00:56:13 Well, I think futures, in that space, I think we would agree that there are areas that have limited capacity and sizes deleterious to that capacity or just means that you’re spreading it over a larger and larger asset base until such time as it’s not really a meaningful source of return to the asset base.
Richard: 00:56:37 Size matters, just not the way you think it’s actually is.
Mike: 00:56:39 Reciprocal. Yeah.
Adam: 00:56:40 Every edge has the capacity above which the edge no longer is attractive. I think you can certainly make the case currently in this sort of style premia space that we’ve exceeded that capacity given that.
Mike: 00:57:01 Fun flows corrupt, absolutely.
Brian: 00:57:05 Yeah, I think that’s fair. And also overlay our earlier discussion of well, what is alpha and some of it is an informational advantage. Some of it is access. Some of it is just structural stuff that like if you can participate in my personal portfolio, I’ve got a large allocation to a very small odd-lot unique manager. I mean, he is making multiples of what MUB ETF is making, because he’s just in there cherry picking all these random bonds that big guys could never ever even begin to touch. And that’s a good thing. There aren’t that many people who want to remain small and do good work, and have sort of alpha on their tombstone as opposed to a big dollar sign.
Mike: 00:57:59 Yeah, Swenson mentions that, absolutely verbatim in one of his books, he’s looking for sort of the non-maximizer from the asset management business, but these weird types of managers who want that on their tombstone. They want that very small limited capacity. Now, I don’t know how you look for that, it seems to me like when we come back to a switch-
Adam: 00:58:23 …
Mike: 00:58:24 Right. Well, not always. Certainly those books are written a couple decades ago now. But do you really think that that type of mindset could overcome the principal agent issue we have where you have an unsophisticated board, largely…well a semi sophisticated board, who’s largely relying on the consultant to hedge away a potential director type of risk. So again, it’s the behaviour is being driven by a set of goals that are not necessarily congruent with the asset owner and even Swenson, Swenson is a classic example of what he’s looking for. He could make I’m sure an order of magnitude more in his compensation if he decided to go to a private hedge fund versus working for Yale. And so it’s a tall ask. So what does that mean? So in my mind what it means is the allocator, the asset owner has to be really ever diligent for this, the asset owner is the final arbiter for these decisions. They’re not in the pension endowment case to the extent they can be, they should be and they need to take the steps to educate themselves, and they need to understand the complexity of this and it’s not enough. It’s not enough to simply cover your liability via a consultant. That’s not enough.
Richard: 00:59:52 This goes back to your earlier point because you just call the allocator the asset owner and you equated those things, but this was back to principal agent problem that you’re so right, so at the end of the day, those two things do not-
Mike: 01:00:07 Are not synonymous. Yeah.
Brian: 01:00:11 My guess is we’re wrapping up shortly I don’t want to leave this call without throwing consultants completely under the bus.
Mike: 01:00:19 I don’t know. No, we don’t want to either. That’s not the point. I guess …
Brian: 01:00:24 So I want to because these-
Richard: 01:00:29 Sorry Mike, you tried to say it wasn’t meant to be let’s just-
Adam: 01:00:32 Alright, so I could hear Mike throw them under the bus.
Richard: 01:00:36 … Brian, please.
Brian: 01:00:39 I might be a fifth level dragon born and either dragon born and he’s has issues with consultants. I know many of my friends are consultants. They’re very bright.
Mike: 01:00:51 They were your friends.
Adam: 01:00:52 Don’t throw any knives here. But there is a whole section later where you get to throw your knives, right?
Brian: 01:00:57 I do have bulletproof on my body. No one even knows what hell we’re talking about. When we talk about the odd lot Muni manager, the Canadian small cap manager, you know who doesn’t give a crap about those people? Consultants. You know why? Because they can’t put them in multiple client portfolios. So when they deploy their high priced talents to do due diligence on these managers, that is literally zero interest to them. So I don’t want them to come out of this unscathed because if the goal is to drive better results for clients, which I hope is everybody’s goal, the fact is that we’re not going to get to a lot of managers that are doing pretty good work, because they don’t offer a scalable solution. And Mike however you put Swenson pointed out, basically doing good work for the right reasons and not trying to just line your pockets. You do have a somewhat closed loop between asset owners, managers and consultants and the circle just keeps going. It’s an anti-alpha circle. That circle is really focused on managing career risk. It’s certainly not focused on sort of increasing client outcomes.
Mike: 01:02:18 Do you know if there’s any opportunity in the multi space like where, okay, so this include this, this subsumes all of it. So no matter whether you’re trying to build a portfolio of alts and risk premiums, and stocks and bonds, you just did the consultants just get it wrong across the board, or is there some way in which they help with asset allocation or allocation to unique strategies that are?
Brian: 01:02:43 Well, there’s a lot of things they do. The first thing that they are is that they’re an insurance premium because they’re who you blame. And in some cases, sue when things go wrong. That’s fine. Everyone knows that. They are insurance. And then there’s things that happen. That’s first and foremost beyond that, you’ve got the asset allocation piece. And I’ve no insider comment there. There’s lots of smart people, a lot of these big firms that I know them and they’re very thoughtful about what the tilt for a pension fund should be in terms of stocks versus bonds versus alts, it’s great. That is what it is. Then there is the manager selection piece which used to be my focus, and in that case, you have well-meaning motivated individuals who cannot pick up on great opportunities because if you can’t…I’m not going to name names. I could name lots of names.
Mike: 01:03:52 Nobody’s watching, go ahead, name some names – do it.
Brian: 01:03:58 I love you.
Mike: 01:04:01 No I’m kidding. Don’t do it.
Adam: 01:04:02 I will say, you know, there’s-
Brian: 01:04:02 But I just finished with that. If you invested 500 million bucks in this particular manager. It’s not worth that firm deploying the assets to not only diligence, but to monitor them and keep them on their approved list.
Mike: 01:04:18 So true. I never even thought of that.
Adam: 01:04:21 There’s other dimensions like there’s an actuarial dimension for lots of plan sponsors and accounting dimension and that sort of stuff which probably there’s an active role for consultants. I think where we are is that they make selections hard like from my perspective, this Swenson example is not really one of Swenson or his team are geniuses at manager selection so much as they have created a culture that attracts managers that have the qualities that are more likely to deliver outsized performance. Like it’s more of a culture or governance and notwithstanding a massive bet on America, which has paid off versus International. I was looking at the current Yale portfolio and noted that while they have a deminimist exposure to US public equities, they have a massive overexposure to LBO and venture, which are almost certainly overwhelmingly US focus. So you’ve gone from US public equity to US private equity, so great. Obviously, it’s been America’s few decades so that’s been a massive payoff for Swenson and Buffett. But notwithstanding that I do think that there’s an element of just creating a spirit of excellence in governance and alignment and commitment to manager development that attracts the right manager. So it’s this like virtuous, it’s this virtual virtuous circle, which, full credit probably was designed as a strategy in advance and has paid off. I just don’t necessarily want to conflate that with manager selection skill because I’m not sure they’re exactly the same thing.
Brian: 01:06:26 Yeah, I agree with that. One is one narrow and very deep issue and then the other one is not as deep and very broad and has a number of different facets to it. And that’s totally fine. I guess where I put a pin in the current debate is that when we have now the history and the tools and the perspective and the models and the technology to slice the factors in every imaginable way, what is manager due diligence? Because like, I spent I don’t know, 10 or 15 hours with … in 2005, Global Head of Prop trading for Goldman Sachs, made a few hundred million bucks, launched, built TPG Axon into a 10, 15, $20 billion hedge fund, so on and so forth. And it’s, hey, tell me stories about stocks that you picked. Okay, in retrospect it was utter bullshit. What we needed to do was see his record at Goldman, see what he was building a TPG Axon and just understand the underlying factor exposures that we were purchasing. And if that’s the case, and I like …, and he did a good job for a period of time. But if the case is that we can now slice and dice factor exposures in such a fine grained way, when we buy a manager what are we actually buying in and what is that skill? Jason on the chat said if you throw out beliefs in edge alpha risk premiums, how do you think about portfolios? I would throw out edge and alpha and I would think about risk, but I would not ever throw about risk premium. To me, it’s about how do you want to take the risk? What do you-
Adam: 01:08:26 So for the record, this is dark blue. Just because my camera resolution and contrast is not- I’m sure up there’s nothing
Brian: 01:08:38 Well, wearing a-
Mike: 01:08:38 It’s our YouTube t-shirt.
Brian: 01:08:41 I’m wearing a tee shirtI got on winter break in Cabo last December.
Richard: 01:08:46 So is there an argument I guess perhaps to be made that the illusion of control, this idea that you’re talking to managers and they have so many horror stories about as you mentioned earlier, knowing the favorite flavors chewing gum for the CFO of the company, that is actually detrimental because it provides you with this illusion that these guys know so much about these companies that there’s no way they’re going to get this part wrong. But at the end of the day, it’s all beta. And you were just fooling yourself into thinking that you were allocating to someone who knew-
Mike: 01:09:21 Richard, can I kind of counter that with maybe you knew that no one was adding value and so you thought you just give it to a buddy.
Richard: 01:09:33 Well, I think now you’re just quoting from the paper so if you want to-
Mike: 01:09:37 No quoting from the paper.
Brian: 01:09:40 I want it known that I am no longer the most cynical person on this call.
Adam: 01:09:46 You didn’t begin there. I made a pact with myself. I told Rodrigo and Mike earlier, I’m going to be a voice of positivity on this call.
Richard: 01:09:55 Yeah. Adam and honestly, I thought you’re going into a deep rant right off the bat. You have-
Adam: 01:10:02 Well Cory before the call Hofstein reminded me that I don’t need to say a thing, I just need to plant a few seeds and Brian will rant for the two of us. So mine was uncharacteristically restrainted. So Brian, you proved Cory and I wrong.
Richard: 01:10:20 …
Mike: 01:10:23 Actually, I don’t know if it’s wrong or just maybe so he did go 14 minutes without taking a break at one point. I did try it, I loved it. I’m like that is this hours going to fly by.
Brian: 01:10:39 I can’t even think past the rage of what I’m going to say to Corey Hofstein. You know that’s-
Mike: 01:10:49 Paladin.
Adam: 01:10:52 Yeah. And yet to Eric’s point. I forget what bias that is, but it’s like the familiarity bias or-
Richard: 01:10:59 It’s control…
Adam: 01:11:01 Yeah. It’s related to that, but yeah, for sure. The more details you learn about a story, the more likely you are to think that you have an edge. That whole experiment that they did about horse racing.
Mike: 01:11:15 Steve’s on to. All the sports betting guy Steve can regale us with that. Yeah, you give them more data they feel more confident, but they’re no more accurate than horse handicappers.
Adam: 01:11:24 Right. It’s very well documented.
Richard: 01:11:28 It’s true. That’s true.
Adam: 01:11:32 So we’re at an hour 11 anyone got any more rants. I’m going to end on a high note.
Brian: 01:11:39 One more 14 minutes soliloquy.
Adam: 01:11:42 Can you sing it?
Mike: 01:11:44 Stalagmite – go.
Brian: 01:11:48 It goes up. The lag part goes down.
Mike: 01:11:52 Things you learn.
Adam: 01:11:54 There you go. All right. Well, look, happy Friday afternoon everybody. Thank you again. Brian thanks for joining us. Lots of fun
Richard: 01:12:01 Thank you guys.
Adam: 01:12:03 And have a great weekend.
Richard: 01:12:05 Yeah. Enjoy.
Brian: 01:12:06 See boys.
Mike: 01:12:07 See all.
Brian: 01:12:07 Bye.