My recent post on “Asset Management is a Peculiar Industry Ripe for Disruption” got one of the most interesting reactions I’ve received. Among the more thoughtful respondents was Terri Chernick, Chief Investment Officer, The Koffler Group. We had an email conversation about the rationality, or lack of rationality, of professional investors.
Anyone who calls me a “son of Voltaire” has my attention!
Terri Chernick: I totally agree with you that the investment management industry is ripe for improvement in so many places, from back office to front office, to payment schemes, etc. As the CIO, I am constantly looking to improve productivity of my office, and I have created many productivity tools and processes that have saved a lot of money and time since I first started. Each family office and every hedge fund has their own learning curve for front and back office for every part of the business. And every process is in employees’ heads, yet so much of the process could be simplified, and much could be automated.
David Teten: I’ve been researching investment best practices for a long time, so I share your interest. Addepar is precisely trying to collect and convert into software these best practices. (ff Venture Capital is both an investor and also runs our back office on Addepar.)
Chernick: I loved your memo, but I would disagree with a few things:
I would argue that you are being too rational in your analysis of people !! Humans are not rational decision makers.
You are the son of Voltaire. But we are limbic system-driven humans first. A psychiatrist once told me to read a great book, “Voltaire’s Bastard.” It’s great reading for anyone that leans too heavily on the left side of the brain.
So here is my thesis:
Crappy advisors and under-performing hedge funds do add value— it’s just not financial value. However, the value is real, and palpable, and bankable.
1. For Joe Schmoe Retail investor: Some investors, who have no financial acumen, are willing to pay with poor performance to have a someone they can trust. This is the “lets me sleep at night advisor”. The number one reason people choose one advisor or firm over another is trust. It is not investment performance. So the retail market is notoriously irrational.
2. For Professional Institutional investors: agency risk is a huge problem.
Teten: Specifically, under traditional compensation models, they’re highly motivated to increase AUM as opposed to increase returns; to massage the financials to smooth returns. To quote my Partner John Frankel, traditional money managers are great at managing your money until there is none left.
3. For pension funds/ endowments: Hedge funds with pedigree and large AUM and a big risk management department are a great fit for certain asset allocators with agency risk, because they offer less agency risk if the allocator chooses a well-known firm.
Teten: No one ever got fired for hiring Och-Ziff, or any other of the massive hedge funds.
Chernick: A big allocator cannot choose index funds. If they did, then how would they justify their big salary and large staff if they are not “active management”? So, some amount of active management helps justify high staff count, which helps justify high salaries.
Teten: Even though the active management + the high headcount + the high compensation all serve to reduce returns. Returns are unpredictable, but expenses are not.
Chernick: 4. For family offices / high net worth investors: the fact that some funds succeed with high returns motivates those with gambler mentalities to chase hot managers or to think that they can use their luck / smarts / intelligence to find the best managers. Such individuals can become addicted to the chase. A different but related issue: Some former entrepreneur family offices like to talk about their hot hedge fund manager on the golf course.
So, active investing does provide a lot of non-financial value to both institutional players and family offices. Specifically: Trust, reduction of agency risk, rationalization for big salary, adrenaline high, ego boost.
Instead of trying to convince these stubbornly irrational investors to make rational decisions and allocate according to investment performance, a “true bastard of Voltaire” should flip the original question on its head.
Instead of giving these investors a “rational choice” for investing which they are rejecting, can we give these these investors a better and / or less costly solution to meet these OTHER non-financial needs? These obviously important needs are like the emperor’s new clothes. No one wants to acknowledge these truths of investor decision making.
Teten: As a thought experiment, imagine a quant pure black box hedge fund, “UltraQuant,” which hires a lot of impressive PhDs. They go to market stressing that their model is highly proprietary. UltraQuant’s real strategy is to create a pure, blind index of the market. Ironically, UltraQuant will have higher returns and certainly lower expenses than the vast majority of hedge funds.
As a second thought experiment, one could do the same in medicine. Imagine a biotech startup, Melchisedec Medicals. The firm hires a lot of PhDs to do research and come out with a wonder drug, and then markets it widely with tons of PR. In fact, Melchisedec is a placebo. However, Melchisedec will have a better health impact than many commercial drugs on the market, with no side effects.
Both those thought experiments show that what people say they want, and what is actually is in their interests, are not the same thing.
Chernick: However, it should be noted that some outstanding asset allocators, just like some outstanding stock pickers, do beat the odds and indices. Just look at Swenson at Yale or Jack Meyer at Harvard as superior tactical asset allocators who also have superior access to superior funds like Lone Pine and Baupost. So, I do believe that there is a 1% of allocators who can build a better asset allocation basket than what an index fund can get you.
Teten: I’m not sure I agree, as inevitably some people will look like geniuses in a random distribution of outcomes. Can you prove that more of these people exist than one would expect from random distribution of outcomes of investing in the public markets? Even if you can, it’s impossible to predict who these folks are a priori.
Chernick: However, net alpha is negative for asset allocators. The advisors have collected the money. And manager alpha is zero as you have pointed out.
We know that we at Koffler have added value, and where we add value, because we measure it.
Our value in the past has come from big tactical asset allocation bets. We over-weighted small cap value stocks in 1998-2002. It was a nutty thing to do at the time. Everyone hated small cap value back then, and loved the large-cap S&P 500 that had ruled for the last 10 years. However, it was the right thing to do from a valuation perspective. And it helped our returns. We did this again, overweighting emerging markets like Africa and EMEA (Middle East) in 2007 because they were cheap with high growth rates.
What we do to keep ourselves honest is we compare ourselves to a tough bogey — the very mirror that you discuss in your memo — a composite of cheap investable index funds. The asset allocation is based on surveys of US institutional advisors. We take their asset allocation and then insert in the least expensive way to invest in that strategy via an index.
What we say is that if we cannot beat this bogey with active management, then we will do the indexing!
The results: We have beaten the bogey return over the last 18 years at Koffler by a large margin. We have also beaten the bogey most individual years. So I think we have proven with statistical significance that active management can work in a small family office. Trying to beat a real bogey keeps me honest. If I cannot beat the bogey, I tell my family that I will join it. LOL
However, one thing to note. Even if Koffler did incorporate the bogey, they would still need someone like me to allocate to index funds that make up the bogey composite.
So even if pensions went to index funds, they still need an asset allocator.
Here is why, two reasons:
1. Asset allocations do change over time. When I first started, the average institutional advisor only had 10 percent total in international and very little in alternatives.
Teten: Agree, that was irrational provincial bias.
Chernick: Now, international allocation is almost as big as US allocation. And alternatives have gotten much larger as hedge funds and real estate have gone mainstream.
2. Second, there are new and better and cheaper ways to index. E.g., from index funds to ETFs. Perhaps, from market-weighted indices to equal-weighted indices. So, asset allocator can always work to add value and decrease costs (or add costs and over-complicate). LOL.
Teten: It sounds like you’ve had a lot of success with this approach. I commend you on measuring yourself against what I think is the fairest bogey.
Another fair bogey: I know one of the top 20 mutual fund companies which every year assesses for each person in the firm whether they would have been better off golfing the whole year doing no trades, or actually putting on trades. They regularly find they have years where they would have had better returns by not changing their portfolio at all.
What are you doing to increase the odds that you’ll beat the bogey going forward? I’m a firm believer in the importance of documenting and enforcing best practices in your internal processes. Process is predictable and controllable; returns, not so much.
Chernick: I don’t see any fat pitches right now to be honest. We are just trying to hit some consistent singles and doubles, and avoid the easy wipeouts.
Teten: Once an investor acknowledges that she is not necessarily a “son of Voltaire” and rational, what should she do?
Chernick: Compare their returns against the generic 60/40 index or some relevant index for different time periods. If they fail in performance, they should ask themselves if they can give up active management. And if not, why not…..i.e., if it is one of the reasons we pointed out. If so, we can discuss the question of how to meet their “irrational needs”.
For example, for “gambler” types, I recommend that they allocate 10% for “gambling.” They recognize that they are gambling. They invest here for fun. They recognize that this portion of their portfolio is meeting that irrational need. With their savings on the 90%, they should go to Vegas.
For those in need of a “trusting” advisor, they should realize that there are many good and trustworthy advisors that use index funds who charge capped rates or minimal fees. One can verify that these advisors are trustworthy by doing your due diligence, i.e., making sure that control of the assets stays in your name, and that they use proper back office controls to protect your assets. One can pay a one-time fee to a third party consultant to help one find and perform due diligence on such advisors. Such consultants often have a rolodex of advisors that can fit whatever the client is looking for. Such consultants can also help negotiate the best possible fee. This third party “stamp of approval” truly ensures that you are getting what you think you are getting and not just a fancy suit. And the ongoing reduced fees on index funds and lower advisor wrap fees should cut your fees in half, if not more.
For those with agency risks, moving towards a “core and explore” strategy of allocating core equity strategies to index funds and satellite strategies to active management frees up the pension management team to focus solely on that portion of the portfolio where they can add value, while emphasizing reduced expenses in the central zones of the fund. Such a strategy shows your Board that you are focused on reduced expenses and adding value where there may be market inefficiencies.
The most important element in all of this is acknowledging that we are not rational; we all hate to fail relative to programmatic trading; and we all enjoy investing for different reasons. However, sticking our heads in the sand like an ostrich comes at a price to our portfolios. One can actually calculate the annual cost to one’s portfolio by netting the difference in return between an indices return and your fund’s actual return. So, do a reality check, and see if your hobbies, fears, and procrastination are really worth that price.
Teten: Thank you so much for your time and insight.
The opinions expressed in this post, and the associated research project at DisruptInvesting.com are mine alone (and/or my interview subject’s), and do not represent the views of ff Venture Capital, any other employee thereof, or of any other institution with which I am affiliated.
Previously published in Forbes.