The Ecosystem: Same, Same… But Different.. But Still Same
In meetings with prospective partners over the last few months, I’ve been thinking a lot about the players in the investment hierarchy. I contend that it starts with an individual investor at the top and funnels all the way down to employees at a company. Further, I think that at every point along the chain, the participants are doing a different version of the same thing. In the chart below, I’ve shown one potential path of capital flow along with each party’s potential incentives and responsibilities. It is lengthy, but not unlikely. In this story, a high net worth individual might select a financial advisor; wanting a diversified alternative investment strategy, this financial advisor allocates a portion of the investor’s portfolio to a fund of funds; the fund of funds then selects a technology focused hedge fund to be twenty percent of their portfolio; the hedge fund doles out fifteen percent of its capital to a portfolio manager whose focus is European software companies; in turn, after meeting with the management of a German cloud computing provider, the portfolio manager allocates five percent of his portfolio to their stock; and, finally, the Board and management believe that they have hired the right employees to help implement their vision.
A Few Observations
- Due Diligence. Each level performs a similar type of assessment on the level below them. The questions may be different but, ultimately, they are all trying to determine if the person they are allocating capital/resources to is capable and trustworthy. The due diligence Fensmere does before buying a stock echoes the due diligence a partner does before making an investment in Fensmere.
- Opacity. It’s already hard to perform good due diligence but trying to make an assessment more than one level down gets exponentially harder. What are the chances that the financial advisor can tell the investor what his exposure to Germany is?
- Incentives. The CEO who owns no stock, is paid a salary and is given free use of the company plane might have different goals than the founder CEO who owns a third of the company and still flies coach. Most financial advisors are paid asset-based fees so do you think they are optimizing for performance or for schmoozing? There’s a reason that Where Are the Customers’ Yachts? holds up after 75 years.
So, if due diligence is hard, transparency is low, and incentives are misaligned, how can we do better? Before I attempt to answer that question, I want to share an anecdote to illustrate just how bad humans are at allocating capital even one level down. Joel Greenblatt, a successful hedge fund manager and author, gave a talk at Google’s campus in 2017 where he discussed a study from his book, The Big Secret for The Small Investor. He looked at the best performing mutual fund of the decade from 2000 to 2010:
“That fund was up 18% per year, 100% long the US equities. The market was flat during those 10 years so 18% up a year is pretty good. Unfortunately, the average investor in that fund on a dollar-weighted basis managed to lose 11% a year because every time the market went up, people piled in. When the market went down, they piled out. When the fund outperformed, they piled in. When the fund underperformed, they piled out. And they took an annual 18% gain and turned it into an annual 11% dollar-weighted loss.”
So, yeah, that’s sobering. This behavior, by the way, is why it’s still possible to screw up investing only in index funds. Ideally, we want to have the ability to select the fund that’s going to return 18% per year and then not be the kind of investor that ends up with an 11% loss. There are two steps involved: The first is assessing the manager; and, the second is improving your own investment behavior.
Managers: Lucky or Skilled? Fiduciary or Parasite?
When performing due diligence, there are two main things we want to learn about an advisor: are their outcomes the result of luck or skill? And, are they working to help us (fiduciary) or to help themselves (parasite)? Unfortunately, we can’t ever know definitively – this is more art than science – but we can ask some questions to look under the hood.
- What is their investment philosophy/ style? Value/growth, contrarian/ momentum, fundamental/ technical, qualitative/quantitative, investing/trading etc
- Is their investment process consistent and repeatable? How do they generate ideas?
- Do their portfolios include leverage, derivatives, or large amounts of unused cash?
- How do they manage risk? How concentrated are the portfolios? Are there a few outliers that account for the returns?
- How has the manager performed across business cycles?
- What would your after-tax returns be? Remember: it’s not what they make, it’s what you keep.
- Do the returns make sense? The US government bond fund making 10% per year is fishy.
- How will they be compensated? Are the fees fair and necessary?
- Are they straightforward and transparent? Do they fess up to problems? Do they analyze things that went wrong?
- What, if any, is the relevant benchmark? How do they want to be held accountable?
- If they didn’t need the money, would they still come to work tomorrow?
- Are they risk-loving or risk-averse? Do they have skin in the game?
There’s no right answer to these questions; what makes sense in one scenario can be absurd in another. The important part is to try to understand the thought process and whether you are comfortable with the explanations. Also, it seems obvious but it is important to point out that unskilled people can get very lucky and the very skilled can get unlucky. Likewise, talented people can be morally bankrupt while nice guys can be incompetent.
You, The Investor: Stupid Is As Stupid Does
Now, let’s look inward. You’ve found your star manager who is going to return 18% per year. How do you make sure you don’t muck it up? In that same talk, Greenblatt discusses a second study about long periods of underperformance for the best managers.
“The top quartile managers, the ones who ended up with the best 10-year record, here are the stats on them. 97% of those who ended up with the best 10-year record, top quartile, spent at least three of the ten years in the bottom half of performance…”
Those numbers get even crazier – 79% of the best managers spent at least three of the ten years in the bottom quartile and 47% spent at least three of the ten in the bottom decile i.e. you spent at least 30% of the time looking like an idiot! So, picture yourself invested in a fund you love that has been outperforming its benchmark handily for the last three years. In year four, the market is up 15% and the fund is down 10%. What’s your move? What if they underperform for another year? Two?
The answer, of course, is: it depends. First off, the more layers you can remove between yourself and the investment itself, the fewer fees you’ll pay and the more transparency you’ll have. Next, have confidence in your work. The key insight is that if you can find a skilled manager, you don’t have to worry about near term underperformance because you believe in their process and philosophy and you can more easily focus on the longer term. Your belief in what the manager is doing will limit your second-guessing yourself. The increased transparency will allow you to determine whether the fund is suffering from ‘style drift.’ When the manager starts saying one thing and doing another, it’s time to go. Finally, if the manager/CEO is invested alongside you, it’s a lot easier to strap in for a bumpy ride knowing that if you go over the edge of a cliff, they are sitting in the first car.
Greenblatt summed up the numbers by saying “to beat the market, you have to do something different. You’re going to zig and zag differently.” I can promise that we will underperform the market by a wide margin in some years but I believe that is the price we pay for concentrated bets and a long-term orientation. In the future, I hope this post helps you to grade my performance and hold me accountable.