by Elliott Morss, Morss Global Finance
I recently urged a number of friends to read “The Death of Expertise: The Campaign Against Established Knowledge and Why it Matters” by Thomas M. Nichols. Nichols bemoans the fact that expertise no longer matters and we have become enveloped in “…a bonfire of arrogance and ignorance.” He concludes:
“To reject the notion of expertise, and to replace it with a sanctimonious insistence that every person has a right to his or her own opinion, is silly.”
I have sympathy for his position. I am an economist who has worked in 47 countries. I know a bit more about economies than others. However, I have a number of engineering friends who know far more about their subjects than I. And the same holds for my “marketing” and “medical” friends. I respect their knowledge and love to ask them questions.
There is however, one group of “professionals” that I have very little respect for: the people who market “investment strategies” to pensions and other large organizations. Nearly all pension funds have investment committees. To avoid being held responsible for losses, these committees hire consultants who in turn help them decide on investments strategies. The consulting firms will then hire the investment managers. Is there ever evidence of investment managers paying the consultants for selecting them? Yes. As I have noted in an earlier piece, there is plenty of evidence.
The investment managers and the pensions they manage are large, very large. Table 1 provides data on the ten largest US pension funds along with the total assets of the largest 1,000 funds in the US. The smallest of the top 1,000 is still large – the Howard Hughes Medical Institute has $1.1 billion assets in its pension fund.
Table 1. – 1000 Largest US Retirement Funds
Source: Pensions & Investments
Table 2 provides data on the largest managers of institutional assets in the world. And they charges fees for their services. And of course when you charge 2-3% for your services on such asset levels, you make a lot of money.
Table 2. – Largest 10 Managers of Worldwide Assets
Source: Pensions & Investments
The assets under management of the 600 largest institutional assets worldwide – $36.1 trillion
All professions use shorthand terms to communicate with other professionals in their group. And this shorthand can confuse/mislead others. But investment managers are in a class by themselves. I should understand at least some of their terms since I have a Ph.D. in public finance. However, these managers are either far more knowledgeable than I or they are really good snake-oil salesmen. Below, I offer examples of terms they use followed by two interesting sales pitches made by two individuals.
Table 3 lists some of the terms used to describe different types of investments. The list was originally included in a piece comparing terms used to market investments and wine.
Table 3. – Investment Descriptors
Source: Many of these come from ads in Pensions & Investments
There are also long-winded, complex-sounding sales pitches being made. I offer two below.
Park is the Chief Institutional Strategist for Janus/INTECH. In a piece he wrote a couple of years back, he claimed there was a way to get higher returns with lower risk. I asked him:
“If you can get higher returns for lower risk, why would not the investment gurus buy up such investments causing their prices to increase and eliminating their return edge over other investments?”
“Thank you for your e-mail and sharing your skepticism over the superior performance of lower volatility stocks over higher volatility stocks….Counter to most in the industry, we do not ascribe to the claim that low volatility stocks as a group exhibit higher risk-adjusted returns than higher volatility stocks as a group; rather, we believe that the superior risk-adjusted return is mostly due to stock volatilities and rebalancing effects that most people ignore.
Further, our focus is on the low volatility portfolio as opposed to portfolio of low volatility stocks, a subtle but important distinction; the former takes into consideration the stock level volatility as well as the interaction among stocks in a portfolio, the latter does not take into consideration the interaction among stocks in a portfolio. And this is the reason why the capitalization-weighted indices cannot be risk efficient is because they completely ignore the interaction or correlation among stocks in the index.
In order to maintain a low volatility portfolio, one must systematically and regularly rebalance or reconstitute the portfolio; otherwise, the original portfolio will eventually drift away from the optimal low volatility portfolio. It is our belief that the systematic rebalancing of the portfolio is the source of superior return for the low volatility portfolio and not necessarily the low volatility stocks themselves.”
Okay. I guess I learned something but not sure what. Park talks of regularly rebalancing the portfolio. This means, at least to me, that in addition to keeping risks down, stocks and bonds are being bought and sold using other criteria. And if this is the case and Park does not ascribe to the view that lower risk stocks do better than high risk stocks, what is really left of the low/managed volatility strategy? I urge you to draw your own conclusions.
Park has not been idle. He just came out with another promo piece ironically titled “The Sacrifice for Simplicity.” I offer a few quotes from this latest piece:
“In the shift to liability-driven investing (LDI), corporate pension plans made progress when they changed their policy benchmarks from asset-centric total return indices to pension liabilities, as they sought to match assets to liabilities. Along with the policy benchmark change, investment objectives changed as well: defeasance of pension liabilities, not maximizing total return of pension assets, became the ultimate objective for most corporate plan sponsors…. Therefore, we believe option market-implied, forward looking measures of downside and upside risk are an ideal way to actively manage beta exposures: increasing allocation to assets with low expected gain-to-loss ratios, and decreasing allocation to assets with high expected losses and low gain-to-loss ratios.”
“To be clear, we are not advocating for the buying and selling of options to manage beta exposures; rather, deducting forward-looking measures of downside and upside risk from the price of options on equities, credit, global sovereign bonds and inflation-sensitive assets.”
“To be clear?” I challenge anyone to tell me what Sun is talking about. I see him using fancy words and at best making tautological statements. But I guess it must work with his clients.
Bill Gross, the former PIMCO bond guru, has concluded the traditional ways to make money trading bonds are over. Returns are too low to be attractive. And the declining interest rate era that allowed capital gains to be made on bonds, is over. So Gross has come up with a new spin: “Unconstrained Bond Strategies (UBS).” According to Gross, UBS have the following objectives:
High income generation;
Dynamic duration risk management and
Diversification of equity risk.
Sounds good. I quote Gross:
“Given these foregoing objectives, unconstrained strategies move away from traditional fixed income benchmarks and increase latitude across regions, currencies, sectors, and instruments and even allow for some income producing equity related instruments…. This combination of increased latitude and a multi-faceted approach affords unconstrained managers the flexibility to opportunistically identify value and fully implement their high-conviction ideas independent of traditional benchmarks…. The end result is a portfolio that seeks to maximize investment returns irrespective of market environment and business and interest rate cycles.”
Maybe I don’t understand what Gross is saying. But it sure sounds like he is saying the historical ways to make significant money via bonds has ended, invest in whatever catches your eye. OK, but if I did not want to invest in bonds any more, why would I use an ex-bond broker to identify investment opportunities? Apparently, others feel the same way. Morningstar has removed Gross’ UBS fund from its up and coming list.
The Suckers At The Other End
Below I offer an abbreviated list of pension funds taken in by the “sophisticated” talk of the investment marketers.
The Westfield MA Contributory Retirement System is looking for a manger to run a $12 million active emerging marketing equities fund that would allow large cap, small-cap and all-cap core strategies.
The New York City Retirement Systems are looking for equity index managers and smart beta/alternatively weighted index managers. They are employing three consultants to help them with this – Callan Associates, Wilshire Associates and eVestment.
The Iowa Public Employment Retirement System hired 6 managers to implement liquid absolute-return strategies. These would function as an “alpha overlay” on its cash allocation.
The Taunton MA Contributory Retirement System is searching for a passive, small-cap core equity manager. In contrast, the Pennsylvania Municipal Retirement System is searching for an active domestic small-cap growth equity manager.
The Buffett Bet
During the financial crisis, Buffett bet a founder of the asset management company Protégé Partners LLC $1 million that a Vanguard S&P 500 stock index fund would outperform several groups of hedge funds of over the 10 years through 2017. Table 4 provides the results to date.
Table 4. – Buffett vs. Protégé
Source: Buffett 2017 Letter
The index fund is up 85.4 % while the hedge fund groups are up between 2.9% and 62.8%. I quote Buffett on the results to date:
“the results for the first nine years of the bet leave no doubt that Girls Inc. of Omaha, the charitable beneficiary I designated to get any bet winnings I earned, will be the organization eagerly opening the mail next January. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000.”
Buffett reports all of this in his 2017 letter. And he makes important points about fees.
“The underlying hedge-fund managers in our bet received payments from their limited partners that likely averaged a bit under the prevailing hedge-fund standard of “2 and 20,” meaning a 2% annual fixed fee, payable even when losses are huge, and 20% of profits with no clawback (if good years were followed by bad ones). Under this lopsided arrangement, a hedge fund operator’s ability to simply pile up assets under management has made many of these managers extraordinarily rich, even as their investments have performed poorly. Still, we’re not through with fees. Remember, there were the fund-of-funds managers to be fed as well. These managers received an additional fixed amount that was usually set at 1% of assets. Then, despite the terrible overall record of the five funds-of-funds, some experienced a few good years and collected “performance” fees. Consequently, I estimate that over the nine-year period roughly 60% – gulp! – of all gains achieved by the five funds-of-funds were diverted to the two levels of managers. That was their misbegotten reward for accomplishing something far short of what their many hundreds of limited partners could have effortlessly – and with virtually no cost – achieved on their own.”
Buffett believes the search for outperformance has caused investors to “waste” more than $100 billion over the past decade. His advice to both large and small investors: stick with low cost index funds.
Conclusion – More From Buffett
Buffett quotes Bill Ruane
“…a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: ‘In investment management, the progression is from the innovators to the imitators to the swarming incompetents.'”
“If a statue is ever erected to honor the person who has done the most for American investors, the hands down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value. In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.”
I conclude with Buffett’s observations on the receptivity of different groups to his advice:
“Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.
I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant. That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate. The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive. In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is – on an expectancy basis – clearly the best choice. My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative. Much of the financial damage befell pension funds for public employees. Many of these funds are woefully underfunded, in part because they have suffered a double whammy: poor investment performance accompanied by huge fees. The resulting shortfalls in their assets will for decades have to be made up by local taxpayers. Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion may be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: “When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”
A final quote from Buffett:
“Long ago, a brother-in-law of mine, Homer Rogers, was a commission agent working in the Omaha stockyards. I asked him how he induced a farmer or rancher to hire him to handle the sale of their hogs or cattle to the buyers from the big four packers (Swift, Cudahy, Wilson and Armour). After all, hogs were hogs and the buyers were experts who knew to the penny how much any animal was worth. How then, I asked Homer, could any sales agent get a better result than any other? Homer gave me a pitying look and said: ‘Warren, it’s not how you sell ’em, it’s how you tell ’em.’ What worked in the stockyards continues to work in Wall Street.”