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Joe Wiggins, "The Intelligent Fund Investor: Practical Steps for Better Results in Active and Passive Funds" (Harriman House, 2022)
01:06:18
An interview with Joe Wiggins
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B
Welcome to the New Books Network.
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D
Welcome to the New Books Network. I'm your host John Emmerich and I'm here with Joe Wiggins, author of the Intelligent Fund Practical Steps for Better Results in Active and Passive Funds. Welcome Joe.
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B
Pleasure to be here, John.
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D
Tell us about your work with asset managers and funds, Joe. Your day job, so to speak.
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B
Yeah, so I've been working in the industry since 2004 with a primary focus on mutual fund investing. So that involves analyzing active and passive funds and trying to identify which ones are best for our portfolios and for our clients and meeting their long run objectives. What I found particularly interesting in my career is the behavioral angle. So I studied sociology as an undergrad and behavioral science as a postgrad. And I've always thought that was incredibly appropriate for fund investing, where we're looking at the behavior of people in terms of fund managers and the decisions that they make, and also us as investors in terms of how we assess those funds, the decisions we make, and how they affect our financial fortune. So the lens and the angle I've always had on fund investing and asset management is how do people behave? What types of decisions are people making, and why are they making them?
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D
Yeah, I'm very biased in favor of that view. Behavioral science, assumed away by modern finance, to me revisiting it 30 years after I studied in business school, explains nearly everything from the failure of active managers, the failure of individual investors, or the existence of factor strategies can somehow be traced back to behavior. I'VE been a vocal opponent of most things modern finance, from MPT and CAPM to efficient market hypothesis. But I've always said in the past that while I know active managers can succeed, markets aren't informationally efficient. I don't know how the individual does any better picking those funds than some of the managers do picking stocks. And that story ends today, Joe, with your book, because you're the first person I know that's actually tried to explain how to do it. One of the first challenges is fund choice that you talk about. I was thinking about today, I didn't look it up. There must be nearly as many funds in the US as there are publicly traded stocks.
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B
And.
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D
And you point out in the UK that it's actually like 6 to 1 versus the FTSE, which is crazy. How do you begin? Most of the book is like a. I'll call it a screen to reduce that number. Walk through a couple of your first passes before you start calling up managers and ask to have meetings.
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B
Yeah, good question. And you're absolutely right. I believe that that markets are wildly inefficient because of how people behave. But that doesn't mean they're easy to beat. Just because something's inefficient doesn't mean it's easy for any given person to improve on those returns. And behavior matters much more than people give it credit for, if you think about what makes an easy choice. So if we have an easy choice is one where we've got a discrete and narrow set of options and we understand what the criteria is for the product or for the service or for the investment that we're looking to consider. Fund investing is the total opposite of that. We've got a huge array of choice, as you mentioned. We've got thousands of funds, new funds launching all the time, from broad global equity index funds to very niche thematic funds. So we've got a huge amount of choice. We don't know what the most important criteria is because it's very difficult. There's so much noise around in terms of short term financial market fluctuations and we tend to focus on the wrong criteria. So we look almost primarily at past performance and think, well, this fund has shot the lights out and done incredibly well over the last three years. That must mean it's going to do well over the next three, five and 10 years, which is entirely the wrong way to think about it. And it's kind of akin to if you're looking at Airbnb and you're looking at an apartment and it gets A a host of five star reviews. That would mean from a fund investing perspective, that your, your future experience in that place will be, will be worse because there's a real mean reverting element to fund investing that when things do exceptionally well, they tend to head back down to earth in the future as well. So filtering the universe is a really difficult thing to do. I guess a couple of really important things I would say is acts of avoidance. So I would avoid thematic funds. Thematic funds are these things with very compelling and persuasive stories attached to them. They might be about robotics, they might be about marijuana. Previously we've had the thematic funds about the BRIC economies and how they were going to change the world. And these are incredibly alluring, both for asset managers because they're easy to sell, and for fund investors because we make decisions based on how compelling the story is. Unfortunately, these types of funds are brought to market after the areas in which they're investing has already produced stratospheric returns and already on very high valuation. So they have fantastic back tests, fantastic historic track records. And then when they're brought to market and people invest in them, they're buying very, very expensive assets where the stories are already in the price. And I think the mistake we make with these types of investing stories is assuming that if the story is true, then it will make lots of money for us. But many times the story is true, but it's already in the price and more than in the price, so you end up losing money. So I think filtering out thematic funds is a good starting point for investors and we'll lose a lot from the viable universe. The other thing I talk about in the book is the issue of staff and managers. So staff and manager, again, very, very appealing to investors. They're these managers with fantastic profiles. They usually make lots of media appearances, opining on all sorts of subjects, usually outside of their own circle of competence. They've got a great track record and they run a huge amount of assets. So it's understandable that amidst this chaotic range of choice that fund investors have, they get drawn towards these individuals who are generally quite charismatic as well. There are a multitude of problems with these types of funds. Primarily, they've got so many assets, it becomes really difficult for them to generate good returns and beat the market. Because as your asset size grows, you can't invest in the same types of companies, the same size of companies that you have before. Their performance in the past has been so strong that it's very likely to mean revert because the valuations of those companies in delivering that performance have become quite expensive. And the other problem, which is a psychological issue, is that when managers have become that rich, that successful, that powerful hubris often takes hold. So they start doing other things. They start dabbling in other areas where they haven't typically invested, where they haven't made a great deal of money in the past. There's a range of warning signs. So I think cutting out thematic funds, cutting out staff on managers, is a really useful starting point to narrowing down that universe.
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D
Yeah, I tried to create a list in my own head about those warning signs. There's a saying here in the US when a company puts its name on a football stadium, that's usually the end of the company. And fund managers, I notice, besides writing books, which isn't always a bad sign, I've enjoyed everything David Dremond's ever written. But they get into competitive poker and just being way too out there on CNBC every week talking their book. And it's a tough thing to study, but I understand exactly what you mean. One of the other wonderful things the book does, and I always say that the institutional investment space is so many times its own worst enemy with its silos and attachment to modern finance, that you come right out and say, look, you're going to have appropriately, some of your fund in active and some in passive. And you just commented earlier, I hadn't really thought about it. This part of your work is analyzing passive funds. So can you talk about, because you get very specific in the book, which is so valuable, talk about allocating between active and passive, how you think about that mix, and then what would you do to analyze? How would you choose a passive fund?
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B
Yeah, it's a really good question. So I think my starting point is always for people before even considering investing in an active fund over an index fund, is are you willing to go through fairly long periods of underperformance? Because that will happen with all active funds, whether you're Warren Buffett or whether you're a fund manager starting out with their first portfolio to manage. If you're not willing to accept that, then you shouldn't be investing in active funds because you will make bad choices when that fund goes through its period of underperformance, which could be one, two, three or more years, you will probably sell it and then buy into another fund that's been generating really strong returns. And that's a path and a pattern of trading which will just destroy returns through time. So if you even want to consider active funds, and it's very much not for everyone, then you need to accept the realities. I think for those that do, a useful starting point is to, is to make the assumption that a market cap index, this is before we think about fees, which is a major issue. But active managers, you'd expect 50% of managers to outperform 50% of managers to underperform a market on a gross basis. So if that's our starting point, then you might want to split your allocation between 50% index funds, passive funds, 50% active funds. I think an important caveat here is when you say active funds, people immediately think about very expensive, high conviction stock pickers. But it doesn't have to be so you might invest in a, a fundamentally weighted index fund or a smart beta fund, which is a handful of basis points, but just does things slightly differently to a market cap weighted approach. So you might start off with 50 50. I think it's useful to adjust that based on the prevailing valuation environment. So the interesting thing I think people forget about the success of market cap index funds certainly over the last 10 years is fees are a huge determinant of long term returns. And that's all, all accept that. We can't deny that. But the other interesting phenomenon is that market cap as a strategy for an index fund does really well when big caps perform well. So when the largest stocks in the market perform well and small and medium sized companies underperform, that makes it incredibly hard for any active strategy to beat a market cap strategy because the majority of the stocks are underperforming. So if I was going to pick a stock at random, the odds of that outperforming the market would, when the big companies are doing well is very low. And we've seen that in the US in particular with the success of Amazon, Microsoft, et cetera in recent years, until more recent times. So think about the structure of the market, the valuations of the largest companies relative to small and medium sized companies, and the performance of small and medium sized companies relative to the largest companies. My inclination would be from a personal perspective. If small and medium sized companies have underperformed significantly and they're relatively cheap to larger companies, you might want to tilt towards other active non market cap strategies away from that 50 50. But conversely, if market cap large indices larger companies that perform poorly and are cheaper than small and medium sized companies, you might want to tilt more towards that style of investing. It's interesting to note that there was a study done in the mid 2010s looking at the market cap approach between 1969 and 2011 relative to any other index weighting methodology. So fundamental weighting, equal weighting, picking weights out of a hat. So any, any type of methodology during that period, market cap was one of the worst approaches to adopt. And that was just because small and medium sized companies outperformed during that period. So doing anything other than market cap worked during that spell. So. So it's an interesting phenomenon and we need to be aware that what we've seen over the last 10 years with the success of US equity markets relative to other developed and emerging markets and the success of mega caps, may not persist and it may be a different environment for the next 10 years. So the simple market cap approach might not find as much favor as other alternative methodologies. But the thing I would caveat it with is low fees always work through time, so they're always important.
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D
Is the US because you talk in the book about the difference between the UK and US specifically in this regard, the way the indexes are kind of structured. Because this is the second time we've been through this in the late 90s it was the same, just four or five different companies behaving the same way. Is the US market, the S&P 500 specifically, just structured different than other countries, or is it when you make a country selection, you're also making an industry selection. Right. You go to Denmark, you're in health care, you go to Australia, you're in commodities, and you go to the us you're in tech. And so is the US just structured different? Because I'm sure you allocate around the world and you can do this assessment the way you describe it in the book, you yourself as the analyst upfront and try to. Again, we're not predicting. You also use the word probability several times in the book, which I love because I look at us as allocators, as odds makers. Nothing's guaranteed, but you're just trying to put the wind at your back and increase your probability of success with some screens like you've used. So this is such a cool topic. If you talk a little bit about, more about the structure of markets and whether you can actually see up front that the. And you use the differentiation between the market weighted index and the equal weighted index. How one could, I mean, it's been, I think it's been 12 years here, but how you look at that, that would be great.
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B
Yeah. So the UK is a really interesting contrast and it's been the polar opposite to the US because the UK markets, if you think about the footsie all share. So for those that don't know, that's been dominated by. Unlike the US which had the tech and the kind of new consumer companies dominating the UK was dominated by what you might call old economy stocks. So you've got banks, you've got resources and materials companies, oil and gas companies, some laggard pharmaceutical companies. So you had a market in the, in the UK where the biggest names that dominated the index were struggling. And that meant the small and medium sized companies for the best part of a decade in the in the UK significantly outperforming the biggest companies in the in the UK market in stark contrast to what we saw happen in the in the US and that meant we had all the. So when you see the data of how many fund managers outperform the index, obviously it's generally typically low, but it was higher in the UK than most other markets and much higher than it was in the us. So you had all these narratives in the UK with people saying, well maybe fund managers in the UK are just more skillful, which is obviously nonsense, there's no reason to believe that. Or that the UK market was more inefficient than other markets, which again as a developed market seems a ridiculous and thickness thing to think. And actually the answer was really simple. It's just because mid and small companies outperform the large companies, the odds of success, the probability of success for me picking stocks randomly, much higher in the UK than it would have been in the US because more stocks outperformed and the vast majority of active managers in the UK had a bias towards small and medium sized companies. And Last year in 2022 in the UK we saw the largest companies outperform because resource stocks did so well. So those big companies in the UK had a rare period where they performed really well. And guess what happened to UK active managers in 2022? Their performance was terrible and most of them underperformed. So it's just a structural feature of markets and I think it's an interesting question about looking at the. So you should definitely look at the structure of the market before you invest in it, understand what type of companies and sectors dominate that market and understand the performance of for example an equally weighted index relative to market cap weighted index. If there's not an equally weighted index available, you can look at the performance of small and medium sized companies relative to the main market and that will give you a good idea about the dynamics of that market and also look at the valuations as well as to Whether the US is exceptional in having this type of phenomenon, I don't know. But I think there is a case you can make that the UK is the leading world economy. Whether there's likely to be more innovation on average, Is it more likely you'll generate dominant global companies in the US than any other market? Perhaps that's true and I don't know. I wouldn't have a high conviction in that view, but I'd say it's more likely to happen in the US than a market like a smaller market like the UK for example.
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D
Okay, so we're avoiding star managers, we're avoiding chasing returns, we're avoiding thematic funds. So you've narrowed down your universe. You think you see some lengthy underperformance in a particular market or sector, you're going to dig in and look for an active manager in that space. How do you, because again, a lot of this is negative selection. How do you then go and select an active manager after you've screened out the ones you don't want any exposure to? It seems an exceedingly difficult thing. I was thinking about it when I was reading the book. There are two people that I know, one's famous, one I just happened to sit on a board with who were really successful at picking star managers before they became stars. One is David Swensen at Yale. People forget that he didn't pick stocks, he picked managers. And the gentleman I know, Mike Stolper who found Tom Bailey at Janus, and my mentor Rick Astor at the Meridian Funds, well before they were stars. And I've never asked them. I should, I'm friends say how did you do that? But what, what, what do you do, Joe, once you've, you know where you want to be and you're looking at managers, how do you, how do you proactively select now that we've screened?
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B
Yeah, good question. And there's definitely no easy shortcuts to doing it. So if you want to do it, you need to be willing to, to put some work in to try and identify those characteristics you think are most likely to lead to strong long term returns. So I think there are three really key elements to think about at the top level. One is beliefs. So understanding the beliefs of any given manager to invest in. The next is process. So what is the process? What are the decisions that they take based on their beliefs that they think gives them an advantage and then the outcomes or the performance and just to take those three things in turn. The beliefs part I think is often neglected. But to me it's fundamental in how we think about any investment manager. So an investment manager, an active manager, needs to have a belief about how markets function. What is the inefficiencies that they're looking to exploit in markets and how are they going to behave differently in order to capture those inefficiencies. And I think here you really need to be very specific or the manager needs to be very specific and clear about what they think the inefficiency is or what their edge is. Too often you see managers who either don't have any clear beliefs or the belief is just kind of meaningless noise. So they'll say we want stocks that have got growth at reasonable price, which doesn't mean anything. Who knows what that means? Don't we all? And it's much better than unreasonable price. So you want someone to say we think markets are inefficient for these reasons and we think we behave in a certain way that we can capture some kind of advantage or edge. Because once you understand their beliefs and make a judgment call, which you have to do about how credible those beliefs are, and that would be different depending on the markets that they're investing in. It could be different for a high yield bond investor to an emerging market equity investor. Once you understand that, then you can link that and get a deep understanding of their investment process and the process and drilling down into the processes. There's lots to talk about here, but the high level is thinking about how they garner information and how they make decisions based on that information. You want to link it back to the beliefs again. So do they have a consistent process for making decisions that on average with maybe a 55 or 60% hit rate, exploit the inefficiencies that they're talking about. So you can spend a lot of time discussing process, you can discuss who's on the team, what's their experience, what's their expertise, how do they model companies if they do that? There's no perfect process. But what we want to understand is, is it a process that has a better than 50% chance of capturing the inefficiencies that they're talking about? So drilling down into the process and linking it to the beliefs is really important. And the final leg is thinking about performance in a, in a different way. So when we, when you assess a manager, I don't think you want to just consider or primarily consider his performance been good or bad. Because lots of lucky managers will have good returns and talented managers will go through periods where they have disappointing returns. Certainly as you shorten the time horizon. So what you want to understand in outcomes is look at given the beliefs and the process, are the outcomes of the strategy consistent with that? If they're looking to identify companies that are on depressed multiples because they're out of favor with the market because they're facing negative narratives and they're able to do analysis that shows that they will, they're likely to mean revert and recover. Is that evident in the outcomes they're delivering? So if we do a holdings analysis of how the manager has behaved through time, do we see them investing in these types of situations consistently? So what we're trying to, trying to build up a picture of, is there a consistent picture of their process and the decision making leading to certain types of outcomes? So that's how I think you need to think about the decision making and the beliefs to get to any level of confidence that manager might have skill. And you want to see them repeat that behavior through time as well. What you don't want to do under any circumstances is just look at performance and say, well, performance has been good for five years. They must have skill or they've outperformed for the last five calendar years. They must have skill. Clearly we've seen even in the last six or seven years many high growth orientated managers who would look like they have skill on any basic performance screen then suffering very savage losses in a much different market environment. So it's all about understanding the beliefs and the process and then the outcomes delivered. Yeah.
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D
What we used to call understanding how you make the sausage and then believing that the manager is going to consistently execute that strategy that you've come to understand and you say that makes sense. I could see how this has a better than 50% chance of adding value versus passive.
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B
And this is really hard to do. Really hard to do well. And that's why.
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D
Absolutely.
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B
Another reason why passive investing is a great idea for many people, because most people don't have the time or the inclination to go through this process to try and identify those types of opportunities. And that's absolutely the right thing for them to do or not do. Right.
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D
Talk a little bit about concentrated funds. I think most of the managers and William Green's book Richer, Wiser, Happier, except for Templeton and Peter lynch who's just six standard deviation event in this industry's history. But most of the managers in there are concentrated fund managers. Buffett famously said, you know, diversification's insurance against ignorance. Obviously you don't want to put all of your money in one fund that holds 20 stocks, but you as an allocator could buy 10 funds that have 20 stocks each. As long as you have a look through to the holdings, know that they're all not doing the same thing, and be somewhat diversified. Does you find, on average, concentrated funds? Does that long term increase the probability that they're going to add meaningful outperformance, or is it not consistent enough to make that claim?
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B
So I think what it does is it broadens the range of outcomes. So the more concentrated you are, the wider the potential range of outcomes that you have in front of you. So if you believe that you have skill in identifying the right types of managers, that gives you a potentially positive asymmetry where you've got a wide range of outcomes, but you're tilted towards the positive rather than negative. I mean, it's too. Two problems with the commonly held views about concentrated funds being better. And even the Warren Buffett argument is that for concentrated funds, markets are incredibly uncertain. The future is incredibly uncertain. We don't know what's going to happen. We don't know everything about the company that we invest in. There are always known and unknown, unknown. So when we're very concentrated, we are quite significantly and sharply exposing ourselves to that risk of things happening that we hadn't foreseen and couldn't possibly have foreseen. So even with the best will in the world, with the most talented investors, if you're very concentrated, one thing has to happen, one event, one piece of malfeasance you didn't spot or couldn't spot, that could savage your entire investment case and your track record. So that makes it inherently quite dangerous. So that's why you've got such a wide range of potential outcomes. The other really important thing, which goes to your point about how you suppose how you manage concentration, is that the risk of concentration is in what you do own. So something you own 25% in going badly wrong and what you don't own. So if you're very concentrated and some of the things you don't own do incredibly well, then the cost of that is likely to be very significant as well. And that's going to be pernicious. So if you are going to invest in concentrated funds, as you say, make sure you're diversified across a range of different concentrated funds. So you remove some of those risks and you reduce or narrow that range of outcomes because you are carrying significant risks. If you are overly concentrated in your portfolio, in a single fund with 20 stocks or a couple of funds with very narrow positioning, I Think the other thing people do all the time, which is a different type of concentration risk and I guess we've seen this a lot is the past 10 years, is when a particular investment style is working. If you only invest in funds that have got great track records through an environment where a particular style has been in favor, then you end up looking at a portfolio and saying well I'm diversified, I've got 10 funds. But actually they're all ultra high growth orientated funds that have done incredibly well over the last 10 years. So you've got 10 funds but you've got one bet on and when that goes wrong that impacts everything in your portfolio. So it's really important to be diversified and to not take very aggressive bets in concentration by stock or by country or by style, because the downside risks can be incredibly severe.
- [28:42]
D
Another criteria to avoid certain dynamics is what you describe as avoiding complexity. And I sit on the board of a bunch of what we call 40 ACT funds here in the US and they're very straightforward. Every once in a while you know there's some option activity. But I wasn't really sure what's out there these days in terms of complexity. But of course the whole, what they call liquid alternative space could be considered complex. I think you start off talking about death bonds but in the UK what do you see is going on that's actually allowed where you sit there and say I do this for a living and I'm not sure I understand or would get comfortable enough with what they do to buy it, no matter how good their performance is. Describe complexity we see in retail facing public equity funds.
- [29:39]
B
Yeah, so I think anything with leverage and derivatives is pushing the boundaries of what a non expert might reasonably understand in terms of what the risks are and the consequences are of those features. I think within, within equity funds it's quite rare nowadays to see overly complex equity funds. I guess there might be complexity in a quant fund that you don't know the details of exactly how stocks are being selected. But that's a different type of risk I think where we see it certainly in the uk, I guess you'll definitely get this in the US as well where you have what we would call absolute return funds. So I guess hedge fund lite. So hedge funds made available for the masses which promise cash plus 5% returns in all market conditions using considerable leverage, usually taking usually using quite complex strategies that certainly non sophisticated investors wouldn't understand. So there'll be option based strategies, they'll be managed futures.
- [30:45]
D
I get asked about all the time. And I don't understand it.
- [30:48]
B
Yeah, absolutely so. And I think so. When you're in a situation where only an expert or a practitioner would understand what's happening within the fund, then as an investor you become incredibly even more reliant on performance. You don't know. As I talked about the process earlier, with these funds, it's often very difficult for you to have a granular understanding of the process. So therefore you lean very heavily on performance. And if performance is good, people are comfortable, and when it's not, they're uncomfortable. But I think the important rule of thumb is do you understand what you're investing in? Can you explain why it might work, or what types of returns and risk it will deliver? If you can't do that, then you shouldn't be investing in it. Again, as we talked about earlier, there are literally thousands of funds available. There is no need to invest in things that you don't understand. It's perfectly easy to invest in simple strategies that will deliver good outcomes for you over the long term without reaching for the complexity and the allure of things that we really can't comprehend.
- [31:51]
C
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- [32:21]
A
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- [32:52]
D
So you've going forward in the process, you found the fund, you've got it signed off on, and the firm is allocating to an active manager. Do you have a and the checklist at the end of every chapter is they're fantastic. Do you have a similar checklist for selling the fund? You know, all the attention security selection is on the buy decision, but in my experience, so much money's left on the table or could be preserved if they had A sell discipline to get out of a stock just like they had one going in. And number eight on one checklist. I noticed you don't call it style drift. It's what we used to say in the hedge fund world. You never got fired, you rarely got fired for performance, you always got fired for style drift. And I'm just bringing that up as one example of looking at someone that you hired who had a discipline, had a strategy, and you go, wait, why are they all of a sudden 40% in energy companies? What are your disciplines for making the decision to walk away from a fund after you've been in it for a while?
- [33:57]
B
Yeah, good question. I think most important thing is having a realistic set of expectations about what you're investing in. So you need to be aware if you're investing in a very high conviction active fund, that performance will be cyclical and it will go through really difficult periods. If you're not aware of that, then as soon as you go through a difficult period, you'll end up selling it and crystallizing those losses. So going into it with your eyes open and writing down or maybe doing a pre mortem and saying these are the things that go wrong with the strategy and understanding how you behave outside of being in the actual moment, what you don't want to do is wait until you're in a hot state and the fund's performing poorly and you're panicking and making decisions at that moment is likely to be very short term and a poor decision. So having clear expectations, going back to my earlier comments about how you look and how you look to identify a talented or skillful active manager. So what you, what we tried to do there is understand what do they believe about markets and what's their process. So what types of companies are they typically investing in? How do they typically structure their portfolio? How do they weight their positions in the portfolio? And you're making the investment based on your understanding and your conviction in what they're doing. So the key issues around selling is are they still acting in a way that's consistent with what I expected from that process? Are they buying the types of companies in the types of size with the types of characteristics that I would expect them to do. If they're still doing that and you still believe that their idea about the inefficiencies in markets are there, then you like to be comfortable sticking with that strategy, other things being equal, if they're doing very different things. So, Brian, high growth companies, expensive companies, where their beliefs are about valuation opportunities and discounted opportunities in markets, that's when the alarm bells start ringing. So that is, that is a type of style drift. When the behavior deviates from you, from reasonable expectations. That's the key one for me is so writing a list down, what do I expect from this manager, what I expect about the process, what I expect them to be doing and kind of match up their behavior with my expectations. There's a few other things that you, you'd always think about. So things like how much of the strategy is reliant on the, on a particular individual relative to a team. So if there's a departure or team changes or the company gets taken over, does that materially alter the nature of the strategy? And another really important one when you enter a strategy is trying to think about the size of assets. So this strategy I'm investing in today is $500 million. We think that above a billion dollars or above $2 billion or whatever number is, that opportunity set gets eroded quite dramatically and our expectations for this strategy are reduced greatly. Because what you can almost guarantee is that fund manager will not be disciplined around capacity. If their fund is making money, if it's getting significant inflows, generating lots of revenues, they're going to push through any capacity considerations that you might have expressed to them before. So you need to be as a fund investor saying this manager made a lot of money in small and medium sized companies and at this size there's no way they can invest in those names again. So that asset size thing is a really important part of a checklist for when actually we want to be investing in managers who are much smaller than this, who've got a far wider opportunity set.
- [37:23]
D
Now I'm going to tempt you into going more behavioral with me in a couple of questions. Another thing to avoid smooth performance should be feared, not sought after. Several parts of this. First of all, I struggle with active fund managers that are actively the individual fund. They could be one of 25 funds that a high net worth client of yours is in. And that individual fund is trying to manage volatility short term by definition. At the same time they're trying to maximize returns. They were reporting sharpe ratios and trainer ratios and talking about how many down days they had in the quarter. It was fewer than the market. This is part of a bigger question, but we're getting into the notion of smooth performance you brought up in chapters three and six and what active managers are doing almost to. I think all that management comes at the expense of long term return. It kind of has to what is your reaction when you. Because the real point is you, Joe Wiggins, should be however you define risk, whether it's, let's say it is volatility. And I agree with you that that's one definition, but it's not the definition. You're the one managing volatility or risk. You know everything you have and I don't. I would suspect. But tell me if I'm wrong. You don't want each of your 25 active managers trying to manage their own volatility at the expense of total return because that just rolls up into lower performance for you. Long winded description, but I think you know what I'm getting at.
- [39:08]
B
I totally agree. I think it fills me with horror if I talk to say, a fundamental stock picker in theory looking to buy companies for the long term and they talk about very short term performance metrics and how they're measuring that and how much drawdown they've captured and what their, you say what their Sharpe ratio might be over a quarter. As soon as you collapse your time horizons, it's just market noise. It's just noise. You can't predict it, you can't control it. There are sensible things you can do by being reasonably well diversified. But aside from that, as soon as you start trying to manage your short term outcomes, you can just wave goodbye to your long term objectives because you can't on the one hand say I'm buying this company for the long term because I think it's mispriced, but it will take time for fundamentals to exert themselves. Also, I'm trying to generate a high Sharpe ratio or reduce my volatility over the next three months. There's just no, there's no credibility in that. And I know why it happens because what's measured is what matters. And the whole industry has gone towards measuring these things over the short term. And there'll be committees and boards and trustees who want to see how have you done over the last quarter. And it's just, and everyone's just obsessed with kind of monitoring and measuring randomness in markets, which is a monumental waste of time. But it's not just a waste of time. It means that long term investing just doesn't really happen that much anymore because everyone's writing quarterly reports about underperforming by 20 basis points, which doesn't mean anything. But I'm a big believer in if you want to invest for the long term. And I always get talked back from this as if I'm extending my time horizon too Far, but let's say 10 years or more. You need to create an environment where you can behaviorally invest for that time period because if you're reporting on monthly performance or managing your portfolio based on month to month or quarter quarter returns, you're not a long term investor. You're just playing the game of short term investing and kind of hoping to keep your job for as long as possible. So yeah, I mean I think it's short term volatility management away from kind of simple diversification principles is generally a waste of time. But unfortunately the way the industry has gone is that everyone's become increasingly myopic and this is why people love private equity and kind of Cliff Asness sole of my thunder about this a bit is that because the stuff's not priced, don't have any volatility, don't have any noise. So you have this volatility laundering process as a AQR and Cliff Asnes call it, it's much easier to do your quarterly report when the market's down 10% and your, your private equity medium sized company fund is, is flat because no one's changed the, changed the marks.
- [41:48]
D
Yeah. And believe it or not I, I'm pointing to my screen which you can't see in my notes and that was my next question was you weighed ever so subtly into that debate with Cliff Asness on social media with private equity funds that are, you know, I think their problem is they're marketing it as low volatility product. And so there are two elements here. They're both right about what they're saying and again but it's the way they're marketing. So Cliff's point is hey, if you mark to market instead of mark to model, your volatility is going to be the same as mine. And I think with the private equity folks who are just marking this as low volatility should be saying instead is yeah, we know we're marking to model but we don't believe in market efficiency. The second part of which Thaler says two sides of the coin is that the stock price, even if it's down 20 and up 20 in the same day doesn't reflect intrinsic value. And so we're trying to more closely reflect intrinsic value in the fund. But as I say, I get what they're trying to do. And what I wonder is, does that, and this is the next question, does that private mark to model fund make individuals better investors in a twisted behavioral kind of way? You know what I mean?
- [43:14]
B
That's absolutely true. I mean the real illiquidity premium is just the inability to trade and the inability to see any mark to market fluctuations. So it's just much easier. I think you're much more likely to be a long term investor if you're locked in and the performance is smooth. So I don't have a problem conceptually with private equity. I have a problem when people say you should invest in private equity funds because they're diversifying from public markets, they have lower drawdowns. It's just right.
- [43:45]
D
That's the marketing piece. But not so bothersome to Cliff.
- [43:48]
B
You shouldn't sell it in that way to people. You need to be clear about what people are buying. And if you're buying a public market fund investing in medium sized US companies and a private market fund investing in medium sized US Companies, you're not diversifying. And if you are diversifying, you need to tell people that you're only diversifying because you're marking it differently. I think with everything in this industry, things would be better if people were more honest and transparent about what was being done.
- [44:16]
D
Yeah. I was reflecting back as I was preparing for this interview on one of Richard Thaler's books, Misbehaving I think it was, where he's talking about myopic loss aversion, things like that. And in the study and I could have the numbers wrong, but the point is going to be on they analyze performance of people who, I swear it was this dramatic joke, check their portfolio once a year against people who check their portfolio eight times a year. And I just laugh because it was done in the 80s. I'm like, how about eight times a day? You know, people checking, you know, their portfolio.
- [44:53]
B
Do you.
- [44:54]
D
And we're gonna have some people that aren't professionals listen to this. Or to borrow another term from fail or mental accounting, any disciplines or tricks because you think we can change behavior and I'm not, I'm personally not so sure. But what, what mental accounting tricks or disciplines can allocators professionals and some, you know, sophisticated high net worth people that do it themselves employ to stay the course and not be react to the whims of the market on a daily weekly basis.
- [45:26]
B
Yes, I very much believe that most people, let's say people have been at a few jobs. Their best performing investments of their lifetime will be when they've had a job for a couple of years and they've been put into a pension. But that was a long time ago and they've just forgotten they had that pension. They've never seen it Never done anything to it. And when they retire, they'll be better performing than anything else they've had where they've had daily access to valuations and have been trading it. So there's definitely an advantage there. I think that there's lots of technological advancements in investing which seem fantastic, but behaviorally are an absolute disaster. So day to day valuations, ability to trade, ability to check your phone on your app and see how your pension or 401k is doing. I mean, that's just every time you check, you create a decision point. Every time you check, you're saying, should I stick with this or should I change it? And you'll be being driven by emotion, by how you feel, by how much red you're seeing on your screen, by what you read on the news or saw on the news. So those decision points are disastrous for long term investment success. You want to create very few decision points, so spread those decision points out deliberately. So don't download the app, don't have a easy to remember password on your brokerage account or your pension. Give your password to someone else and tell them, if I ask you for this password, tell me I can't have it until I've asked you for a few times. Never make a decision, an investment decision, until you've slept on it. Just step away from that moment of making that decision. Because often investment decisions will just be made by how we're feeling at that moment. And what we want to do is just enjoy short term relief. So when markets are tanking, if it's, let's say it's March 2020 and we've got these dramatic swings in markets, our time horizon is there. Even if we've got a 30 year plan, our time horizons are about 30 seconds in that moment. And what we want to do, we're in panic mode. We want to remove that worry. And the easiest way to remove that worry is to hit the sell button and go into cash, which in most scenarios is the worst possible thing to be doing. So the thing you should be thinking about is how can I add friction to this investment approach that I've got? By not checking your portfolio, by not having the app, like, just like, how'd you stop looking at your phone and checking Twitter is. Put your phone in another room, make it difficult, add some friction to your decision making.
- [47:46]
D
Add some friction. That, that's a great idea. You know this, this is not a sad story. My mom had a wonderful life, lived a long life. She, she passed away end of last year and my Brother and sister and I were uncovering financial stuff, little accounts they had all over the place and she actually had, she turned out to be brilliant. Three drip accounts, right? The direct reinvestment funds that she bought directly from the companies. So she sends money to Aflac, they pay a div. They just keep reinvesting the div, I'm guessing for 20 years, you know, and I thought I was pretty good at what I did and I realized that my mom has trumped everything I did when I was a paid professional just by doing that. And so I love the idea of increasing like self imposing some friction. I'll have to think about how else we do that. I've never been a fan of necessarily big 5% loads going in or out. But you know, we did have our hedge fund look. These were professionals giving us money. If they wanted their money back, we always had the ability to give it to them. But we had what was called a soft lock. So if you redeemed in the first 12 months it was like a 3% redemption fee in the second year, 2% in the third year, 1% after that, no cost. I don't know that any public fund manager would be willing to do that. But somehow creating friction is a great idea. I did an interview with someone on the HR side of life and management side and we talked about emails being sent in anger in the moment. Right, Fire it off, send to all. And there's an app, she said, well, there's an app out there that actually will compartmentalize that email for 24 hours automatically and then ask you the next day at noon, say, are you sure you want to send this email? That's kind of a self defense good side of technology.
- [49:49]
B
I guess that yeah, never want to send that email either, do you in the cold update.
- [49:54]
D
It's always a bad idea.
- [49:56]
B
But yeah, there's so much. I said two things. There's huge scope for innovation in fees and asset managers don't want to do it for obvious reasons. But there's huge scope for changing fee structures to better align with client interests and incentivize long term investing. And also a technology for most trading platforms is obviously designed to make people trade. They want to remove friction because they want you to trade what platforms, whether it's pension providers or investment platforms should be doing is thinking about these are the bad behaviors that investors have. How can we create structures and incentives and tools that help them invest? Like what you just said for investing where you've made this trade, we'll sit on it for 24 hours and then ask you again, do you really want to do this again? Things like that. There needs to be a lot more thinking about how do we make. We know people have got these behavioral issues that leads to poor investment decisions. Can we create structures and systems and tools that help them make better decisions through time? It's not going to transform everything. But even those marginal changes can have a big long term impact.
- [51:01]
D
Yeah. Instead we've innovated ways, as you said, to make it even easier and easier to trade. I reflect on John Bogle when the ETF phenomenon happened. I didn't appreciate he's so such a smart guy. He said he was worried about them just because it was going to make funds even easier to trade than they. Than once a day you could trade them like stocks. And you see that a lot with fund managers using the Russell 2000 Index ETF to just hedge or get exposure extremely quickly.
- [51:33]
B
It's an industry built on just doing stuff. You've got to do stuff. And I find this myself. I obviously believe in long term investing and doing less. But it's really hard to build a career if you believe in doing less. You want to be seen doing stuff. What's your next trade? What's your next idea? How you're adjusting the portfolios and all this stuff but the majority of the stuff will be value destructive over the long term. But in the moment you get rewards and benefits for doing it. Yeah.
- [51:58]
D
The institutional imperative to do something when the best thing almost all the time is to do nothing. And that leads us to one of my favorite chapters, Chapter nine on Time Horizon. The counter to myopic loss aversion. Value is a factor. Quality is a factor. We didn't really get into factor funds. Momentum is a factor. I argue time is a factor. It's the one that gets talked about the least. And in fact it makes the other factors work. You buy value today, it may not work next year, but you're betting on mean reversion to some extent that it's a real factor and it will work. And conversely as long as if you don't put yourself under the gun with leverage like the Long term capital geniuses in 98 the returns will eventually out. But it's hard and I don't. We've talked a little bit about it. Thalers must have. I use this term all the time mental accounting trick with some of my clients. You can weigh in on 60, 40. I think that's part of the problem. I try to separate the at risk portfolio from the Bond ladder. My father in law say look, you've got five years of cash in short term bonds, high grade bonds. It's going to be there, you're going to be fine. Don't look at the other 70%, just let that.
- [53:27]
B
Go.
- [53:28]
D
But you also say you can overstay your welcome. How can staying too long be a problem?
- [53:35]
B
Yes, I'm a very big advocate of long term investing and think that it's the greatest edge that any investor has is benefiting from the cost of short term investing. Most people do by taking a long term approach and that compounding of those that temporal advantage through time is massive. But no one in the industry has the ability to capture it because everyone's so obsessed with what's happening over the next quarter, what markets did yesterday that creates the premium. Why the long term investing premium at which I think about exists. The exception to that is if you're making poor decisions in a long term approaches not the, not the right way to go. So if you're investing in strategies which have tail risk, so they're the risk of catastrophe or disaster or major failure, then a long term approach is to your detriment because every day you go by. So if you, if you don't buy, if you don't buy insurance on your, on your house or your, your car for one day, you might get away with it as a minor risk. If you do that for 10 years then you're likely to be exposed to the tower risk of, of your car being stolen or your house burning down. So if you're investing in complex or leveraged funds or very highly concentrated funds that have got this tail risk of things going badly wrong, their long term approach is to your detriment because there's more opportunities for that tail risk to come to pass. So provided you're making sensible prudent investment decisions, then a long term approach is absolutely the right thing to do. But if you're investing in Bernie Madoff's fund, long term approach is much worse than the short term approach because you're likely to be holding the can when it comes to light.
- [55:22]
D
I want to ask about the asset managers above the funds that you're looking at because of a couple of behaviors we're familiar with inactive management such as index hugging or, or just as you referred to earlier, the fear of losing your job I imagine. But although I haven't seen a ton of it, that the employer of that fund manager can structure their career in such a way that supports long term investing, saying we're not going to fire you as long as you're doing what you were hired to do. Do firms do that? What are the innovative things have you seen firms do to make sure their fund managers are focused on the long term and not this quarter?
- [56:10]
B
Yeah, it's a great question. I think this is a particular problem for large listed asset managers because they're under pressure from shareholders to deliver over the short term. So short term profitability, which means rising assets under management, positive flows and maintaining, at least maintaining fee level. So they are incredibly short term performance sensitive because they don't want to disappoint at the next earnings announcement. So it's really difficult for them to create an environment that incentivizes long term investing because if their managers start underperforming and assets start walking out the door, then that chief executive or that executive team are going to be under huge pressure about the performance of that company. So it's much harder in listed companies that might be in a, in a partnership or it might be in a small boutique where you can have alignment with the owners of that business who tend to be the employee. So I think the best route is when you get a set of individuals working for an asset management company when they're aligned in the philosophy, they're aligned in their approach and they have a remuneration structure which is consistent with what a client would hope for. So that is rewards based on long term investment results. And we're talking more like seven and 10 years than one and three years. I mean, I see it all the time when I'll meet with a manager and they'll say we're long term investors, we want to be assessed over a minimum of five years. And that's what we think about. And then we say, so your remuneration package, what's that based on? That's based on one year return. So. So you tell me one thing, you tell me your investment philosophy and then you tell me your incentives. What do I think drives your behavior? Or I know it's your incentives. So you see, I rarely see incentive packages at fund managers that genuinely align with clients and are long term. Genuinely long term in the nature is far too often it's just one in three years and that's it. And that just encourages asset managers and fund managers to try and maximize returns over those time horizons, generally via performance chasing and occasionally index hugging as well if they're looking to protect some kind of return they've generated in the past. So incentives need a big rethink, but particularly for listed asset managers, it's really difficult to do well because of the pressure they're under to deliver short term results.
- [58:36]
D
Yeah, alignment. That's the word I was looking for. That's a great word. And just another example where I think the industry can be its own worst enemy. We've talked about a lot of things. I'm with you on market efficiency and the way those studies measure what percentage of active funds outperform that they like to put out there every once in a while. Any more thoughts on why active managers do underperform? When they do underperform, sometimes, as you said, they just have a strategy that doesn't even add up to the the prospects of significant outperformance. But what other things do you see active managers doing to basically put themselves behind?
- [59:21]
B
So the overarching problem for active managers, and this is an industry issue they need to deal with, is that the fees are too high. So fees compounded through time make it extraordinarily difficult for active managers to outperform. So they they need to be reduced to better reflect the probability of outperformance. And yeah, active fund fees seem to be still at legacy levels rather than realistically priced. If active funds of all active fund managers within a certain sector, this is a gross simplification. Before their fees were commensurate with passive options, then you'd expect half of them to outperform, half of them to unleash. So once you add on whatever feeload it is, then you'd expect the vast majority of them to underperform. So I think there's a lot more that can be done. And if the active industry wants to improve its image and improve its outcomes, then it needs to think about the fees it charges and making a change there to make them more competitive and increase the odds of active management success. And I think the other thing we've already talked about is that I think for most strategies you need to be able to adopt a long term approach. It needs to be able to deliver over more than one or three years. But because incentives are so aligned with meeting short term performance targets or chasing recent market trends, you end up with lots of active managers trying to maximize their profits over the short term by latching onto the latest market fad or trend or the latest major irrationality markets, which works for a period and lots of active fund managers will make a lot of money for 2, 3, 4, 5 years and then that will unwind. So investors will be worse off over the piece. But a lot of active managers will have made lots of money from riding that wave. So the key thing is for me that as we talked about already, is just aligning the long term interests of clients and investors. And if we can have better alignment, then investors can make better long term decisions and try and exploit those short term inefficiencies. And investors will have far better outcomes if they can just extend their time horizons. But there needs to be a rethink about fees and about incentives and about how to encourage the right behaviors.
- [61:36]
D
Those are the big three. And one, since you just referenced behavior, is there a favorite book on behavioral finance that you remember from either your work or your studies? I just want to make sure I haven't missed one because it's such a favorite topic of mine and so relevant to this field.
- [61:52]
B
So the one that got me into it all those years ago was Behavioral Investing by James Montier, who I think now works at gmo. But I remember seeing him talk when he was working, I think at Societe General, and he was the first person I heard talk very clearly about behavioral biases in investing. So that's a relatively old book, but still a classic, I guess something that I've read more recently, which I'm sure is known to you, which is not behavioral finance, but it's very related to the job Is Thinking in Bets by Ali Duke. Just about how to, how to think probabilistically when you're dealing with uncertain environments. And I found that really helpful in just trying to, trying to improve my own thinking and decision making when we're faced with lots of noise and lots of uncertainty.
- [62:43]
D
Yeah, I especially like the correlation to what we do to poker. Not because either of them is gambling, not because they shouldn't be. I argue poker isn't even a card game, it's a betting game. And it's the probabilities and knowing when the odds are in your favor and betting accordingly. And to me that correlates pretty well to what active managers are supposed to be doing.
- [63:08]
B
Everybody does. And it's just that investing is a lot noisier than poker. So the luck and skill balance is tilted a little bit. But what I always say when people ask about how much luck and skill is in investing depends on your time Horizon. If it's one day, then it's pure luck, but if it's 20 years, then it's much more skill involved in doing it. So the time horizon is the most important thing.
- [63:32]
D
It is. And Joe, we barely scratched the surface of the book. We introduced a lot of the topics, but that was by design. I want to tease the listeners into reading not have this become an audiobook. Is there anything though that I left untouched? One more thing you'd like listeners to think about in terms of what the book represents and could do for them.
- [63:55]
B
Yeah. So I think that a couple of things I say. One is that although most of us are fund investors in some way, whether we know it or not, we probably invested in funds through some scheme we're invested in. So it's ubiquitous, but there just aren't that many books about it. And fund investing is just a unique behavioral challenge because then we're investing in individuals and teams because we're investing in pools of assets because there's so much choice and so much noise. It's a really difficult behaviorally to do it well. So what the book is designed to do is to think about some of the behaviors that we perform that lead to poor long term outcomes and how we address them. And also some of the beliefs we hold about fund investing that might be erroneous. And if we can rethink those beliefs and behaviors, I think that people can have better outcomes. And that's not with dramatic changes, but really subtle changes to how we think about our investment decision making can really transform our fortune. So hopefully the book can help in how we encounter what is a really difficult decision.
- [64:58]
D
And it's so valuable. I don't know any other book like this. I've been stunned in the last four years that I've been researching asset allocation and the wealth management industry. How many wealth managers of former stockbrokers mostly that are still picking stocks in their clients individual portfolios. When you have this universe and this systematic way to improve the odds of outperformance, as you said, hopefully increasingly at a lower cost because that's so important.
- [65:25]
B
Absolutely, yeah.
- [65:27]
D
Joe Wiggins, I can't thank you enough for your time today. I love the book, love talking to you and best of luck with it. Hope we can meet again soon.
- [65:35]
B
Likewise. Thanks so much. Really enjoyed it.