Posted by: Thomas F. McKeon, CFA on April 9, 2019
The investment tools and techniques exist for investors large and small to have optimally efficient, risk-limited, ultra-low cost portfolios, as institutions have had for decades.
Back in the early 1990s when I first entered the investment advisory business and began advising clients and managing portfolios, a typical portfolio for a High New Worth individual would consist of about forty US Large Cap stocks (the usual suspects…GE, Procter & Gamble, Philip Morris, Exxon, Caterpillar, etc.), a handful of US municipal bonds plus some residual cash. Three asset classes—that’s it. But is was a fiduciary portfolio and defensible based on then current best practices and reasonable diversification.
Institutions—with their vast pools of wealth—of course had much more access to investment exposures both traditional and esoteric, because they could meet the large minimum accounts virtually all institutional asset managers could command, and their thinking was more advanced. With far greater access to global market exposures, diversification and alternative strategies, institutions have had far more efficient portfolios than the typical High Net Worth investor has had, for quite a long time.
In the simplest possible terms, a more efficient portfolio delivers better returns, lower risk or both. This is something all investors should want.
Are you a money manager or a consultant?
At my previous firm, in the mid-1990s we published a quarterly newsletter. Early on in each issue we featured one stock we held in client portfolios and one no-load mutual fund we held in client portfolios. Even then I knew that private clients needed additional market exposures other than the large cap stocks we managed for them, and they need them for just the reasons that still obtain today—broader allocations, better diversification and more efficient portfolios. I was doing the right thing for clients but that did not sit well with some folks we were marketing to.
In that time, I was marketing our large cap strategy to the class of investment professionals known as consultants: who advised clients by selecting separate account managers such as we were then. The division of labor in the industry then was: some professionals managed portfolios by analyzing and selecting securities (money managers), some professionals recommended asset allocations for clients and implemented by selecting managers—separate account managers or mutual funds. These folks included: investment consultants and a broad array of brokers serving as consultants. There was some overlap of course, but the demarcation was fairly sharp.
I had been in to see a brokerage team in Delaware who were very large and well-known in the hopes of making the roster of money managers they delegated out to for their clients. After receiving our newsletter, the principal on the brokerage team called me angrily demanding to know whether I was a “money manager” or an “investment consultant.” At first I did not get the point. He had to spell it out for me: if I picked stocks I was a money manager and his team could hire us, if I picked mutual funds I was a consultant, and would effectively be a competitor. So we stopped featuring mutual funds in our newsletter and portfolios, because our primary objective was to grow our business as money manager, distributing our product through consultants, brokers, wealth managers, planners, etc.
The Times They Are a’Changin’
Much has changed in the investment industry over the intervening twenty-plus years. Business and service models have merged. Investment products (ETFs) have been born and matured. Evidence about what approaches to investment work best is widely available. Markets have grown more volatile and perhaps entered a secular, low-return environment. Investment fees are under great pressure. All of these trends have forced investment professionals to re-evaluate and adapt. ETFs in particular have put enormous pressure on fees and provided the tools to build low-cost, optimally efficient portfolios. That is all good for investors large and small, and advisors like Clothier Springs who are not trying to extract maximum economics from our clients. For everyone else, it is a serious existential threat.
Thought Leaders—Grounded in Evidence
Many of us in the investment advisory business like to follow other fellow professionals who supervise or manage large portfolios whether they are an asset manager or someone like a pension or endowment trustee. Most people at this point know who Warren Buffet is and follow his company Berkshire Hathaway and look forward to his folksy and insightful annual letters. Many of us pay some attention to what the huge Ivy League endowments are doing with their money and many of us consider them some of the best and brightest in the business. Some principals at large money management firms are also quite articulate and insightful about the markets and the business. And let’s not forget Jack Bogle—recently deceased—who founded the Vanguard Mutual Fund company. Some of the commentary is philosophical in nature, some of it more investment-centric, some of it business model-centric.
Some years ago David Swensen—the man who then managed the Yale University endowment—wrote a book titled “Unconventional Success.” Written in 2005, he argued that a portfolio allocated to a handful of low-cost, no load mutual funds offered individual investors the best opportunity to have an optimally efficient portfolio and to meet their own unique objectives. He was not wrong. In looking at the book now in 2019, he even makes a case for low-cost Exchange Traded Funds (ETFs) which comprise 100% of Clothier Springs Capital Management liquid portfolios.
He was effectively making an argument that individual investors could attain institutional quality, globally allocated, broadly diversified and optimally efficient portfolios and results through low-cost vehicles such as ETFs.
Just like the old saw that “science advances one funeral at a time” much of the investment advisory industry clings to a business, advice and pricing model that is somewhat less than current and somewhat less than optimal for their clients, but optimal for themselves, in terms of workload and compensation. Everyone in business must adapt or perish. However in the investment business, client inertia is a well-known thing. Clients stay with brokers/advisors/planners and their inefficient, expensive portfolios/products because “they like their broker” or some other irrational excuse. If they only knew how much it was costing them.
ETFs have now become the most disruptive product in investment history. Institutions, individual and advisors have embraced them in a big way and ETFs now account for the vast majority of new asset flows in the industry…at the expense of traditional actively managed mutual funds or actively managed products. The pain in active-management land is real. And it is not going to let up.
Beware the Story
Some time ago we embraced a paradigm growing in the advisory industry known as “Evidence-Based Investing.” It simply means that we make recommendations and build portfolios based on evidence: evidence of asset class return, risk and return dispersion data. While long-term history is no guarantee of future results, it is a powerful indicator of what any given market exposure is likely to do in the future.
Contrast that with any number of “stories” that active managers weave to get investors to ignore the data, embrace their story of potential outperformance, and overlook the expense ratios. Stories that sound like “we scour the globe for the next great idea,” or we invest most of the portfolio in our “best” ideas, or the most dishonest of all, “who wants to invest in average?” Humans in general are suckers for a good story. Almost all marketing conventional wisdom urges markets to “tell a story.” Investing is where stories tend to lead investors astray. We also note that stories are almost exclusively crafted to sell an investment product with high fees.
The Great Investing Paradox
Nobel Prize winner Bill Sharpe observed long ago that collectively half of active managers will outperform the market and axiomatically the other half will underperform, both before expenses. After management fees and transaction costs, active managers collectively underperform the market by a good margin. Passive investors seek to simply match the market return by owning the same basket of stocks in the benchmark at ultra-low cost. The great paradox of investing is that seeking to match the market is a more effective strategy than trying to outperform the market and as such is not average, it is above average, typically top-decile. It is not a sexy story. But the evidence is unassailable. Also, the economics of evidence-based investing is less robust than “story” investing. A story is always crafted to sell the potential for outperformance, which the vendor/manager hopes will justify his fat fee. Evidence-based investing does not hope to deliver excess performance and as such, its fee structures tend to be much more modest, and we would argue, ethical.
The impulse to write this piece came from seeing a fellow advisor publish an article about how investors could have institutional-like portfolios with a handful of ETFs. We could quibble about the market exposures he recommended but the big idea is right. And something we have been doing at Clothier Springs from our founding in 2010, and before at a previous firm.
Through the power of ultra-low cost ETFs and numerous global asset class and market exposures, it is now possible to build globally allocated and balanced, broadly diversified, institutional-quality portfolios that are optimally efficient.
If you or your advisor is not providing a portfolio like that, it’s because he is clinging to his legacy business model and compensation scheme. And as Jack Bogle so wisely observed, “clients earn returns net of fees.” Your advisors’ economics come directly from your portfolio. So if you are not investing like an institution, you are probably earning lower returns, accepting more risk, paying too much or all of the above.
We’re all institutional investors now…or should be.