Learning from the Dumb Money
For years, Ted Seides refused to pay attention to private wealth managers. But was he missing the forest for the trees?
I paid no attention to private wealth managers early in my career. Their transaction-based compensation model with bank-owned parent companies created obvious conflicts of interest. Furthermore, closed-platform narrowing of investment options made it easy to dismiss their investment activities. After all, institutions backing independently-owned asset managers with better-aligned incentives, surely seemed an intellectually superior pursuit of capital allocation.
But what if I was missing the forest through the trees?
And what if institutional allocators are missing it as well?
If I make a 10% return on money, I should meet all of my obligations and be happy. If I make 2%, I probably won’t and shouldn’t. Sometimes I wonder why investing isn’t that simple.
High-quality private wealth managers endeavor to understand their clients’ goals and create an investment strategy that offers the best chance of achieving those goals. They focus equally on their clients’ assets and liabilities. Most of the time, a variety of easily accessible investment options - often low-cost vehicles - can put clients on a likely path to success.
The thoughtful attention to matching an investment strategy with the purpose of the money changes the way advisors spend their time. These wealth managers have little need to spend an inordinate amount of time building relationships to access capacity in the leading India-focused venture capital manager, for example. The pursuit of optimizing investments independent of a holistic understanding of liabilities is irrelevant to the bigger picture.
In contrast, institutions spend immense amounts of time fine tuning one side of their balance sheet - the asset side. Correspondingly, increased sophistication in understanding the science of investing has led to an era of benchmarking: Each asset allocation, asset class, and asset manager are tied to a benchmark. Institutional investment teams and their governance boards spend the preponderance of their time scrutinizing every bottom-up decision. It’s easily measurable, and results primarily in repeated behavioral errors like firing recent underperforming managers.
Seth Masters, the recently retired CIO of AllianceBernstein, highlighted structural flaws in the investment program of many institutions on a recent Capital Allocators podcast. “It’s like someone deciding that they’re going to check every newspaper in the world for grammatical and graphical errors as opposed to understanding whether or not they’re reading fake news.”
In Seth’s estimation, the low hanging fruit is for each board to spend less time in the weeds and more time focusing on the core problem the money is intended to solve. It’s about the hard questions of the purpose of money and our relationship to it, not the easy one of whether a manager beat a benchmark. It’s about the specific goals, risk tolerance, spending requirements, liquidity, and time horizon of each institution, not the headline performance compared to peers, each with a different nuanced objective.
One such enhancement comes from integrating investments with operations. Despite revolutionary improvements in asset allocation and investment selection, few institutions have thought differently about spending and fundraising practices. Connecting the two does not involve asset allocation or investment implementation, but can have even more impact on the longevity and sustainability of a pool of assets than the investment activity itself.
For example, few institutions break down their expenses into fixed and variable costs. Should a foundation alter its grant giving methodology or an endowment change its compensation policy to delineate fixed and variable costs, any market shock can be addressed in a planned and orderly way by selling assets, reducing spending, or a combination of both. In the process, the long-term pool of capital may be well-positioned to be a selective buyer in a downturn instead of a forced seller of assets at temporarily depressed prices.
The disconnect reminds me of the pricing of equities and credits in the same capital structure twenty years ago. Participants in different markets didn’t talk to each other, and the equilibrium price for supply and demand in each market separately often didn’t consider the relative pricing in securities across the equity and debt of the same underlying business. It made no sense back then - and those who understood the gap reaped the rewards of the inefficiency.
Changing a long-standing practice at an institution is a lot easier written than done. Imagine the challenges in altering the way money gets spent in a politically charged setting like a pension fund or university endowment. At a time when the U.S. government has imposed its first tax on large non-profit investment pools, the pushback that would come from professors - if their compensation were amended to be partially exposed to significant market drawdowns - would be intense.
On the other hand, a thoughtful, patient approach to introducing the concept of alignment across an institution’s balance sheet might offer another arrow in an investor’s quiver at a time when capital market prices seem set to disappoint going forward.
At least this one time, CIOs can take a lesson from the private wealth community. Shifting the investment program from benchmark-based to goal-based allows every institution an opportunity to succeed, however they may define success.
I’ll take my 10% return and say thank you very much, even if the S&P soars twice that amount.
Maybe that dumb money wasn’t so dumb after all.