Third Party Managers

07-09-2019

Someone recently asked me how I feel about mutual funds and using “SMA’s” (seperately managed accounts). 
 
My first thought was, it makes sense if your goal is diversification using niche experts. For instance, I will never be able to know as much about international and emerging markets as an international portfolio manager.
 
My second thought was, mutual funds and SMA’s only add value if you are not capable of investing yourself. In my first years investing, relative to today, I had no idea how to select investments. Even though clients asked me to invest money, I shifted responsibility to mutual funds, SMA’s and ETFs (‘third parties’). The percentage of misinformed advisors is shocking, even basics like the differences between stocks and bonds is hard for some. This paradox of misinformation among professionals isn’t new, but it is trending.
 
My third thought was, and this was somewhat of an epiphany, that these third parties are expensive. Expensive, actually, in two ways. 
  1. The expense ratio and explicit fees.
  2. Opportunity costs of finding outperforming public companies. Implicit costs.
Opportunity costs mostly occur on time horizons outside of 15 years. Within 15 years, the goal for wealth is to provide for living needs. In this case, #2 doesn’t apply. #1 applies, though. Using simple allocations and ETFs can fund your goals more simply and more reliably than using mutual funds and SMA’s.
 
Long term horizons. Let me dive further into Implicit costs, which is very often the majority of the cost iceberg you’ll run into.
 
CEO envy (i.e. the institutional imperative) also applies to finance managers. That is, doing what other wealth managers are doing or what your clients direct you to do. The convention being that the manager can’t lose business if they do what other managers do. Who would switch to get the same thing elsewhere? This is the persistent belief of 99% of all investment managers, and is why salesmanship is the feat of strength for such managers. 
 
Iconoclasm is generally more rewarded than following the crowd blindly, and I expect this phenomenon to continue. Such inconoclasm flies in the face of using salesmanship to earn clients. 
 
The value of a financial advisor at the residual 1% is to determine what has value, without following the crowd. The way I explain this to my mom: if you are in New York and someone on a street corner offers a $5000 Diamond necklace for $500, do you buy it? Mom says no, explaining that the diamonds are probably fake. Similarly, when a company drops significantly in price, how do you know that it is worth anything at all? In this context, the advisor is a diamond appraiser, and I feel that is mostly a correct abstract. Except in our business, we can buy thousands of such cheap diamond bracelets, whether to our success or failure.
 
The wealth manager will argue that discovering and determining a great third party manager to use is just as important (if not more so) as buying great investments.
 
If you pick one third party manager, you are investing in that manager like you would invest in the company. Your capital is dependent on his expertise, his ideas, his ingenuity. When you invest in a company’s stock, aren’t you doing the same thing? 
 
Behaviorally, the best managers focus on the product (i.e. returns) instead of selling to new clients. When I first knew about Elon Musk in 2012, he said in an interview, “It’s more important to develop a great product than to market a mediocre product.” The capital and time at Tesla, SpaceX, and Solarcity is dedicated to innovation and not marketing. A great product markets itself. 
 
The difficulty pervasive in wealth management is that too few people believe anyone can consistently outperform the benchmark index. 
However, take Facebook’s Mark Zuckerburg: over 28% return per year since IPO. 
Take Google’s Larry Page. Over 22% since IPO.
The list of outperforming CEO’s (including Warren Buffett, Henry Singleton, John Rockefeller, Reed Hastings, Stephen Schwartzman, W.R. Berkley) goes on and on. Third party managers simply don’t think as CEO’s do. 
 
The outperforming companies are often highly diversified within themselves. Berkshire Hathaway (BRK) owns hundreds of businesses, for instance. BRK, though, charges no management fees. There are teams of the best consultants in the world working for Facebook and Google. These people will likely provide higher returns than any mutual fund. They work 16 hours a day. They are fueled by passion and not money. The top employees are compensated largely with stock, providing governance incentives to align them with shareholders. I would imagine that Jeff Bezos, Zuckerburg, and Buffett have most of their net worth in their companies.   
 
M&A and repurchases directly affect shareholders, whereas investing in a mutual fund will rarely entitle the client to such benefits. 
 
The institutional imperative as an example – a client invests money with a bank. The bank then invests in a mutual fund. The mutual fund invests in 80 companies, including say, Berkshire Hathaway. Is this diversification or a form of ignorance insurance?
 
The client, putting money with the bank is trying to accomplish the same thing as BRK. The client, though, will never get the same returns as BRK, since there are both of the two nagging expenses – a layer of fees (two in this case), and implicit costs. The question is: is there any conceptual difference between investing with a wealth manager or with Warren Buffett? So, if a client invests with a wealth manager, that manager should do more to find those great CEO’s rather than third parties. But how?
 
I argue that if wealth managers saw CEOs as investors just as if they are a mutual fund or an SMA, that manager would earn a higher total return for clients. However, such investments are risky, so there would need to be a long time horizon and proper risk evaluation.
 
Ideal investment portfolio – Own one asset that pays you at least 9% CAGR, beating the market over the past 80 years. However you get there, that’s the goal and the path to wealth. Over 50% of the Country’s richest people do that with over 50% real estate. A significant portion of the residual will get wealthy by owning a single business (ie a single stock). Preferably, you can take the best of all worlds and do all of these things (read: diversification) to get that 9% return on capital. 
 
The wealth manager’s job is to find the safest way to earn the 9%. To find those managers (joined with good operating results) for clients that can’t identify them. 
 
The bottom line: Evaluating an investment in a single company is much more beneficial for the client with a long time horizon than evaluating third parties. The time and due diligence behind finding qualified third parties is better spent on finding the best CEO’s.
 
We are long FB, GOOG, WRB
 

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