There is no doubt that there are some significant challenges to the economy and markets in today’s environment. While some of the conditions undoubtedly make life more difficult, I can’t help but to be fascinated by the constant change and complexity of the issues and opportunities.
In this edition, I am going to discuss a couple of different challenges. One is the challenge to the U.S. economy. Clearly high unemployment and fiscal deficits are big problems that need to be addressed. Despite this challenge, we see silver linings in the process.
The second is a challenge within the money management business. Because so much of the nature of the business is intangible, it is difficult to judge quality. As a result, many investors use size as a proxy for determining “quality” of a money manager. If we have learned anything over the last two years though, it is that size can just as easily impinge upon quality as enhance it. In fact, I founded Arete two years ago, with the mission of delivering functional excellence in money management — because I thought a small, independent firm had structural advantages in delivering active investment performance and high fiduciary standards.
I always enjoy talking about the money management business in general and about Arete in particular. If you are going to be in downtown Baltimore, please let me know, I’d love to get together. I enjoy sharing the ideas I have to try to make things better and it also helps me to hear what investors are most concerned about.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Citizens from all walks of life are becoming extremely concerned about the multitude of challenges facing this country. Huge fiscal deficits, high and enduring unemployment, and potential for significantly higher inflation are all very serious problems. It is especially troubling that wherever we turn, we see institutions that are woefully deficient in constructively addressing such problems.
While we do not dispute the severity of such issues, we are not fatalistic about them either. This position was brought into clear relief in a presentation we attended a couple of weeks ago in which the speaker asked the audience two questions. The first was, “Are you optimistic?” The second was, “Do you expect your children will be better off than you are?” Most of the audience, including us, responded positively to the first question and negatively to the second.
This struck us immediately as interesting because at the very least, our responses were superficially inconsistent. At worst, they were logically inconsistent. So the questions forced us to better-understand, or at least to better-articulate, the rationale behind the responses.
Let’s start with the second question first. Why do we believe that our children will not be better off than we are? We see all of the issues listed above as being part of a bigger problem: This country has been spending more than it takes in for a long time. The problem, however, is more onerous than this because it does not account for the liabilities of Medicare and Social Security. As a country, we have been mortgaging our future. In order to restore balance, we will need to redefine the social contract and the costs will necessarily fall on future generations.
Nobody likes picking up the tab for someone else which is why we believe our children will not be better off than we are. Importantly, however, we don’t believe they will be much worse off either. We actually see several reasons to be optimistic about the future.
First and foremost, we see the populist outrage towards unemployment and the deficit as providing important impetus to finally address problems that have been lurking for many years. The biggest of these problems is the cost of large entitlement programs such as Medicare and Social Security. We know the dollar amount of promised benefits of these programs will eventually dwarf our ability to pay for them.
While the annual fiscal deficit is just the tip of this big iceberg, at least people see it now and know that it represents a big risk to the future of this country. We believe this recognition is an important step in the right direction.
We don’t have any delusions that the political path to fiscal prudence will be an easy one. We don’t view the problem as being intractable, however. We see it more as an issue of proper communication and education.
For example, A recent billboard stating, “Keep the government’s hands off my Medicare!” we think captures some of the popular misconceptions well. The link between benefits and costs is apparently not clear to everyone. At the end of the day, however, we believe most parents want a better world for their children and will make the appropriate tradeoffs and sacrifices to accomplish that end.
What do investment prospects look like for young families? Again, we have several reasons for optimism. For those who are just entering the wealth creation phases of their lives, the first investment is often a home. With low mortgage rates, excess supply of homes, and a significant retrenchment in home prices, this is a great time to be looking for a home.
The opportunities for other investments are also attractive. Having just emerged from the worst ten year stock performance on record, we are at a much better starting point for those who are beginning to invest with a large allocation to stocks. Conversely, the outlook for fixed income investments is fraught with risk. With interest rates at rock bottom, they will almost certainly rise higher over the next several years. When they do, returns from fixed income vehicles will suffer.
In conclusion, we do believe there are very serious fiscal and economic challenges that need to be addressed. These problems are likely to make it difficult for “our children” to be better off than we are. Nonetheless, we see many reasons to be optimistic. We believe widespread acknowledgement of fiscal deficits increases the chances of a solution. In addition, the opportunities for young families to invest in homes and stocks are actually extremely good. While there are concerns and uncertainty, we may very well look back ten years from now and marvel at the historic opportunity.
As in any business, the more familiar one gets with underlying structures, relationships, and incentives, the more likely one can identify disparities between common perceptions and underlying reality.
Our goal in this section is to share our insights into how the investment management business really works. One way we hope to do this is by wading through the blizzard of information that surrounds the business and distilling the most salient points for investors. Another is to identify and forewarn investors of some of the business practices in the industry that can work against investors’ objectives. In both instances, we hope to provide greater clarity.
We discuss these ideas for a couple of reasons. First, we want to share our knowledge of, and experience in, the money management business to help people better achieve their investment goals. Second, we do this to help differentiate the value of our services. We believe the more we can help you understand the underlying reality of the investment management business, the more you will appreciate what we do and why we do it.
Arete Asset Management was founded with the mission of delivering “functional excellence in money management.” Indeed Arete’s creation arose from two related premises. One is that while there are thousands upon thousands of money managers, there are too few exceptional ones. The second is that there will always be demand for excess performance (alpha). In this section, we describe how we view “quality” and in doing so, will clarify the logic for how we pursue business.
One of the seminal works of research in finance is called “The Limits of Arbitrage” by Andrei Shleifer and Robert W. Vishny. For some background, arbitrage is not some obscure or trivial exercise. Instead, at its essence, arbitrage is the effort to find disparities between value and price. Colloquially, this essentially means “buy low and sell high.” Any effort to “outperform” the market through active management is an exercise in arbitrage.
As the world of investing has become democratized over the last thirty to forty years, an important change has occurred. Now, “Arbitrage is conducted by a relatively small number of highly specialized investors who take large positions using other people’s money.” This relationship between investors, who act as principals, and money managers, who act as agents, has important implications for asset pricing.
A key insight of the report is that the arbitrage exercise can become ineffective in “extreme circumstances when prices diverge far from fundamental values.” The explanation is that some nervous investors can pull capital out of money managers at the worst possible time — the time of greatest opportunity for the money manager. In doing so, investors themselves actually limit the ability of their money managers to outperform.
An excellent example of the limits of arbitrage occurs with mutual funds. When market prices fall, and the gaps between prices and fundamental values widen, some investors get nervous and withdraw funds. Withdrawal of funds forces the mutual fund manager to sell stocks at exactly the same time that manager is finding the greatest opportunities to buy. Research points to the fact that such fickle fund flows impair a manager’s ability to perform, regardless of that individual’s level of talent.
Given this insight, it is clearly incumbent upon a money manager set on delivering outperformance, to find client investors who are committed to riding out market volatility. Such “patient” capital allows the manager to leverage his or her skills of effectively exploiting arbitrage opportunities. In short, there is a distinct benefit to the money manager for having client investors with long time horizons.
This is not a one-way street, however, because there is also a distinct benefit to client investors for being patient. That benefit comes in the form of enhanced performance opportunities! In other words, superior performance derives at least partly from a symbiotic relationship between manager and client. In a very important way, quality in money management is a function of the nature of that relationship.
We find it worth noting that one of the most successful investors of our age, Warren Buffett, does not run a money management firm. He has insulated himself from the vagaries of nervous client fund flows and instead substituted the regular inflows of insurance premiums. As a result, he can pursue arbitrage opportunities without undo constraint.
Since an important part of the proposition of delivering investment quality is finding the right clients, Arete places a great deal of emphasis on this. We very much believe that our ability to leverage arbitrage opportunities and deliver performance is contingent upon it.
In doing so, we consciously resist the temptation to grow for the sake of growing, to take in whatever assets we can. Based upon our experiences, when small money managers overreach to gather assets, principles of stewardship are almost always compromised. For one, weak and/or inappropriate relationships can hinder performance through the limits of arbitrage. In addition, once a firm prioritizes asset gathering over performance, it is almost impossible to go back — the culture is set.
Of course this presents a paradox rich in irony. Our mission of delivering quality investment management services largely prescribes deliberate and measured business development. Yet many investors use size as a proxy for quality, or at very least as a minimum standard of entry. Unfortunately, we believe this state of affairs often leaves both parties worse off.
We and plenty of other emerging managers start our businesses because we feel strongly about delivering superior investment value to an undersupplied market. Arete specifically was built on the principles of sharing our investment skills and providing exceptionally high standards of stewardship. To any investors who complain of high fees, mediocre returns, and/or unreasonable terms from their money managers, we would very much enjoy having a conversation.