| Areté Quarterly Q218 |
Business update
One of the most influential books I have ever read was the Origin of Wealth by Eric Beinhocker. The reason is because I found its thesis so compelling: The origin of wealth is knowledge that serves a useful purpose. This encapsulated my own thinking in a very concise and articulate way and in doing so also highlighted knowledge development as a productive activity.
It also happens to be a pretty good guide for investment management. After all, a huge part of the exercise of selecting good long term investments is figuring things out. And in order to do that you need knowledge. Indeed, many recommendations of how to be successful with investing emphasize reading as an efficient means by which to gain knowledge.
For the last several years however, knowledge has not been the “origin of wealth”, at least not in regards to the markets. If anything, it has seemed that the most thoughtful, considered, and informed investment decisions have performed the worst. As I reported last quarter, “it’s pretty clear to anyone paying attention, that the traditional practice of conducting in-depth research in order to reveal underappreciated stocks and to better manage risk doesn’t work in a world awash in liquidity from central banks.”
This creates quite a quandary for conscientious service providers. You can stick with the “knowledge” strategy believing it will work in the long run, but underperforming during the interim and risking loss of business for as long as it does. Or you can nervously follow trends you don’t trust (in order to retain business) knowing they can blow up at any time. As Rusty Guinn summarized in a note for Epsilon Theory [here]: “We can do the right things for ourselves and our clients. But not both".
Of course it’s not hard to find providers who opt for doing the right thing for themselves. Guinn describes one approach: “We can recognize the overwhelming influence of abstractions and continue to sell products and ideas that don’t.” In other words, as money managers and advisors, we can recognize that old approaches don’t work, but continue to talk about them and sell them as if they do. It’s disingenuous and does not help clients.
Guinn describes another similar approach: “We can recognize the overwhelming influence of abstractions and DESIGN new products and ideas that don’t.” This involves the same basic logic except it incorporates the “smoke and mirrors” of new product design to distract from the reality that such products are unlikely to work for the same reasons. It too is disingenuous and does not help clients.
What should money managers and advisors do in such a hostile environment? In an important sense, my choices have been less fraught because I have never considered it an option to anything that would come at the expense of clients' welfare. That's not why I got into the investment business to begin with and it's not why I founded Areté.
In order to determine the best course of action for the business that is also consistent with Areté's pledge to help investors invest better, I have come to realize that the decision really comes down to a couple of major assumptions. One is about the sustainability of central banks' efforts to keep the world "awash in liquidity". If you believe that central banks can continue on the path of liquidity infusion indefinitely, then I think Guinn's assessment is basically correct; you can either do what's right for your business or your clients, but not both. Conscientious managers who believe this often close their funds until better conditions prevail.
I don't believe central banks can continue to intervene successfully forever, though. Continued success is contingent upon an improbable set of conditions. Notably, the intended benefits of intervention must clearly outweigh the increasingly visible costs in the forms of misallocated capital and increasing wealth inequality. As such costs mount over time, so too will the legitimacy of central bank interventions diminish.
The implications for investment strategy are enormous. Market valuations imply that rates are expected to stay low for a long time. When markets finally succumb to the reality of a higher rate environment, valuations can fall substantially. Declines will be exacerbated by a number of strategies that will be forced to sell into declining markets.
I'm not the only one who is reading the potential for a severe market correction. RealvisionTV interviewed a number of top investors in September 2017 [here] which revealed that many shared the same concerns. Kyle Bass said, "If you look at all of the different constituencies of the market today, it resembles the portfolio insurance debacle of '87 on steroids." Jesse Felder noted, "Buying the stock market today is essentially taking an incredible amount of risk ... for the prospect of I see it as zero reward." Jim Rogers declared bluntly, "We're going to have the worst bear market of your lifetime, of my lifetime even, next time around."
All of this points to the notion that the knowledge strategy is still the best means for creating wealth (and avoiding massive losses) over the long term. There has been an important change though. Whereas the knowledge strategy used to be effective in generating wealth by way of identifying attractive individual securities, that is no longer the case in “a world awash in liquidity”. As I discussed [here], the knowledge strategy is now more narrowly effective in managing systemic risk.
This has created a great deal of pressure on money managers who have primarily focused on stock picking and this has certainly affected Areté’s mid cap core strategy. As such, I have adapted Areté’s practices in some important ways. For one, I have oriented existing portfolios to defensive positions that are well placed to preserve capital and to take advantage of cheaper prices when the downturn arrives. In addition, I have waived fees for new client portfolios that are not yet fully invested in an effort to make it as palatable for them as possible to maintain a defensive position. I do this even though I absolutely believe that there is significant value in managing systemic risk right now.
In addition, since systemic risk has become a greater investment concern, I have reasoned that it makes sense to have a service option better suited to dealing with it directly than the core mid cap stock strategy. I did this by creating the Personal Chief Investment Officer (PCIO) service. My rationale is that people may want/need more modular access to high level investment expertise in order to manage through systemic risk or to just help navigate the investment landscape. These were easy things to do because I already do all of the same research as a function of my work on Areté's mid cap core strategy.
So I have developed an approach that still focuses on knowledge development as its philosophical anchor for value creation, that still puts clients first, and that I have adapted to the current market environment. While it is still a tough slog operating in an environment that does not reward knowledge, I am reasonably certain that this is only a temporary condition and insofar as it is, Areté can benefit in a couple of ways.
The first is through investing. By preserving client wealth through a market downturn and by maintaining my focus on valuation, I will be both willing and able to productively deploy money into investments with attractive expected returns after the fallout. Indeed, history and experience suggest that there are usually only a handful of occasions over a lifetime for which investment outcomes are materially affected. I strongly suspect this is one of them.
Another is through increased credibility. When you maintain a position and the market works against you, it is easy for people to take potshots and think that you are missing the boat. When you maintain your position in the face of such adversity and end up being right for the right reasons and saving your clients money, things change in a big way.
After all, it was not that long ago, after the financial crisis, that investors felt so betrayed by the media and by Wall Street (which had served as primary sources of investment information). None of them warned about the potential for crisis. This vacuum created an opportunity for alternative investment research providers such as RealvisionTV which "realized the media had let people down and the banks had let people down. They just didn't want to tell people the bad things were out there and that they should pay attention." Here we are again and there still seems to be a market for knowledgeable insights and honest assessments.
Of course it is possible that this won't work out or that it won't pan out soon enough to be a viable business opportunity. But I think one thing is clear regardless: Older investors who have realized great benefits from appreciating financial assets over their careers may be willing to overlook some shortcomings in financial service providers, but younger investors will have no such tolerance. Investment firms of the future will have to clearly provide value AND demonstrate a record of honest dealings with clients. I am also quite certain that list of providers will be much shorter than today’s list.
If you have any suggestions for me or know of someone I should get in contact with, please let me know. I strongly suspect there is a lot of potential in brainstorming and leveraging resources. Let’s see what we might be able to accomplish together!
Thanks for your interest and take care!
David Robertson, CFA
CEO, Portfolio Manager
One of the most influential books I have ever read was the Origin of Wealth by Eric Beinhocker. The reason is because I found its thesis so compelling: The origin of wealth is knowledge that serves a useful purpose. This encapsulated my own thinking in a very concise and articulate way and in doing so also highlighted knowledge development as a productive activity.
It also happens to be a pretty good guide for investment management. After all, a huge part of the exercise of selecting good long term investments is figuring things out. And in order to do that you need knowledge. Indeed, many recommendations of how to be successful with investing emphasize reading as an efficient means by which to gain knowledge.
For the last several years however, knowledge has not been the “origin of wealth”, at least not in regards to the markets. If anything, it has seemed that the most thoughtful, considered, and informed investment decisions have performed the worst. As I reported last quarter, “it’s pretty clear to anyone paying attention, that the traditional practice of conducting in-depth research in order to reveal underappreciated stocks and to better manage risk doesn’t work in a world awash in liquidity from central banks.”
This creates quite a quandary for conscientious service providers. You can stick with the “knowledge” strategy believing it will work in the long run, but underperforming during the interim and risking loss of business for as long as it does. Or you can nervously follow trends you don’t trust (in order to retain business) knowing they can blow up at any time. As Rusty Guinn summarized in a note for Epsilon Theory [here]: “We can do the right things for ourselves and our clients. But not both".
Of course it’s not hard to find providers who opt for doing the right thing for themselves. Guinn describes one approach: “We can recognize the overwhelming influence of abstractions and continue to sell products and ideas that don’t.” In other words, as money managers and advisors, we can recognize that old approaches don’t work, but continue to talk about them and sell them as if they do. It’s disingenuous and does not help clients.
Guinn describes another similar approach: “We can recognize the overwhelming influence of abstractions and DESIGN new products and ideas that don’t.” This involves the same basic logic except it incorporates the “smoke and mirrors” of new product design to distract from the reality that such products are unlikely to work for the same reasons. It too is disingenuous and does not help clients.
What should money managers and advisors do in such a hostile environment? In an important sense, my choices have been less fraught because I have never considered it an option to anything that would come at the expense of clients' welfare. That's not why I got into the investment business to begin with and it's not why I founded Areté.
In order to determine the best course of action for the business that is also consistent with Areté's pledge to help investors invest better, I have come to realize that the decision really comes down to a couple of major assumptions. One is about the sustainability of central banks' efforts to keep the world "awash in liquidity". If you believe that central banks can continue on the path of liquidity infusion indefinitely, then I think Guinn's assessment is basically correct; you can either do what's right for your business or your clients, but not both. Conscientious managers who believe this often close their funds until better conditions prevail.
I don't believe central banks can continue to intervene successfully forever, though. Continued success is contingent upon an improbable set of conditions. Notably, the intended benefits of intervention must clearly outweigh the increasingly visible costs in the forms of misallocated capital and increasing wealth inequality. As such costs mount over time, so too will the legitimacy of central bank interventions diminish.
The implications for investment strategy are enormous. Market valuations imply that rates are expected to stay low for a long time. When markets finally succumb to the reality of a higher rate environment, valuations can fall substantially. Declines will be exacerbated by a number of strategies that will be forced to sell into declining markets.
I'm not the only one who is reading the potential for a severe market correction. RealvisionTV interviewed a number of top investors in September 2017 [here] which revealed that many shared the same concerns. Kyle Bass said, "If you look at all of the different constituencies of the market today, it resembles the portfolio insurance debacle of '87 on steroids." Jesse Felder noted, "Buying the stock market today is essentially taking an incredible amount of risk ... for the prospect of I see it as zero reward." Jim Rogers declared bluntly, "We're going to have the worst bear market of your lifetime, of my lifetime even, next time around."
All of this points to the notion that the knowledge strategy is still the best means for creating wealth (and avoiding massive losses) over the long term. There has been an important change though. Whereas the knowledge strategy used to be effective in generating wealth by way of identifying attractive individual securities, that is no longer the case in “a world awash in liquidity”. As I discussed [here], the knowledge strategy is now more narrowly effective in managing systemic risk.
This has created a great deal of pressure on money managers who have primarily focused on stock picking and this has certainly affected Areté’s mid cap core strategy. As such, I have adapted Areté’s practices in some important ways. For one, I have oriented existing portfolios to defensive positions that are well placed to preserve capital and to take advantage of cheaper prices when the downturn arrives. In addition, I have waived fees for new client portfolios that are not yet fully invested in an effort to make it as palatable for them as possible to maintain a defensive position. I do this even though I absolutely believe that there is significant value in managing systemic risk right now.
In addition, since systemic risk has become a greater investment concern, I have reasoned that it makes sense to have a service option better suited to dealing with it directly than the core mid cap stock strategy. I did this by creating the Personal Chief Investment Officer (PCIO) service. My rationale is that people may want/need more modular access to high level investment expertise in order to manage through systemic risk or to just help navigate the investment landscape. These were easy things to do because I already do all of the same research as a function of my work on Areté's mid cap core strategy.
So I have developed an approach that still focuses on knowledge development as its philosophical anchor for value creation, that still puts clients first, and that I have adapted to the current market environment. While it is still a tough slog operating in an environment that does not reward knowledge, I am reasonably certain that this is only a temporary condition and insofar as it is, Areté can benefit in a couple of ways.
The first is through investing. By preserving client wealth through a market downturn and by maintaining my focus on valuation, I will be both willing and able to productively deploy money into investments with attractive expected returns after the fallout. Indeed, history and experience suggest that there are usually only a handful of occasions over a lifetime for which investment outcomes are materially affected. I strongly suspect this is one of them.
Another is through increased credibility. When you maintain a position and the market works against you, it is easy for people to take potshots and think that you are missing the boat. When you maintain your position in the face of such adversity and end up being right for the right reasons and saving your clients money, things change in a big way.
After all, it was not that long ago, after the financial crisis, that investors felt so betrayed by the media and by Wall Street (which had served as primary sources of investment information). None of them warned about the potential for crisis. This vacuum created an opportunity for alternative investment research providers such as RealvisionTV which "realized the media had let people down and the banks had let people down. They just didn't want to tell people the bad things were out there and that they should pay attention." Here we are again and there still seems to be a market for knowledgeable insights and honest assessments.
Of course it is possible that this won't work out or that it won't pan out soon enough to be a viable business opportunity. But I think one thing is clear regardless: Older investors who have realized great benefits from appreciating financial assets over their careers may be willing to overlook some shortcomings in financial service providers, but younger investors will have no such tolerance. Investment firms of the future will have to clearly provide value AND demonstrate a record of honest dealings with clients. I am also quite certain that list of providers will be much shorter than today’s list.
If you have any suggestions for me or know of someone I should get in contact with, please let me know. I strongly suspect there is a lot of potential in brainstorming and leveraging resources. Let’s see what we might be able to accomplish together!
Thanks for your interest and take care!
David Robertson, CFA
CEO, Portfolio Manager
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