Cutting Through The Noise


Small Business Looking Large

Small Business looking large

Cutting Through the Noise - a financial blog by Bill Martin, CFA

I was all set to write about the headwinds and tailwinds impacting the markets going forward, when up popped an economic number that made me double take.  I typically create a mosaic of economic indicators for a sense of the economy’s future direction, but sometimes a particular number moves so much that requires focused thought and analysis. January’s NFIB Small Business Optimism number is one of those number’s.

 Now, I don’t want to give the impression that I am an outright Bull… I like to think I maintain a balanced view with an eye toward finding underappreciated opportunities.  Sometimes investment opportunities arise from caution and sometimes from optimism. 

I focus on this chart because small businesses, which are defined as companies with fewer than 100 employees, now make up 67% of all new jobs in the country.  As small businesses go, so goes the economy.  With all market participants watching so many economic numbers so closely, it’s important to focus on data that can actually make a meaningful impact on the underlying economy.  For example, although consumers comprise about 70% of all spending, the hyper-watched consumer confidence number is known to be fickle and more a reflection of the direction of stock prices.  That indicator is what I would call “noise” and is unlikely to be of much help foretelling the direction of the economy.  As another example, notice how Small Business Optimism last peaked in 2004-2006, well before any hints of the Great Recession were being picked up by other data.

The Small Business Optimism Index is comprised of 10 equal weighted factors that breakdown different aspects of capturing the outlook for a small business.  The recent "jump" in the SBO Index score for December (released in January) was driven primarily by the following 3 factors in descending order:  1.  Expect Economy to Improve  2.  Expect Higher Real Sales  3.  Now a Good Time to Expand.  Taken together, the magnitude of the scores in these three areas clearly point to more optimism heading into 2017.  

What we see in the chart is that the Small Business Optimism Index (SBO Index) has just popped to the positive more than at any other time in the 21st Century….by a long shot.  Small businesses are feeling as optimistic as they were during the strongest years of the housing boom, several years prior to the bust.  Business optimism is so important because it is often in response to expected profit.  That expected profit can lead to increased jobs and higher wages, which all lead to creating more demand.  Lather, Rinse and Repeat.  That is how an economy tries to break out of the slow-growth doldrums. 

Importantly, the SBO Index tends to get the larger trends in the economy correct.  It is not infallible, no single economic statistic is that good.  However, as you can tell, I think this number bears watching.  This level of breakout could be something that will bubble up and reverberate throughout the economy and propel us higher through other messy situations that arise, or it could just be a head fake (see mid-2008).   

The reason for the bounce is quite clear.  Small businesses are optimistic about the prospective cuts in de-regulation and costs that are on the horizon in the new administration.  A word of caution… we have traveled this path before, only to find that sometimes regulation is necessary and can be a governor for going too far in one direction.  Do you remember way back to 2008 and the lexicon of CDO’s, toxic mortgages, sub-prime loans and liar loans?  Yeah, that happened. 

That said, for today, many businesses and market participants are choosing to only see the positives in the prospective changes coming from the new administration.  As such, for now, we will just celebrate this one number.  However, as famed private equity investor, Howard Marks, likes to say…

“Sometimes the market interprets everything positively and sometimes it interprets everything negatively”. 

These strong leanings can create opportunities!

I’m now off to a small, informal gathering with former President of the Philadelphia Federal Reserve, Charles Plosser.  Charles was often one of the more hawkish (inflation fighter) members during his time on the Federal Reserve Board.  This should be fun, interesting and hopefully provide some insights for next month’s blog.

Here’s to sifting through the data in search of nuggets to help us get it more right than wrong, sooner rather than later…

The Times, They Are A-Changin'

Public versus private markets | A conversation with Jason Portnoy


This year we have seen the impact of the unstoppable force, named global systems (global trade, central bank policies, currency management, ect.) run smack into the immovable object, named local politics….both here in the US and abroad. The results have been a pendulum swing back in the direction of protectionism and isolationism, at least at face value and on the margin.  I suggest, speaking ONLY for the markets and avoiding all social/political discussion, that the results of the most recent election could be considered a mixed bag. There are economic policies that are currently being put forth, which could only be considered “pro-business” (tax cuts, cash repatriation, de-regulation and infrastructure spending) and others, such as tariffs, that could be considered harmful to the deficit, inflation and to global trade.  I will not go further than to say that uncertainty has increased in many respects... markets typically do not like UNcertainty.   

Indeed, the times, they are a changin’ but not just in reference to political maneuvers and their outcomes. Rather, the times are changing in the way public markets are viewed vis-a-vis private markets (private equity and venture capital).  You didn’t see that coming, did ya?  Sorry, but I recently had the pleasure of seeing Bob Dylan perform in concert the evening following his Nobel Prize announcement.  Hence, the title for this blog was chosen prior to the election, so I had to weave it in somehow : )

The private markets have long been viewed as the “wild west” with little understanding of pricing mechanisms, while public markets had what were believed to be open and transparent price discovery mechanisms.  Keeping politics out of this discussion, it is not difficult to see how governmental organizations have moved to make public markets less transparent and perhaps more managed.  Is it now possible that the private markets provide more sanity and less systemic risk?  

The private markets have long been viewed as the “wild west” with little understanding of pricing mechanisms, while public markets had what were believed to be open and transparent price discovery mechanisms.
— Bill Martin

Much of the focus of earlier blogs was on the stagnant global economy.  The reasons for this stagnation are varied, political, and not necessarily straight-forward.  However, there is some consensus that one factor contributing to stagnation seems to be too much capacity.  Too much capacity discourages productivity enhancing investment on the margin.  A possible cause for too much capacity is posited to be too much “easy” money available due to central bank activities, which helped to keep sick companies on life support.  I don’t want to stir up old wounds about the role of the Fed with such little time, but will point out that private markets have not benefited from easy money policies to nearly the scale as public markets.  As such, they compete tooth and nail for every available investable dollar.  If growth opportunities dry up, so does the capital and life support.  At a high level, this is a model that has thus far worked and continued to create growth rates that are more in line with what we expect from the broader economy.

I am super excited to explore this public/private paradigm and new arc that has developed between them with successful entrepreneur and venture capitalist, Jason Portnoy.  

Jason Portnoy has spent his career contributing to some of Silicon Valley’s most impactful technology companies.  After first earning an engineering degree at the University of Colorado, he joined PayPal as employee number 34 while still a graduate student at Stanford University. As a Vice President on PayPal’s finance team, he helped support the company through its hyper-growth, Initial Public Offering (IPO) and subsequent $1.5bn acquisition by eBay in 2002.

Jason next gained privileged insight into the formation and rapid growth of two highly influential asset management firms. He was part of the founding team of Clarium Capital, which grew to over $3bn under management during his tenure. He later helped launch the Founders Fund whose early investments included Facebook and Palantir Technologies.  He was the first Chief Financial Officer at Palantir Technologies and later served that same role at Practice Fusion. In both cases, Jason helped guide the company’s early culture, fundraising strategies and industry leadership positioning.  

Jason honed his investment philosophies through angel investments in several ground-breaking companies including Facebook, Palantir Technologies, Yammer and Stemcentrix.  Today, Jason applies his many years of experience through the framework of Oakhouse Partners, a firm whose mission underscores his deep commitment to discovering and supporting talented entrepreneurs pursuing important challenges.

Jason is also a Kauffman Fellow, and a member of the famed and fabled PayPal Mafia whose membership includes icons like Elon Musk, Reid Hoffman, Peter Thiel, Max Levchin and Roelof Botha.

Bill:         Welcome Jason, it is great to have you here, especially during these uncertain times. Before we get into the topic at hand, I need to ask about what is on everyone’s you have any thoughts about the election and how this plays out in relation to the economy and the markets?

Jason:      Great to be here Bill, I really enjoy reading your blogs and have been looking forward to contributing.  As you know I am not a public markets person, but do have views on deploying risk capital.  I would also like to mention that I go to lengths to stay apolitical and am not willing to comment on social issues in this forum.  That said, following the morning-after hangover from a contentious campaign season, I am excited about the possibilities from a business perspective.  I believe the election results threw a lot of risk into the equation and this could either pay-off well or end in disaster.  But as a risk-seeker and risk taker, this feels good.  If we are re-entering a period of risk taking as a nation, I feel good in knowing that Silicon Valley will have a role.  Risk-taking is something Silicon Valley does very well.

Risk-taking is something Silicon Valley does very well.
— Jason Portnoy

Bill:          It is interesting that you focus the discussion on risk taking and not risk reduction, like most of my public market colleagues.  Do you see any parallels between how the public markets have gotten to where they are relative to the private markets within that risk framework?

Jason:      Absolutely, and I think you touch on some of that in your introduction.  Over the last few decades, most investors in the public markets have been looking for less risk, so public companies have responded by engaging in risk (aka volatility) reduction efforts like outsourcing their research & development (R&D) to the broader venture capital ecosystem and using financial engineering (e.g. stock buybacks using leverage) to deliver predictable returns on equity.  In fact, since the tech bubble burst in the early 2000’s, we have seen an explicit attempt by large tech and telecom companies to cut R&D spending in a desire to cut risk and increase cash flow.  These large, slower growing companies are using small start-ups as their R&D labs and then look to add these innovations through merger & acquisition (M&A) activity so they can leverage the growth opportunities over their larger platforms.  In any event, the net effect of outsourcing the R&D activity seems to segregate the consistent and lower risk cash flow businesses of a large public company from the high risk/high growth profile of a venture capital company.  

Bill:          That is so interesting, I saw the same “outsourcing” paradigm take place in the gold mining industry in the late 1990’s.  When the price of gold traded below the cost of production, the large mining companies reacted by cutting their exploration teams who identify “green field” growth opportunities. This was an attempt to cut budgets and risk, while increasing short term cash flow.  These exploration teams re-formed as mining start-ups (so to speak), and they are the ones who knew where the good gold deposits lay.  Those same mining start-ups then went to the Canadian capital markets to get cheap financing in order to drill out the properties and “prove up” the gold reserves.  This system continues to this day, where “wildcat” exploration teams find the gold and are then acquired by the larger, short-term focused, growth starved major producing companies. To your point, Jason, risk reduction by some leads to greater risk taking opportunities for others.

Bill:          And how has this dichotomy in risk translated to returns?

Jason:      As a result of the lower underlying risk, investors in public equities have been rewarded with commensurately lower returns.  I don’t see this happening in the private markets.  I’ll focus on venture capital for now since that is the area with which I’m most familiar.  If you look at the Cambridge Associates data below, you see that private market investors, who are comfortable taking risk over long time horizons, are rewarded with much higher returns than those available in the public markets.

US Venture Capital Index
...private market investors, who are comfortable taking risk over long time horizons, are rewarded with much higher returns than those available in the public markets.
— Jason Portnoy

Bill:          Those data are very compelling, Jason.  I’ll attempt to put those returns in perspective.   First, Warren Buffet returned 19.8% over his entire 50 year investing career (through 2015).  He has returned only ~14% over the past 25 years, while the Venture index has returned over 22%. Much of Warren Buffet’s tremendous growth occurred back when he was pursuing aggressive, small-cap opportunities along with private companies...similar to the venture capitalist of today.  It is tough to compare different investment era’s, but Mr Buffet achieved an approximate 30% compounded annualized growth rate over his first 25 years of investing, because his then smaller asset size allowed him to invest with a riskier profile.

Lastly, from a different dimension on this return comparison point, I would argue that the public markets have benefitted more than venture capital investments from the Fed’s aggressive monetary policy activities over the past 5-8 years.  These activities have likely had the effect of making the more recent returns even closer than they would have been.   

Bill:          So Jason, why do you think this bi-furcation in risk has occurred?  

Jason:         I’ve had friends say things like “Chicken or egg.  Lack of risk appetite or lack of opportunities?”, but I disagree.  There is no shortage of opportunities out there to take risk and invest in the future of our civilization.  I think a lot of it goes back to government and central bank intervention conspiring at every turn to try to reduce risk in our publicly accessible financial systems.  Forest fires are healthy, they clear out the dead brush.  Financial markets should be allowed to go through that same regenerative process.  When markets are allowed to self correct, capital and labor are freed up for more productive uses in the economy.  In the private markets, this dynamic still works quite well, so some investors are responding by seeking out investments in private companies.  A recent economist article shows that the fraction of total US equity enterprise value that is held in private companies has grown significantly over the years.

Bill:          This shift over just the 13 year period cited in the report is dramatic.  I’m sure with the growth of some of our ‘unicorns’ that shift toward privately backed companies has only accelerated.  I mentioned the surprising move toward fewer companies on the listed exchanges in a prior blog, but this really helps highlight what has been occurring.  I’m sure a part of this shift is simply growth of venture backed companies, as well as private equity acquisitions of companies that had previously been public, ala Dell.  Lastly, the private markets have just performed better and attracted more institutional money in response.  It all ties.

Bain & Company Private Equity chart

Bill:          And what has been the response to this bi-furcation of risk?

Jason:      Primarily, we’re seeing a corresponding bi-frucation in our capital markets.  Previously, companies had to go to the public markets to find the capital they needed to grow and scale their businesses.  More recently, if you are a risk-taking CEO focused on a very long time horizon, it’s been much harder for you to find like-minded public market investors to finance your vision.  Enter the private market investors, most of whom are hungry for growth, are willing to tolerate volatility and illiquidity, and have long time horizons.  These investors are now finding like-minded CEOs with whom to partner in the private markets..  On the other hand, investors who prefer predictability and liquidity continue to partner with like-minded CEOs in the public markets.  Neither one is right or wrong- if the right buyers (investors) and sellers (CEOs) are transacting with each other then that is a sign of a healthy market dynamic.  I believe it is only a matter of time before a private stock market works alongside the public stock market.

Bill:         I agree that the public markets have traditionally offered more predictability and definitely more liquidity.  However, I sense that with an artificially suppressed yield curve due to central bank activity, some of that “predictability” and transparency has been altered.  Investors just seem more uncertain about how the market operates and how they can benefit.  If I may, their returns seem more subject to be “Blowin’ in the Wind”.   

Jason:         Yes, it does indeed feel like participants in the public markets have to spend a lot of energy thinking about how government tinkering (either through the Fed, tax policy, etc.) is going to impact their investments, whereas we don’t tend to worry about those things in the context of most venture capital investments.  

Bill:         To what do you attribute private market success?  Is it just this uninhibited regeneration process?

Jason:      No, there is more to it than that.  In addition to the ability to regenerate, I believe private market investors benefit from having a very long term time horizon which allows them to tolerate more volatility.  They tolerate more risk-taking by the companies in which they are invested, and are generally rewarded for it.  

Bill:          Is there a way for retail investors to participate.  Should they start thinking longer term for the risk appetite portion of their portfolio?

Jason:         Yes, I believe they should.  They can learn from what large institutional investors have learned over the previous decades.  I’ll reference Cambridge Associates again.  They recently published a report that characterized the performance of foundation and endowment investors by how much they allocated to private market investments.  There is definitely positive correlation between their allocation to privates and their returns.   The table below shows how institutional investors begin to see outsized excess returns (mean = 4.0%) in their portfolios when they allocate greater than 15% of their capital to private investments.

Cambridge Associates research

I believe retail investors should follow suit.  At a high level, I would encourage them (and their financial advisors) to stop thinking of private company exposure as purely an “alternative investment”.  As we saw earlier, privates are becoming a much larger fraction of total equity enterprise value, so if you leave them out of a portfolio you are starting to leave a big hole.  In addition, the hole that is left is exactly the growth story that many retail investors crave.  Think of it this way: It has always been the case that some companies are growing and some are stagnating (or potentially being displaced altogether).  Now that private capital markets are increasingly more developed than in the past, and growth stage private companies wait much longer to go public, one can make the case that the private market represents a bigger fraction of growing companies, while the public market represents an increasing fraction of stagnating or soon to be displaced companies.  If true, then a portfolio that only includes public market equities is less exposed to growth than it was in the past, and that’s a problem.

...stop thinking of private company exposure as purely an “alternative investment”.
— Jason Portnoy

Bill:         That is an awesome point, Jason.  You brought up companies taking longer to issue an initial public offering (IPO).  Can you comment on the liquidity cycle in the private markets.  It is no secret that the IPO market has dried up.  Is that more from a supply/demand standpoint, and is it impacting the venture world?  Just as the public markets have perhaps had too much capital chasing too few good opportunities, is it possible the private markets have not gotten the good re-cycle of cash?  

Jason:      I have a couple thoughts on that.  First, successful companies have not gone public because they don’t have to, as I mentioned before.  They don’t want all the legal baggage and distraction that that goes along with being a public company, and they are finding great private market investors to finance their growth.  On the other hand, for a company where a good chunk of the employee compensation is in the form of equity ownership, an IPO still feels like the most efficient way to distribute the value to the employees who helped create it.  I’ve wrestled with the IPO issue for a number of years - I even wrote a blog piece about it called “IPO is not a Four Letter Word”.

In short, yes, the fact that companies are waiting longer to go public (if they ever do at all) is definitely having an impact on the venture ecosystem, although I would argue that it is a net positive.  In the late 1990s we saw too many companies go public because they could, even though their business models were not quite ready for it. That capital was quickly liberated, which may have led to excessive cash recycling and the first famous tech bubble of the late 1990s ensued.  I don’t think we’re seeing the same phenomenon this time around because so much of the capital is still held in private companies like Uber, AirBNB, etc.  That may be what is forcing VCs to be more disciplined than they were in that first internet bubble.

I believe we are living through a one-time shift in this regard - like a meal moving through a snake’s belly.  Let’s imagine companies went public in year 5 and now are waiting until year 8 or 10.  That means we’ll have a period of 3-5 years of very few IPOs, but then at some point all of the companies who would have gone public at year 5 will start going public, and the cohorts behind them will similarly.  The resulting pace will reach a new steady state.  As a venture capital investor it is OK for this liquidity shift to happen... as long LPs (the investors in those funds) are comfortable with it and believe they will be compensated for the wait.  Let me add that IPO has almost always represented the minority of liquidity events for venture backed private companies, with acquisitions making up the majority.  In recent years the M&A market has been fairly robust, so venture capital investors get liquidity this way as well.

I believe we are living through a one-time shift ... like a meal moving through a snake’s belly.
— Jason Portnoy

Bill:         Going back to the retail investor; how should they actually incorporate private equity exposure into their portfolio?

Jason:         Unless they are an expert in investing in private companies, they should invest in a fund, FULL STOP.  Whether it is private equity or venture capital, they should look for a great fund manager and allocate that way.  I’ll focus on venture capital since that is where I spend all of my time.  I see a lot of high net worth individuals go out and start making angel investments, only to watch the capital disappear in short order.  Private company investing, especially at the very early stages, where most high net worth (HNW) individuals get access to investments , is extremely risky.  In a portfolio of 20 companies you will have one or two (three if you are lucky) that drive all of the returns.  There will be a few investments that generate modest returns, and the rest will be a loss.  This was the case in my angel portfolio: the big gains were all driven by Facebook, Palantir Technologies, Yammer, and Stemcentrx.  I had about 35 angel investments in that portfolio and those four outcomes drove the entirety of the returns.  

So I recommend working with a professional.  You probably wouldn’t try to represent yourself in court or perform surgery on yourself.  Pay a professional to help you navigate the venture ecosystem.  Also, investing in early stage private companies is not just about picking companies - it is about post investment support.  That support does two things (ideally): 1) it helps improve the company’s chance of success, and 2) it gives the VC investor incredible amounts of data that help them assess if they should continue investing in that company.  Most venture capital gains are made by investing follow-on amounts in the best companies.  You can’t do that if you aren’t working on it full time and getting intimately connected to each company in the portfolio.  You don’t have the data and, perhaps more importantly, you don’t have the relationship to do it.  In the best companies the CEOs have the pick of who they want as investors, and they are going to pick investors with whom they like to work.  Without those relationships you won’t be able to invest in the best companies, and you will have an adverse selection problem on your hands.  

A further benefit of investing in a VC fund is that in many cases the fund will offer opportunities for you to co-invest with the fund down the road in the fund’s most promising companies.  Now you have a *proverse* selection situation, and that is a recipe for success.

Without those relationships you won’t be able to invest in the best companies, and you will have an adverse selection problem on your hands.
— Jason Portnoy

Bill:          Proverse selection.  I don’t think I’ve heard many investors use that term.  Can you tell me more about that?

Jason:         Well in that prior statement I was simply referring to the fact that if you are co-investing with a fund in later rounds of a company’s financing, you may have the opportunity to cherry-pick the best investments from that fund, which gives you great odds from the start that the investment has a chance at a nice return.  But more generally I refer to proverse selection as the phenomenon that exists, somewhat uniquely in venture capital, where great portfolio company outcomes (and fund returns) build up the brand of a VC firm, which then attracts a higher quality of company to seek out that firm for investment, and that then leads to more great investment returns.  It’s a positive reinforcing cycle, and it goes a long way toward explaining why certain venture capital funds consistently deliver the best returns.  I’ve written about this in the past in an article titled “The Secret Law Every Successful LP Understands”.

Bill:          Lastly, are there specific sectors that you believe offer tremendous growth opportunities?  Better yet, how would you suggest investors learn to identify some of these opportunities on their own?  

Jason:      Healthcare, finance, and robotics are all areas that I’m very excited about right now.  The first two have been popular for some time, but both industries are so big that there is still a lot of innovation coming which VC investors can help finance.  Robotics is in its early days because the commoditization of sensors and hardware that resulted from the proliferation of smartphones is still gaining speed.  As this continues and hardware costs continue to come down, robotics begins to look a lot like software, and that’s when innovation can start happening even faster.  There is a lot of discussion about artificial intelligence and blockchain, but I personally tend to focus on how those underlying technologies are going to disrupt various industries, and then look for investments in those industries (versus in the underlying technology itself).  

There is a lot of discussion about artificial intelligence and blockchain, but I personally tend to focus on how those underlying technologies are going to disrupt various industries, and then look for investments in those industries.
— Jason Portnoy

For investors to find these opportunities on their own, there is no good substitute for getting out and talking directly with entrepreneurs.  Or better yet, listening to them.  If you listen closely to enough conversations you start to stitch together an idea of where these new technologies are heading and which parts of an industry they will disrupt. That’s where you start doing your research.  

Bill:          That was fun, Jason.  Thanks for allowing us to “listen” in.  You speak as eloquently about risk as Dylan waxes about change - poetic.  It has been fascinating to hear you share your views and outlook for our Silicon Valley growth ecosystem and beyond.  No surprise, you also brought up a whole host of other questions. I hope you will come back next year and let us hear your thoughts on the long-term impact of disruptive industries on the broader economy.  

Have a Happy Thanksgiving!


Taking the Temperature of the Economy


Cutting Through The Noise, a financial blog by Bill Martin CFA

  • The yield on the 10-year Treasury is the economy’s thermometer. The economy’s current growth rate, growth and inflation expectations, and the cost of debt financing are embedded in one number—the rate our government borrows money at for ten years.
  • Our thermometer registered a feverish reading in the hyperinflation of the 1970s, and steadily fell for decades thereafter, measuring a much healthier interplay between growth and inflation.
  • The current reading of our thermometer indicates that the economy has walking pneumonia, which is to say that it struggles to maintain its current low level of activity, particularly with all the headwinds or potential viruses the global economy presents.   

About 25 years ago, as a newly minted analyst, I was invited to my first investment meeting, which included a guest speaker, Lang Wheeler, a successful hedge fund manager.  

Someone in the audience asked Lang, “what is the single most important piece of information that you look at?”  I have heard this question at least a thousand times in meetings since, but that was my first meeting, so I recall vividly Lang’s response… “The 10-yr Treasury Note”.  He continued “If I were on a desert island with only my satellite phone, and I had to choose one piece of information to trade my account, I would choose the yield of the 10-year Treasury.”  This surprised me because he was an value + momentum equity investor.

If I were on a desert island with only my satellite phone, and I had to choose one piece of information to trade my account, I would choose the yield of the 10-year Treasury

As I earnestly scribbled in my notepad, I knew I had just heard something incredibly important for my investment career. Of course in those early days, everything seemed incredibly important.  In any event, the single best indicator of the economy’s vigor and expectations of future growth, Lang told us, is the yield of the 10-year U.S. Treasury Note.  This instrument is considered risk free, often offers investors a fair return on their money to protect against inflation, and normally provides a bit of a premium for parting with their money for 10 years.  Think of it as a long-term savings bond with liquidity.

The yield on the 10-year Treasury tends to track with overall economic growth. As such, an investor can typically grow their money without risk at a level roughly similar to the rate of overall economic growth. As a point of reference, long-term economic growth has averaged around 6%--which breaks down to 3.5% actual growth and 2.5% inflation. 

Virtually all loans made in the market—mortgages, car loans, student loans, and more—are priced off the 10-Year Treasury.  The 10-year Note has such a strong history of yielding a bit more than economic growth adjusted for inflation, that knowing only this number meant you could also reliably gauge what was happening in the economy.  As Lang quipped, if the 10-yr Treasury is between 4-7%, then the economy is humming along fine.  Above 7%, we have inflation concerns, and much below 4%, we likely are headed for a recession, or contracting growth.

With the overall economy growing at about 3% per year, and 10-yr Treasury yields currently anchored below 2%, Lang’s trading strategy would not have worked well in the current environment. I can’t help wonder how many margin calls Lang would have received on his S&P 500 puts by now, had he continued to trade blindly off the 10-yr Treasury note. Times change and the data changes with them. I don’t say this to pick on Lang (well, maybe a little bit), but to demonstrate that much of the data we see today is unprecedented and was unthinkable from the perspective of twenty-five years ago.   

Of course, market relationships change over time, but there is still no underestimating the importance of the economy’s thermometer—the yield on the 10-year Treasury note. This first chart by the St. Louis Fed shows the yield on the 10-year Treasury note for the last fifty years.  After declining for three decades, the yield has been below what would typically be considered recessionary levels since at least 2008. 

FRED 10 year Treasury

This is our new reality.  What does the current level of the 10-yr Treasury tell us?  Firstly, it tells us there isn’t much current growth or fear of future inflation. In other words, the patient—our economy—is suffering from a case of walking pneumonia. It’s plodding ahead dutifully, but anytime it tries to run, it succumbs to a coughing fit. Investors are currently not being compensated for having the courage to avoid putting their money in the mattress.

...the patient—our economy—is suffering from a case of walking pneumonia

The chart below takes the yield on the 10-year Treasury and removes the loss of purchasing power due to inflation. As you can see in the chart, investors in the 10-yr Treasury get a negative return after factoring in the effect of inflation.  Risk-free assets are so expensive that they no longer cover the cost of most inflation measures. The only other times this has happened was during the rapidly accelerating inflation period of the 1970’s. At that time, the 10-Year Treasury, our financial thermometer, registered a dangerously high fever.  Historically, investors have earned 2.5% over and above inflation, which is a pretty penny for little risk.

FRED 10 year treasury

This phenomenon—a negative yield in the risk-free investment—encourages investors to seek a positive return in other “riskier” assets, but we will get to that in future blogs.  I want to use this opportunity to step back and understand this environment.  Take the temperature of the economy, if you will.

Again, our economy’s health could be likened to walking pneumonia—well enough to move forward on its own two feet after swallowing large doses of monetary medicine, but still very sick and in need of special care.

Basically, The US maintains a relatively high standard of living, but growth is still very anemic.  We have entered the 7th year of our economic expansion.  Unemployment is back under 5%, near all-time lows, while the stock market is at all-time highs and consumer debt is trending lower, yet we still have slow global growth, low wages, weak labor force growth, and low productivity.  I call it the 2% two-step.  Any time the economy has hinted at being able to grow at a faster rate, growth proves to be fleeting and falls back to below the long-term trend, and we continue to hover around 2% GDP growth.  Again, our economy’s health could be likened to walking pneumonia—well enough to move forward on its own two feet after swallowing large doses of monetary medicine, but still very sick and in need of special care.

Perhaps this is the new normal, as many have claimed.  But what does this imply for investors?  Well, low growth with high overall debt levels will likely lead to higher volatility once global Central Banks get out of the way with their Central Planning. 

Low growth does not mean NO growth.  So there will be relative winners and losers.  With so much money in the system, courtesy of central bankers, there will be crowding towards those perceived winners.  Crowding ultimately leads to disappointment and volatility.  I think this may be the new environment for which we must prepare; ”boom-bust” rather than “buy the dip.”

This conversation about the low growth-low opportunity reality  sets us up next month’s conversation where we will investigate some aspects of the private markets that are experiencing solid growth.  Private markets continue to offer access to growing industries without the “mark-to-market” volatility we see in the public markets.  I will be speaking with Jason Portnoy, Venture Capitalist with OakHouse Partners.  Jason is kind enough to drop by to give us some insights about the Venture and Private world.  I look forward to sharing my Q&A with Jason during our next blog.

Lastly, I want to supplement this offering with an ELECTION SPECIAL, a nod to my favorite blogger.  The Heisenberg’s latest blog incorporates some recent reports that help to distil the election environment. I am not sharing this to pick an election winner or even back a horse in this race.  I share it because I think this report provides a bit of perspective on trends in our system that make this election different. Call it the Bernie or the Trump effect. Either way, there is something new rising up and I think his report helps shed some light. Note: you may need to sign up (just enter your email) to access the blog, but I think it will be worth it.

Here’s to being more right than wrong and early rather than late (just not as early as Lang) : )

Slow Growth Meets Market Turbulence

Cutting Through the Noise - a financial blog by Bill Martin, CFA

Slow Growth Meets Market Turbulence

Slow Growth Meets Market Turbulence

Opportunities in a slow growth/high volatility investment world…

We all know the proverb about the three blind men and an elephant, in which the blind men come to completely different conclusions about the elephant’s characteristics because of their limited perspectives. So what happens when the three blind men perfectly describe the entire elephant? Call me crazy, but I am going to tell you that it is, in fact, an elephant.

When three market sages with different training and varying vantage points happen to be seeing and describing the same tectonic shift in different ways, it’s time to take note. Bill Gross; legendary bond investor, Francois Trahan; renowned stock market strategist, and Lawrence Summers; accomplished government policy maker, all have indicated that there is a significant economic shift in the offing that may change the nature of investing for years to come. My investment perspective, informed by thirty years of fundamental and quantitative investing and economic analysis, generally agrees with their shared conclusions.

This tectonic shift is likely to include slow growth, low investment returns, and higher volatility due to “boom and bust” cycles. As investors, we need to modify our playbook to prepare for this economic shift.

Facing a New Reality in Investment Management

·      Low returns and high volatility—  Lower long-term returns are nearly a mathematical certainty at this point, and bouts of volatility typically coincide with low returns, particularly when excess liquidity is chasing returns in various markets. It is highly unlikely that the high stock and bond returns of the past 40 years will persist into the future.

·      Boom and bust cycles will prevail— the combination of low returns and high volatility will likely lead to an investment paradigm shift from “buy and hold” investing to “boom and bust” investing. Strong and sustainable sources of economic growth are becoming more and more elusive.  The last two business cycles—the dot com bubble and the real estate bubble—both ended in busts.

·      Investors must be more nimble, active, and diversified—with the correct strategy going forward, investors may still be able to achieve solid returns by tending to their investments more often and more actively.

Bonds: You Might Find Your Returns on Mars

A recent article entitled “Bon Appetite” by Bill Gross at Janus Capital, has been getting a lot of attention.  In this report, he convincingly argues that investors are spoiled by declining interest rates and the corresponding impact on equities over the past 40 years.  He calls this recent period an outlier and claims the odds of a repeat period are more likely to occur on Mars than on Earth. Mr. Gross implies that for bond investors to duplicate the historical returns they have seen over the past 40 years, the math dictates that interest rates would have to drop to approximately -17% (yes, that’s a negative sign)!

This fundamental disconnect in the math behind bond returns forces us to accept a new reality.  If you believe bonds will supply the solid, steady return that we’ve all grown to love, you also have to believe that your kids will be investing in a government bond with a -15% yield. In short, it makes little mathematical sense to believe bonds will deliver gains on par with the past. If you can hitch a ride to Mars, all bets are off.  

The bottom line is that investors need to get used to lower total returns from their investments.  Gross’s outlook points to annualized fixed income (bond) returns in the range of 1.5-3% going forward, with the impact on principal from rising rates being offset by higher coupon payments. 

Equities: Ground Control to Major Tom

Equities have spent the last forty years launching into the stratosphere, but the ship is now experiencing some technical difficulties. Forecasting the equity market (stocks) is always bit trickier than bonds because variables such as future earnings, productivity, earnings multiples, and risk aversion affect their long-range potential.  That said, these variables tend to suggest that investors should expect equity returns of 4.5-6%. 

Francois Trahan has been ranked the top strategist by Institutional Investor in 10 of the past 11 years. The only way to get such accolades in this industry is to be right more often than wrong.  He recently asked us, in a May 11, 2016 conference call, to consider the possibility that the era of “buy and hold” investing is past its prime, and that we are moving to “boom and bust” investing. Mr. Trahan added that this call may be his most important of the last 10 years. He also stressed that the one thing investors need to hear is… markets may be moving from a long-held “buy and hold” mentality to a new “boom and bust” paradigm, which may last for a very long time.

Mr. Trahan’s call is significant, because it will impact the returns of savers and investors for the next generation and perhaps beyond.  Investment returns can have a self-fulfilling effect on the overall economy – in both directions.  The Fed and other global Central Banks have made that exact bet with their fire hoses of liquidity provided through QE (Quantitative Easing) to increase the impact of the wealth effect on the economy.  Imagine the ramifications if that self-fulfilling effect starts to work in the other direction?  Think Japan (we will be thinking more on that in our next letter).  Paradigm shifts normally unfold very slowly, but it is better to accept the new reality early, rather than late.

Secular Stagnation: The Same View from a Different Bridge

If Trahan’s outlook is correct, we might expect to see persistently weak and disappointing economic growth as a precondition to a “boom and bust.” Well, both of the last two business cycles have ended in busts—dotcom and real estate—and since the financial crisis, the economy has only grown at about half of its long-term rate despite unprecedented amounts of monetary stimulus.   

Here again, skilled policy makers are taking note of the new environment. The economic backdrop that leads to “boom and bust” cycles is what Lawrence Summers, former Treasury Secretary, terms “secular stagnation”.  Too much savings supply and not enough product demand for those savings is the dynamic that produces secular stagnation.  Low product demand leads to slow revenue growth, lower overall economic growth, and correspondingly low levels of capital expenditure. Rising demand is required for a virtuous economic cycle. Absent strong contributions from government, economies can and often do stall or stagnate for long periods. (More on the combined responsibility of this phenomenon will be discussed in my upcoming blogs). Interestingly, the International Monetary Fund weighed in on the subject and fundamentally agreed with Summers’ secular stagnation thesis. 

So What?

When forecasters and market strategists decide on the amount of stocks and bonds investors should hold, they all tend to look at similar historical data.  The more data the better, as statisticians like to say!  If we go back far enough in time, we see that stocks tend to return 9-10% and bonds return 5-6% over the long run.

However, the basic math points to future returns that are much lower than past returns. Extrapolating on Gross’s bond return forecast and the equity return expectation detailed above, a typical, diversified buy-and-hold investor could expect a long-term return of approximately 3-4%. The outlook for buy and hold investing, a successful strategy over the past 40 years, is in a word… sobering.

The problem with allocating capital based on high long-term, historical returns is that the analysis masks some very weak market regimes on the way to these high returns. For example, there have been a number of times when stocks declined for ten- and twenty-year periods. Throughout history, Sometimes stocks recouped their losses in a matter of months. Other times, getting back above water took years, or even decades. There have been periods of very high volatility with little return (“boom and bust”), and periods with very high returns and low volatility (recent history).

During these long stretches of low returns with high volatility, “buy and hold” investors felt all of the risk of the market’s ups and downs for decades, but had nothing to show for it. Even more damaging, many investors lost patience with their long-term strategy at the worst possible time, and sold their holdings at market lows.

In that same “boom and bust” environment, investors had tremendous opportunities to improve their returns if they realized, early on, that fleeting gains would be followed by substantial downturns. Francois Trahan’s work demonstrated that “boom and bust” investment cycles are actually more common than the era of “buy and hold” that seems normal to most of us after enjoying the last forty years of outsized gains. That observation was likely an eye-opener for many younger professional investors on the call.

The starting point for the recent period of unprecedented gains was the high interest rates and inflation of the late 1970s. The Federal Reserve, led by the strong hand of Paul Volcker, finally did the hard work of killing inflation, unleashing an era of relative prosperity and rising asset prices. No such catalyst exists for the markets today, understanding that the Fed, which is the preeminent market force throughout history, is holding interest rates near zero. The Fed is not in a position to give another forty-year gift to the markets.

We believe that “boom and bust” is where we currently find ourselves within the long-term investment cycle.  The quicker we forget about a “buy and hold” investing strategy in this environment, the better off we will be.

This “paradigm shift” will be the basis for our first seminar series – “Opportunities in a slow growth/high volatility world”.  Future blogs will expand on and continue to examine the causes of a “boom and bust” investment world and the best ways to profit. I will dig deeper into the outlook for slower growth, and take a deep dive into the preconditions for more volatility going forward.

Here’s to being early instead of late and being more right than wrong.


Questions and Answers

Isn’t calling paradigm shifts risky?

When it comes to forecasting paradigm shifts in investment approaches, three axioms reign supreme: 

1.     There are many more false alarms than actual signals—a well known industry anecdote says economists “accurately” forecasted eleven of the past three recessions.

2.     If the relevant data and indicators consistently disprove your view, it might be time to change your view.    

3. In those rare occasions when a shift is actually taking place, it is better to be early than late.

Do you think things are really going to get that bad?

Our outlook is not a doomsday call in any way, shape, or form. I am not suggesting that we are about to revisit the Great Financial Crisis of 2008-09. The coming “boom and bust” strategy shift can be better described as a carry-over effect of our last Great Financial Crisis and the choices our politicians and central bankers made to deal with it. The booms and busts can be much less dramatic than the Great Financial Crisis or the Great Depression.

If this is a “call to arms” in anyway, it is a call to be realistic about the world in which we live, and make personal choices to better our situations and remove unnecessary risks.  We actually see meaningful opportunities to improve returns in the current “boom and bust” environment.

Is Mr. Summers alone in believing that we are entering a period of structural stagnation?

Summers and the IMF are not alone in recognizing that we are entering a period of structural stagnation. Many hedge funds are already positioned for such an outcome. Key signs of this symptom are weak organic revenue growth, manufactured earnings growth, and stock buybacks funded by earnings that have been artificially inflated through increased borrowing at artificially suppressed interest rates.

How does all this “boom and bust” and secular stagnation play out together?

We will likely see lower-than-expected global economic growth lead to low stock and bond returns.  With lower levels of economic growth, held back by lower levels of growth in the labor pool and lower productivity, we will have lower returns.  This will lead to growing debt.

What is the risk of sticking to a “buy and hold” strategy?

The big risk would be having little return for any level of risk taking. The even bigger risk to “buy and hold” investors is that they end up selling at the wrong time, just as the markets find their pain point.  This happens every cycle.

How will we know if “boom and bust” cycles aren’t in our future?  

We return to a period of organic revenue growth, not just earnings growth.  We will see revenues growing at higher levels, increased stability, and declining debt levels. Increased Cap-Ex spending and rising demand would be a clear indication that “boom and bust” had transformed into more sustainable growth trends.

What are the risks of a “boom and bust” cycle? 

Our biggest risk is that the first leg is a “boom” and we are relatively under weighted equities.  We see this risk to be manageable, particularly given the current high level of valuations for stocks and lack of clear room for meaningful appreciation.

Where are the opportunities?

…Smart rebalancing, tactical asset allocation, and active managers aligned with their investors would all present significant opportunities to boost returns in a “boom and bust” cycle. This approach could help to achieve higher than “buy and hold” equity-only returns with much less volatility. The results could lead to marginally higher returns with moderately lower risk and much better sleep, despite the noise of a low return/high volatility world.

TAKING STOCK: An insider’s view of the mutual fund ecosystem over the past three decades

Cutting Through the Noise - a financial blog by Bill Martin, CFA

The mutual fund industry has offered investors many benefits over the years:  professional management, diversification, and market access. However, these benefits have come at a price of relatively steep fees and middling results. Unfortunately, a strong case can be made that some of the benefits of professional management have slowly eroded as mutual fund management decisions are increasingly led more by sales and marketing teams, and less by the professional investment team. The good news is that as the industry has evolved and matured, many of the benefits can now be accessed in a less-expensive format.

The following is an insider’s view of the path the asset management industry has taken over the past 30+ years. We argue that the mutual fund industry’s “golden age” occurred roughly from 1980 to the bursting of the housing bubble in 2008. The remarkable growth in assets and profits resulted from the confluence of a series of regulatory, political, and economic changes on a global scale. Furthermore the evolution and competition in the mutual fund industry over this 30-year period leave it poorly positioned for the future in many respects. Indeed, the characteristics of successful fund companies—tremendous size, aggressive distribution arms, and high cost per unit of active risk—have been at odds with requirements for investing success for many years now. The dramatic rise of low-cost, index-replicating passive strategies on the one hand, and high-cost, less liquid and less transparent hedge funds, on the other hand, are evidence of this fact. Rather than stick to tightly prescribed processes where active risk and investment professional judgment are minimized, we argue for an approach favored by the most sophisticated investors, typified by the Yale and Stanford endowments, among others. This approach seeks to maximize compound returns (that is, what the investor actually receives) on a risk-adjusted basis over time. This can be accomplished through diversifying, keeping costs down in largely commoditized markets, and seeking superior managers in less followed markets that allow for higher excess returns.  In this paper, we will lay out in detail the important historical and coming trends that have and will impact investors, explaining how we got here, and where we are going. 


The last three decades mark a period of remarkable growth and transformation in the financial services industry. A series of events in the late 1970s and early 1980s transformed economic and financial conditions, and essentially gave rise to the modern mutual fund industry. In 1978, Congress created the 401(k) individual retirement account, taking the burden of retirement planning out of the hands of employers and putting it squarely on individual employees. Not only was this a massive boon for corporate America, but overnight it also created huge demand for professional management and market access offered by the mutual fund industry. It’s no coincidence that the number of Americans in private industry covered by defined benefit pension plans peaked in 1980 and has been in decline ever since. Similarly, the individual retirement account, or IRA, was created in 1974, and later became widely available in 1981. Other profoundly important events at that time which continue to resonate today included deregulation of the financial industry; the end of China’s isolation and entry into the global economic system; the dramatic increase in interest rates by the Volcker Fed, effectively breaking the back of inflation; and the introduction of the personal computer that ushered in the move away from an industrialized economy toward one driven by rapid technological change and productivity gains.       

From this backdrop, we saw an ensuing long, secular decline in interest rates and inflation; the increased globalization of the labor force and consumer markets; and decreased economic volatility (more modest growth and less severe recessions) all worked in conjunction with an elongated business cycle to reduce perceived market risk and increase investment asset prices. It is no coincidence that the S&P 500 went up in a more or less straight line from the early 1980s to 2000, during this period. Following this dramatic run-up, we have seen historic volatility in the wake of the dot-com bubble and 2008-09 Financial Crisis, yet the market still stands near a record high, as this is being written.

The undisputed beneficiaries of these events have been the asset management firms (mutual fund companies) themselves. Total assets under management (AUM) in the mutual fund industry have grown from approximately $100 billion in 1980 to almost $15 trillion in 2015. This does not count the rapid growth and proliferation in exchange-traded funds (ETFs), which now account for almost $5 trillion. Such spectacular growth in AUM led to a number of fad investments, diluted talent, and hubris, while the number of registered mutual funds has grown from around 500 in 1980 to well over 10,000 today. All of this rapid growth has occurred while the total number of listed stocks in the US peaked just short of 8,000 in 1997, and has since shrunk to under 5,000. There are now more mutual funds than there are stocks. Think about that for a moment. To quote one well-known observer of financial markets:  The parasite is now larger than the host.


Nothing was more important to asset management growth than the creation of the IRA and 401(k), created by Congress to alleviate pension funding burdens on Corporate America. As the accompanying graph shows from Money Zine (based on Department of Labor statistics), the growth in defined contribution plans has far exceeded that of defined benefit pension accounts since the introduction of these laws.

Plan Participation Rates

Department of Labor Statistics - defined contribution vs defined benefit participation 1979- 2009

Department of Labor Statistics - defined contribution vs defined benefit participation 1979- 2009


According to surveys conducted by the U.S. Department of Labor's Employee Benefits Security Administration, participation in defined benefit plans peaked back in 1980. At that time, there were 30.1 million participants in these retirement plans. Over the next 30 years, participation decreased by nearly 40%.

Not surprisingly, participation in defined contribution plans increased 281% from 18.9 million to 72.0 million participants over that same timeframe. This increase is attributed to both the scaling back of defined benefit offerings by employers as well as the rapid rise in the popularity of 401(k)-type plans.

Prior to the increased popularity of the IRA and 401(k), traditional defined benefit pension plans reigned supreme. These plans were run by employers and offered few choices. This approach largely bypassed the mutual fund industry and usually delegated investment decisions to the company’s treasury department or a big bank’s trust department and could often be over-reliant on company stock. The movement from traditional pension plans to defined contribution plans (IRA, 401(k), 403(b), SEP IRA, etc.) brought HUGE profits in the form of fees for the mutual fund industry, along with a dizzying array of choices for investors. Some of these changes were good, and some not so good for individuals. What we can say for sure is that these changes completely remade the retirement landscape for the average American worker and jumpstarted the entire financial services industry. 

Altos believes…  Because the responsibility for retirement savings has slowly transferred from the employer to the employee and the participation decision has become voluntary, the retirement savings/benefits have actually declined for the individual. The positives from moving away from the pension plan system have flowed to the corporations through lower costs (the same can be said for sharing costs of health care). The benefits of increased investment choices have not offset the commensurate loss in individual retirement savings contributions, thus putting the burden of an aging workforce with underfunded retirements on the increasingly hollowed out labor force. In most cases, individuals lack the investment acumen to make the appropriate investment choices to match their risk tolerance, investment horizon, and savings needs. In other instances, investors may get set up properly, but end up bailing out of their plan after a big drawdown (at just the wrong time), and then feel discouraged and avoid making future decisions altogether. This is where and when an experienced advisor can help investors stay the course or, better still, use market turbulence as an investment opportunity.


With individual investors increasingly responsible for their own retirement success, new services sprung up to advise individuals on their investment decisions. One such service was Morningstar, who created so-called “style boxes” to help investors better categorize and understand what was driving the performance of their investments. Morningstar helps investors view mutual funds through the prism of size and style, utilizing a three-by-three matrix with small-, medium-, and large-capitalization stocks on one axis and value, blend, and growth styles on the other axis. This matrix placed every domestic equity mutual fund in any one of the nine boxes.

Given the proliferation of mutual funds in the period since 1980, the need to organize and categorize funds was clear, and for this service Morningstar is to be commended. But this advent may have also had an unintended consequence of stultifying and “boxing in” good asset managers. Consider the interaction effect between style purity and the newly minted “investment consultant” community. The consultants were hired by large 401(k) plans and other large asset pools to help pick the best funds for each style box. Since money talks, and 401(k) plans became the largest recipients of new money inflow, these consultants gained considerable power over the allocation of investment dollars between mutual funds. The style box system made allocation simpler and easier for consultants to understand and explain. As a result, the mutual fund companies segmented each of their funds into a box to follow rigid investment processes. Fund managers were strongly discouraged from moving to another box or deviating from a stated investment process, regardless of prevailing market conditions. As a result, the value of an investment manager’s stewardship to identify the context around when a process is likely to be effective has been eroded in exchange for simplicity of messaging. 

The consultant community wanted to understand a mutual fund company’s process and expected them to stick to that process, even if the fund manager himself believed their proprietary process may have been out of step with current market conditions.

The following is an excerpt from an article by Alpha Architect titled Even God Would Get Fired as an Active Investor

"… consultants say they’re counseling clients in two ways. One is simple patience. The other is imparting a more sophisticated understanding of a particular strategy’s role in their portfolio. That means clients shouldn’t necessarily be troubled when a strategy performs poorly, but rather they should worry when returns are out of whack with what the manager said to expect", according to Steve Foresti, CIO at Wilshire Consulting. “It all comes back to education and understanding the whole investment process and what it is that’s driving the risk premia investors are trying to collect.”

We highlight this paradigm to show consultants’ views of mutual fund returns. Consultants wanted to be able to understand and explain exactly how a fund will perform in relation to all market movements. Therefore, they prized consistency of process and style purity above all other traits. If a manager was in the large value box, for example, and the other funds in that space declined, his fund also ought to have declined. Otherwise, in the immortal words of Ricky from “I Love Lucy,” you got some ‘splainin’ to do! The “active” mutual fund manager has become beholden to a narrowly prescribed process with little range to exercise his investment acumen or expertise with changing market conditions. In short, active managers have become less and less active over time.

The consultants also wanted to bring down a fund's risk relative to market benchmarks. Again, the goal of this exercise was to increase predictability of performance relative to a given market index or style box. Bringing down risk usually brings down returns. Since the mutual fund management companies were loath to bring down fees… investor returns got squeezed. Hard to imagine legendary investors like Warren Buffet, Peter Lynch, or Bill Miller would have been as successful as they were had they committed to stay within a box and simply harvest a “risk premia” when it was in style.

A dirty little secret… statistics show that consultants are no better than the little guy at picking asset managers. Both tend to buy five-star funds after they outperform and sell them after they underperform and become three-star funds. This approach tends to “book” both the higher fee offered by active management as well as the poor performance period of a fund’s performance contour.

Altos believes... over the past 30 years, the impact of style boxes and investment consultants has effectively stacked the deck against investors…  Not just against small investors, but against all investors. The decline in net investment returns has resulted in increased competition from two relatively new animals in the investment ecosystem, the hedge fund and the index fund (or exchange-traded fund (ETF)).  


First let’s discuss hedge funds, which are not pinned down by style boxes and remain free to go anywhere in pursuit of higher returns—and fees. Hedge funds contrast with typical registered mutual funds not only in process and fee structure, but in other important dimensions as well. For example, there is typically less liquidity and transparency in hedge fund positions. Crucially, many hedge funds seek to provide the highest risk-adjusted return, rather than absolute return. Indeed, the name “hedge fund” connotes that managers are actively seeking to hedge risk. Contrast this with a typical mutual fund whose risk must match that of the market, give or take a few percentage points. Hedge funds also typically give primacy to the investment decision, and are much less concerned about sales and marketing dynamics. So much so that many successful managers often end up returning client money at some point and only continue to manage the partners’ capital.

The hedge fund vehicle has often been looked upon derisively, as ‘carried interest’ made its way into the political discussion. Plus, the fees are onerous when the results don’t meet expectations. Nevertheless, this type of investment entity has attracted the most talented asset managers, and is where investors get the best bang for the buck—even after higher fees. Hedge funds typically demand 2% annual fees and 20% of the profits, are generally available only to investors with liquid net worth greater than $2,000,000, and have minimum investments above $250,000. Additionally, hedge funds usually only allow liquidity once per quarter with the request being made 30 days in advance. This liquidity feature provides protection for the remaining shareholders, as in the film “The Big Short”. In that film, had investors been allowed to redeem at the wrong time, the big gains would not have been realized. Those really big gains were only available in a hedge fund format. Of course, the goal of a long holding period and limited liquidity is to provide hedge fund managers with broad leeway to pursue their investment objective. Ideally, then, hedge fund investors will often be compensated for this lack of transparency and liquidity.

Altos believes… Like in all walks of life, there are good and bad hedge fund managers and a select few very good managers. The really good ones more than compensate for the fees paid by the investor. Specifically identifying hedge funds with excellent track records and proven and flexible processes offers good risk/returns for certain high net worth investors. Hedge funds can be an excellent source of excess returns given current economic and market conditions— GDP growth looks muted going forward, stock valuations are comparatively full, and market volatility is likely to increase. Due to our industry contacts and Advisory Board members, we can identify select hedge fund managers with whom we place and monitor investments.


The second group of animals that emerged from the declining investment return climate were the index funds and ETFs that lay on the opposite end of the fee and value-add spectrum from the hedge fund. An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. This investment vehicle offers market access, typically at a very low fee. The defining feature of these vehicles is that they offer investors passive exposure to security returns as opposed to active management. The ETF market continues to gain market share as professional mutual fund managers continue to struggle to beat passive benchmarks after transaction costs and fees. The Russell 3000 index ETF is an example of these types of vehicles. This ETF offers the exact returns of investing in the top 3000 stocks in the US market using a market capitalization weighting scheme, at a cost of about eight basis points (a basis point equals 0.01%, so eight basis points equal 0.08%). There are also more customized and extremely targeted ETFs, such as an ETF that invests only in companies with growing dividends or a specific industry. These more customized ETFs offer construction challenges and are not as straight-forward as basic benchmark investing, so the fees may climb to as high as 40 basis points, though this is still noticeably below standard mutual fund fees of 0.75% to 1.50%. The advantages that ETFs offer in certain markets is starting to have an impact. The chart below created by the U.S. Department of Labor demonstrates that ETFs have grown at more than three times the rate of standard mutual funds, while hedge fund asset growth falls somewhere in between. These data end in 2013, but antecdotal evidence shows these trends have only accelerated in recent years.

Altos believes… We want to be very thoughtful and considerate with respect to managing client expenses. In pursuit of a client’s investment objectives, we may utilize both high- and low-cost vehicles commensurate with their potential reward and role in client portfolios. As such, we expect to utilize ETFs as an efficient means to access segments of the market that are largely commoditized with few value-add opportunities. Examples may be to gain market exposure to large-cap global markets and most fixed-income markets. We also see a use for ETFs in certain special cases, such as “rising dividend” funds or targeted and opportunistic exposure to investment styles such as value versus growth, or large versus small stocks, or to capitalize on investment themes such as tech, Asian productivity gains, aging population, or cyber security.


To this point, we have tried to make the case that the classic mutual fund industry is severely challenged by comparatively high management fees and low value add in an investment vehicle adhering to tightly prescribed investment parameters regardless of market conditions. The reasons for these deficiencies are many, and include the ascendance of sales and marketing regimes both within and beyond the mutual fund companies themselves. These conditions have given rise to growth in low-fee, low-value-add ETFs on the one hand and high-fee, high-potential-value-add hedge funds on the other hand. Next, we want to provide a real-life example of how it can be beneficial to deviate from style box and process constraints when attractive investment opportunities present themselves. Finally, we close with a discussion about size and the advantages of comparatively small, nimble boutique managers over their larger brethren.

Warren Buffet and his flagship conglomerate Berkshire Hathaway successfully demonstrated what could happen when asset managers are not confined to a style “box” by Morningstar, consultants, and mutual fund marketing and management teams. Consider that Warren Buffet was long hailed as a value investor. He was willing to take big risks in large positions of individual companies. He was willing to utilize leverage, and to engage with private company management teams to help maintain or improve the company’s advantage. However, Warren Buffet did not always stick to a “style” box. One of his most profitable positions of all time was his purchase of Coca-Cola (KO) in the 1980s. KO was not a value stock, but Warren contended it was cheap based on where he saw the market going… not on historical measures. This would not fly in today’s style box world, nor in a world where a consultant expects all of a mutual fund’s investment positions to fall within a tightly articulated stock selection process.

It would have been a shame had Warren not found early success and not become bigger than the fund rating companies early on in his tenure. It was indeed this early success—his ability to define attractive investment opportunities for himself and his clients without regard to size, style, or other constraint—that allowed him to be considered a legendary investor. His early success may not have been possible in the more segmented mutual fund environment of today.

Altos believes… Indeed, Warren Buffet was able to go anywhere/do anything, including invest in private companies to achieve his success. However, we believe there is also a cautionary tale in his Berkshire experience. Returns over the last decade or so lead one to question whether Berkshire has gotten too big—perhaps too big to invest without leaving a trading footprint, or just too complex to manage efficiently. Not to mention the obvious succession issues associated with an 86 year old Investment Chief. Consider that in the 30 years ended 2007, Berkshire Hathaway outperformed the S&P 500 21.3% versus 11.8% per annum (according to Bloomberg). This actually compounds out to a whopping difference of 4700% versus 828%! The power of compounding and superior asset management cannot be overlooked. However, since the end of 2007, as AUM and complexities increased at Berkshire, we have seen a bit of a reversal. From 12/31/2007 to 2/29/2016, Berkshire has underperformed the S&P 500 by 1400 basis points, 43% versus 57% on a cumulative total return basis. This is but one prominent example of a phenomenon documented in academic and industry research—it becomes harder to outperform as AUM increase. The good news is that there are still outstanding, comparatively small investment managers that have taken Warren’s example and stepped out on their own. Which leads to boutique investment firms.


Much like Warren Buffet and unlike large mutual fund companies, boutique firms do not have ascension, succession, or survivorship issues. At large mutual fund companies, it is very common for successful mutual fund managers to be moved to larger and more profitable funds within the company after a period of successful outperformance. This often leads to manager turnover and a lack of team cohesion. Eventually, successful managers often leave those large mutual fund companies to launch their own boutique firms or hedge funds. Boutiques fund firms tend to have much more freedom than typical largely distributed mutual funds because they tend not to play the style box game to help raise assets. Investment focus as opposed to marketing focus can make a huge difference.

Altos believes… that boutique investment funds tend to be more nimble than their largely distributed brethren. In most cases, these strategies can still invest anywhere, outside the “box” so to speak, and thereby stand in direct contrast to large mutual fund companies. We feel there is a role for boutique managers for our clients, particularly in markets that have a history of offering large opportunities to beat market-based benchmarks. These investment areas include tactical asset allocation funds, small-cap funds, and emerging market funds. We believe that in certain instances the best talent in the industry has landed with these boutique funds. 

The latitude afforded these managers, alongside an “investment first” culture as opposed to a culture based on asset gathering, helps explain the long term superior returns offered by boutique investment shops.  As described in an article by Bloomberg and an AMG press release… first and second decile boutique funds respectively best their relevant benchmarks by over 10% and 5% annually.  This outpaces more mass distributed competitor funds by multiples and more than pays for investor fees. 

It is important to understand how to buy and sell these funds, rather than to simply identify them.  The Social Science Research Network published an article by 3 professors from Caltech, UCLA and Penn State that identifies a number of typical mistakes institutional and individual investors commonly make when selecting a mutual fund.  Simply put, buying after a prolonged period of outperformance and having high Morningstar ratings typically leads to periods of underperformance, and vice versa. It takes discipline, but it is critical to identify a solid process and a team that knows that their approach may not always be in style...and most importantly, be willing to do something about it by re-shaping the contour of their investment process. This leads to long-term outperformance, even after fees. After spending more than a quarter of a century in the mutual fund management business and either participating in a panel discussion or competing in a finals presentation with these managers, we feel we have the necessary insights to lead this search.


Next, we turn to the trend toward targeted income investing. This trend is a result of very low interest rates, as a result of the Federal Reserves asset purchase program (e.g. Quantitative Easing - QE) that benefit investors, but punish savers.  Income investing was pushed as a necessary style of money management, particularly for investors in or near retirement that are living on a fixed income. Arguably, income-focused investing was an investment product created by the fund industry to target older investors that tend to have more significant assets (from which the industry can take fees). The fad of fixed-income focused investing came about when the industry began to sell the idea that an investor on a “fixed” income needed to achieve this target income amount from bonds or dividends, often at the expense of growth and stocks. It also should be noted that the rise of income investing coincided with the proliferation of debt in America (repackaged and sold as asset-backed securities) and the abundance of fixed-income securities that the government and industry needed to sell. Finally, management fees present a challenge for fixed-income investing in general and income investing in particular. Low levels of volatility and interest rates at present mean it is very hard for fixed-income mutual fund managers to earn back their fees.

Altos believes… In contrast to specific, targeted income products we believe it makes more sense to adopt a sophisticated, institutional approach focusing on total growth and capital preservation. A winning strategy focuses on the total portfolio throughout the entire investment cycle, rather than just the amount of income thrown off at any one time. Then, when one needs income, taking distributions from the larger asset pool can offer more flexibility with less risk. This is a very institutional approach to providing income distributions, similar to what is seen from large endowments, such as that of Stanford University, or a public pension plan, such as Calpers.

We believe the best way to manage income needs is to achieve the best risk-adjusted after-tax returns for our clients in every investment environment. This strategy keeps the horse in front of the cart by outpacing inflation and avoids the current problem of “yield grab” in low interest rate environments. Yield grabs tend to reach for higher yields than market available rates, while taking on more risk, and with less diversification than the investor may realize. The problems associated with pursuing higher yields will become apparent in a rising interest rate environment or the next recession.

To be clear, there absolutely is a place for fixed income (bonds) in an investment portfolio, but the benefits come more from diversification, capital preservation, reduced risk, and potential price gains when interest rates are declining. Fixed-income securities are often a great compliment to equity securities. However we are dubious about the merits of an income-only portfolio, or investing to yield targets, which can lead to investors unintentionally acquiring credit risk or interest rate risk inconsistent with their goals and risk tolerances. Regardless of the specific role fixed-income securities play in a portfolio, we believe strongly that this asset class should be accessed in a cost-effective manner.        


Congress is intent on helping small investors and providing confidence that the financial deck is not stacked against them. Lawmakers are putting the onus on the advisor to act in their client’s best interest in a fiduciary role. This will be evaluated on a net return (after fees) basis. As such, if advisors are charging fees for products, they need to demonstrate that their advice is worthwhile or they will be subject to penalties. The regulatory emphasis will be on the retirement plan advisor to allocate investments that maximize return versus risk and keep costs low. In general, the market is moving in the direction of the fiduciary role that has always been the cornerstone of the (RIA) Registered Investment Advisor.

In particular, Congress is not happy with the large fees that mutual fund companies charge for relatively low returns. As such, they are tightening the reins on investment advisors by increasing their fiduciary responsibility. This will drive many “old boy” transactional brokers (e.g. Merrill Lynch and Morgan Stanley) to change their business model and offer opportunity for objective and independent fee-based advisors that find low fee investments (such as ETFs) or funds that outperform over the long terms….i.e. boutique shops!

To its credit, the CFA Institute, the leading organization run by and for investment professionals, has long had a strong ethical component in its charter, by emphasizing integrity and best practices in the behavior of all its members. The very changes Congress, the SEC, and Department of Labor are seeking to implement have long been practiced by CFA charter holders, of which this author is one. As a result, our clients can rest assured that we always put our investors first and operate to the highest ethical standards.


Automated asset allocation models (robo-advisors) are the traditional asset management advisory industry’s response to Congress’ tighter fiduciary laws. The benefit of robo-advisor tools is that they help simplify a concept that can be complicated to the novice investor. Robo-advisor tools also help to rebalance risk as markets move. These tools are taking concepts that professional investors have used for years and putting them in the hands of individuals. They can be beneficial if used properly and by the right person. However, it is also true that the tools are generally created by and for the benefit of the big brokerage shops by drawing new assets to their firm, or retaining current assets that otherwise may be seeking out lower-fee solutions.

Altos believes… Automated investment solutions have a role in portfolio allocation. However, one must keep in mind that robo-advisor models are based on historical regressions over-layed with correlations of assets and asset classes. As a strong user of these types of models for over a quarter of a century and an early adopter of this technology, we know these models work until they don’t. Said differently, they do a fabulous job of providing a path when markets are behaving “normally” and an investor doesn’t really need help. The other side of the coin is that these models lead investors to a false sense of security and can really do damage during times of market stress, as was the case in 2007-09. Within the institutional asset management industry, optimizers such as these are known cynically as “error maximizers” and experience “fat-tail events” during times of financial stress. They will tend to lead to an extreme and incorrect solution. Therefore, we feel it makes sense to have someone at the helm that understands the inputs and the instruments when navigating a storm. Altos will use these types of tools to provide analysis for our clients. But we will also use our market experience and understanding of context to avoid the pitfalls that ultimately arise during times of market stress.

That’s a wrap…

The investment arena has undergone tremendous changes over the past three decades. With so much at stake and continued advancement in financial technology, we can expect the industry to continue to evolve at a rapid pace. We feel in some ways that the scales are tipping in favor of the small investors in relation to access to information and investment tools, as well as a more investor-friendly regulatory environment and emphasis on cost containment. At the same time, however, expected investment growth rates are clearly compressing from that to which investors have become accustomed based on historical returns. This disconnect between investor expectations and market realities as the baby-boom generation moves into retirement will likely lead to increased market turbulence in the future. We shall leave this topic for the basis for our first seminar series scheduled for the fall.

In conclusion, we hope we have laid out the path to attack the investment markets through targeting the right product types within the right market segments and proper pricing. We continue to believe that it is possible to identify superior asset managers by knowing where to look, knowing when to accumulate, and knowing when to taper. We hope we've identified ways for investors to successfully navigate the changing investment landscape by; using the benefits of financial technology, while avoiding some of the pitfalls to create a risk- and time-horizon appropriate portfolio, and sticking to the simple tools of boutique mutual funds and cost-efficient ETFs, while mixing in some alternative investments that provide downside protection or market-beating opportunities. Regarding the topic of downside protection and creating a smoother performance contour... that's fodder for future discussions. We look forward to regularly diving into the topic of risk management and “taking the market’s temperature” through this blog. Thank you.