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Bigger Is Better? For Investment Managers, Maybe Not
It’s no secret that America has long operated under an obsession with size. Over the last couple of decades, the average house size has continually increased (even as lots are shrinking ), cars have become supersized , food portions have grown, retail stores continue to sprawl, and even our waistlines have gradually expanded. Everything, it seems, is increasing in mass or breadth , as our national focus on size-above-all becomes ever more pathological with each passing year. This “bigger is better” mentality bleeds over into our financial lives, as well. Even as we rail against the “Too Big To Fail” banks for destabilizing our economy and extracting rents from working-class Americans, we continue to bank with them en masse, lured by the convenience and security of working with a known brand name. As a result, the big banks continue to get larger still, to the point that they’re now bigger than ever (and, coincidentally or not, failing some government-led stress tests). Click to enlarge Unsurprisingly, this same mentality holds true when it comes to our investments, and the advisors we choose to work with. Most individuals simply default to working with the big wirehouse brokerages (Morgan Stanley, Merrill Lynch, Wells Fargo, etc.), even when they could be obtaining better service (and true fiduciary advice ) by working with a smaller, independent Registered Investment Adviser firm. And yet, there’s a growing body of evidence that smaller (and not bigger) might actually be better for many things, including our investment returns. In early 2013, a study released by Beachhead Capital found that among approximately 3,000 long/short hedge funds, the funds managed by firms with total assets under management (AUM) between $50 million and $500 million outperformed those run by larger firms over essentially every time period studied. And the amount of outperformance was significant — 2.54% per year over five years, and 2.20% per year over ten years, with the outperformance concentrated in the years immediately preceding and following the financial crisis of 2009. Risk measures were roughly the same for the different types of firms, so the outperformance can’t be explained by greater risk-taking. And while “dispersion” measures were greater among the smaller advisors — meaning that returns varied more for smaller firms than for larger ones — the overall difference in performance is too large to be ignored. These findings run counter to what much industry research might predict. Whether at hedge funds or at investment advisory firms, scale is generally expected to improve purchasing power, and to allow for access to a broader range of investment vehicles (like certain swaps and derivatives or other over-the-counter products that smaller firms simply can’t access via their existing custodial channels). If nothing else, size is supposed to improve the terms that managers are able to negotiate, whether via lower commissions or fees or via improved investor protections in potential bankruptcies or other corporate restructurings. And yet, intuition aside, these benefits of scale simply don’t seem to be flowing through to the bottom line, for the firms or their investors. Beachhead presented a number of potential explanations for the disparity, a few of which I’ll paraphrase here. Some investments don’t benefit from scale Contrary to conventional wisdom, bigger isn’t always better in the markets; sometimes, size can be a limiting factor, constricting the types of investments that a firm can realistically add to its portfolio. Take the case of the Harvard Management Company, the group tasked with managing Harvard University’s sizeable endowment . For years, HMC’s investment performance was top-notch, consistently beating its peers as its talented managers consistently generated high double-digit annual returns. But as HMC’s portfolio continued to grow, it found itself running out of viable places to put all of its money. In many markets, they had already become the single largest owner of available shares, and to increase the size of their stakes in those investments would impede their ability to exit (or trim) those positions in the future. In some markets, HMC had effectively become the market, simply by virtue of its size. Funds (or managers) in that position are left with two basic options: either begin to branch out into ever more esoteric investments and asset classes, or else pile into the so-called “hedge fund hotels” , those few investment vehicles that have the opportunity for outsized gains, but are also large and liquid enough to accept massive inflows of capital without enduring wild market-moving price shifts. Neither option is particularly attractive, from the investment manager’s point of view. Choosing the “esoteric investments” route often means accepting significantly less liquidity (and an attendant increase in volatility), which tends to limit flexibility while also exacerbating the impact of downturns on fund returns. Indeed, this is exactly what happened to HMC during the 2009 financial crisis, a dynamic that led to a reconsideration of overall investment strategy. But the “hedge fund hotel” route is similarly problematic: for one, how can a fund distinguish itself from its peers when all funds own the same investments? Wouldn’t larger firms then, by definition, simply trend toward standard “average” market performance over time? And, perhaps more concerningly, what happens when a majority of the large funds all run for the “hotel” exits at the same time? At best, the fund is, again, forced to endure greater portfolio volatility, and at worst, the managers are trampled like so many young men in Pamplona . The fact is some investment opportunities are small enough that only a small advisor can really avail itself of the benefits — the market for the investment could be so limited that the large manager’s entrance would simply overwhelm the market and thus eliminate any mispricing opportunity. Even if the large fund were successful in its trade, the gross size of the gain might be so small as to barely impact total fund returns. Think of the old parable of Bill Gates stooping down to pick up a 100 dollar bill (or a mythical 45,000 dollar bill ) — reaching down to pick up that $100 would have little to no impact on his net worth, and it might even be a complete waste of his time to bother with picking it up. For a panhandler, though (or a poor college student, or me or you), that $100 would make a meaningful impact on our bottom line. The same holds true in the markets: sometimes, the available opportunity in a specific investment is limited to a set dollar amount, an amount that will certainly help improve small manager returns, but that would have little to no measurable impact on the returns of the larger fund. Beachhead refers to this dynamic as the “broader opportunity set” dynamic, and it is very real. If it weren’t, then “hedge fund hotels” would never have existed in the first place. As it stands, the larger you get, the fewer markets (or opportunities) you can find that are large and liquid enough to accommodate your increased size. Hence, in some markets, smaller advisors are at an inherent advantage in terms of percentage performance. The “talent” gap It’s generally assumed that the most talented managers will be enticed to work at the largest firms, since those firms have the greatest resources and opportunities, enabling young and talented advisors to thrive and become rich. However, there’s a counter-narrative in play that makes at least as much sense. If you’re truly talented, and capable of generating outsized returns, why would you want to sell that skill off, enabling a large corporation to profit from your work? Wouldn’t you be better off launching your own firm, so as to profit off of your own work, rather than counting on your boss (or a board of directors) to determine your ultimate compensation? Indeed, there’s an argument to be made that smaller advisors represent a specific type of self-selection: only those advisors who are very confident in their ability to survive on their own will even bother to break away and start their own operation. Yes, they’ll be smaller by definition, but their talent and ability to generate returns for investors will be unaffected by a switch in the logo on their business card. As demonstrated above, the advisors might even be able to open up their investment opportunity set by doing so. Arguably, those who choose to work at the largest firms (and stay there for the long run) are simply those who crave the stability and comfort that those firms provide or promise. Particularly for the millennial generation, there seems to be a trend toward entrepreneurship and betting on oneself , and that trend impacts the investment advisory industry as well. If you’re an investor, do you want to hire the manager who needs (or who thinks he needs) a big brand name in order to succeed, or one who trusts in his ability to swim on his own, even without the resources and advantages that the larger firm provides? That remains an open question, but the evidence is beginning to mount in favor of the smaller firm. The importance of each individual client One dynamic that Beachhead does not mention, but that may be particularly important for those looking to choose an investment manager, is what I will call the “burning platform” issue. At a large firm, complacency can often be a very powerful force. For the big wirehouse brokerages, a sudden loss of 1 or 2 or clients (or even, say, 5-10% of clients) may not be meaningful enough to really impact the bottom line over the long run. Sure, a few layoffs and restructurings might result, but the viability of the business is rarely threatened. At smaller firms, though, the experience and importance of each individual client is amplified. A period of sustained underperformance that leads to client attrition could , in fact, threaten the long-term viability of the firm, as well as the paychecks of the managers in question. The closer a manager is to the end user — and the greater the importance of each individual client — the less room for complacency and apathy there will be. At smaller firms, there’s simply less room for ignorance of client needs — you either perform or you’re history, generally speaking. At the end of the day, while we all might derive some comfort from size, research shows that betting on smaller managers can often be a savvy move. Ultimately, brand names are little more than a signalling mechanism — “we’re safe, we’ve been vetted,” say the big brands. You can trust them, they’d argue, because their size indicates that many others have (presumably) done their research and chosen to work with them already. 50 million Elvis fans can’t be wrong , right? Thus, when we blindly choose to work with the big brand name, what we’re effectively doing is outsourcing our due diligence to others. Instead of choosing to learn about the firms or managers in question, we simply rely on the brand name to protect us, because it’s the seemingly “safe” play. Increasingly, that approach doesn’t hold water. As an investor, take it upon yourself to learn more about the actual services that are offered, the actual philosophies that guide different offerings, and really get to know the diversity of service offerings. All of the various industry players have different strengths and weaknesses, the relative merits of which may or may not be important to you; don’t assume that the big guy has exactly what you want and need just because they’re big. In reality, it’s rarely the case. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: The author is a contract employee and partial owner of myFinancialAnswers.com, and he is compensated to provide industry commentary for the site. The opinions provided here may also be published at myFinancialAnswers.com.
Protection Always Beats Prediction: The Un-Beta Portfolio – Part II
I can’t say if we are in a bear rally or, after 7 years, phhht, that was all the correction we got before heading off to the races again. But since I don’t know, I’m very happy with our Un-Beta Portfolio. In my last article, here , introducing this portfolio, I noted that for a generation now, a little more than 70% of the total market return has come from dividend income. Some might say, “Yeah, but didn’t people who invested that way miss the big moves?” First of all, what is a “yabbit” and second, yes, the massive rise from April 1997- Dec 1999 skewed the capital returns to the upside – but the 2000 to mid-2002 decline took 100% of the rise back again! Ditto for the rise from mid-2002 until the spring of 2007; all that and more was lost by March 2009. (By the way, if Un-Beta has a familiar ring to it, readers of a certain age may recall my inspiration for this title: back in the ’70s, Geoffrey Holder, the Tony Award-winning actor, dancer, choreographer, painter and singer, pitched “The Un-Cola” for 7-Up, to distinguish its clean, refreshing, unadorned taste with all the other colored, flavored, more complicated colas out there.) It “seems” to me, now that we have had 7 good years of good market (certainly prolonged by Fed intervention, stock buybacks at ever higher prices, and a proliferation of pro forma rather than GAAP earnings reporting) that we are likely to see another decline. But no matter how many gurus tell you they “know” what the market will do, no one really knows. So mine is not a prediction, nor do I invest with the certainty “it must go up” or the certainty that “it must go down!” So I put my money, and that of our clients, where there is some certainty in an uncertain situation. I look to form the base of my investing pyramid by placing 50% or so in fixed income. That doesn’t mean bonds necessarily, though I’m happy to use them where appropriate. And it doesn’t mean we have a static portfolio; one must always fine-tune as a better opportunity to increase yield or raise quality comes along. In my last article, I mentioned some of my favored foreign and US bond funds and closed-end funds; municipal funds, closed-end funds and ETFs; and specific preferred shares, all of which we purchased below par and all of which, thanks to the Fed’s unwillingness to stick to its charter of keeping employment high and inflation under control (in favor of goosing the markets to the detriment of savers!), have roared ahead just like common stocks. All these form the base of a very solid investing pyramid. If you’d like to review some of these for your own due diligence, I refer you to that article. The next level up on our pyramid are dividend-paying real estate investment trusts (REITs) and a select few dividend-paying common stocks. Again, I must caution: these are not static positions! The asset classes themselves are a constant in our “protect, don’t predict” Un-Beta Portfolio but there are many different types of REITs, some of which do best in certain market environments, some of which do poorly. This situation is always fluid so I watch these like a hawk and do my best to stay on top of the game by sliding into the up-and-comers and out of the overbought or likely to underperform areas. For instance, with an improving economy, many investors have concluded that business travel will pick up again and with cheap gas, more vacationers will travel this year. But others are concerned that Airbnb (Private: AIRB ) will make a serious dent in the hotel business and that the USD is still too strong to encourage tourists to visit the US. I tend to come down on the former side. So do at least some others. Lodging firm Starwood (NYSE: HOT ), the non-REIT parent of among others, St. Regis, The Luxury Collection, W, Westin, Le Méridien, Sheraton, and Four Point hotels, is currently mulling two competing takeover bids. The dollar is 3% cheaper this month than last and I believe Airbnb is enjoying the first flush of victory but without any real competition. If their business model proves a success, it will beget competitors and sooner or later quality will suffer. Plus, there are a very large number of business travelers who don’t want “unique!” “cozy!” or “friendly neighbors!” They are there to get work done and they want privacy, quiet, certain amenities like WiFi that absolutely must work, and above all – no surprises. Add to these folks like me who are happy to experience the unusual or unique when traveling but, on balance, if on a road trip, I want to accrue loyalty points and have dependable quality since I’m just passing through. I can stay at the Hampton Inns and Hyatt Places that are located along the way, in smaller towns where there is no Airbnb option and, by accruing those loyalty points, stay where I prefer in London, Paris or New York, where there are lots of Airbnb choices. I know some of the Airbnb homes can be quite nice. I just saw photographs of the $10,000 Airbnb home that Beyonce and (separately) Justin Bieber stayed at in Los Altos, CA. 5 bedrooms, infinity pool, 11 acres with an orchard, etc. Of course, pandering to celebrity, high sport these days, Airbnb picks up the tab for numerous celebrities in order to get the biggest bang for their marketing dollar. “As a hospitality company that embraces hosting, we work with a number of celebrities and often pick up the tab for their stays,” Airbnb said. Since I’m pretty certain Airbnb is not going to invite thee and me to enjoy such earthly delights, I’ll use my accrued points to stay for the same price – free – at the Bangkok Hilton, the Grand Hyatt Hong Kong, the Singapore Conrad, the (Hyatt) Hotel Madeleine in Paris or the (Hyatt) Hotel Churchill, don’tcha know, when in London. I don’t need 5 bedrooms, and the infinity pool at the Bangkok Hilton is sized just right – for two. Among the lodging REITs I like best is Ashford Hospitality Prime (NYSE: AHP ). Their properties tend to be high-end so Airbnb or a strong dollar are unlikely to deter guests who like to be pampered at properties like the Pier House in Key West (just down the road from my own version of Airbnb, our lower Keys vacation home we rent when not there), the Bardessono Hotel and Spa in Napa, the Water Tower Sofitel in Chicago or the Ritz-Carlton in Saint Thomas. AHP carries a higher debt load than most of its competitors and does not compare as well in ROA, ROE or operating margins. It doesn’t even pay as good a dividend. In other words, management just doesn’t seem to be on the ball. On the other hand, all this is already reflected in the price – it’s only a couple points off its 52-week low – and the activists are circling. The company’s second-largest holder, Sessa Capital, is currently trying to get board representation to get this company’s management moving. Two other lodging REITs I am reviewing for possible inclusion in client portfolios are the much larger, better capitalized and better managed LaSalle Hotel Properties (NYSE: LHO ) and Host Hotels and Resorts (NYSE: HST ). I am also a fan of most health care REITs. It’s true that health care is down right now, having participated only weakly in the recent (thus far) short rally. But whether the Feds decide to penalize the health care industry even more than Obamacare already has or not, people are still going to age and they are still going to get sick. We may have no doctors left to treat them (my little town here at Lake Tahoe had 4 two years ago; 3 shut down their practice, citing the fact that Obamacare forces them to pay more attention to the clock than their patients!) but if we do, they’ll need clinics and offices and hospitals. Our clients own three REITs that specialize in such medical office and treatment buildings: Physicians Realty Trust (NYSE: DOC ), Healthcare Realty Trust (NYSE: HR ), and Healthcare Trust of America (NYSE: HTA ). We also own some REITs that specialize in gerontological care and accommodations. Before my mom’s Alzheimer’s became so bad she needed special care, she had her own private apartment in such a facility, with common meals, many activities, and nurses on staff and doctors on call for any medical issues. This piqued my interest, so early on I researched and bought Ventas (NYSE: VTR ), LTC Properties (NYSE: LTC ), Welltower (NYSE: HCN ), Omega Healthcare (NYSE: OHI ) and National Health (NYSE: NHI ). I could go into a long discourse on each but here’s a better idea. I am indebted to Brad Thomas , editor of the Forbes Real Estate Investor, for the latest research and opinion on many REITs, these among them. I’m not vain enough to claim every idea is my own or all my research is seminal; no one has a lock on all the good ideas. So I would suggest that you Google his name and affiliation for more on these and other fine REITs. (Brad is also a frequent contributor to Seeking Alpha.) Finally – except for our cash position, some special situations particularly in energy, and a few short hedges, which I may discuss in a future article – we come to our flexible funds, long/short funds and managed futures funds. In the interest of time and tide, I will go into them in greater depth in my very next article, but for now know that this part of our Un-Beta Portfolio is critical. These are the holdings that allow us to move up with the market but cushion us, to varying degrees, when it declines. There are ETFs for all these strategies but, frankly, the sharpest talent in most of them are the active managers in mutual funds. This is nowhere more evident than in the flexible portfolio arena where two Leuthold funds, Core (MUTF: LCORX ) and Global (MUTF: GLBLX ) rise to the top. Others of note in this niche or the closely-aligned mixed asset target allocation area are Vanguard Wellesley (MUTF: VWINX ), Ridgeworth Conservative Allocation (MUTF: SCCTX ) and Hartford Balanced Income (MUTF: HBLAX ). I recommend all of these for your own due diligence. Rounding out the rest of the long-bias, but still long classic long/short playing field, are my three favorite true long/short funds, Boston Partners Long/ Short Research (MUTF: BPRRX ), and Global Long/Short (MUTF: BGRSX ) as well as AQR Long/Short Equity (MUTF: QLEIX ). And I like the managed futures funds from AQR as well, both AQR Managed Futures (MUTF: AQMIX ) and its close cousin AQR Equity Market Neutral (MUTF: QMNIX ). Warning! All classes of the AQR funds are available if you work with a Registered Investment Advisor (and maybe other types of financial advisors as well); go to them on your own, however, and the minimum purchase is from $1 million to $5 million! If that’s not your cup of tea, then you might take a look at QuantShares US Market Neutral (NYSEARCA: BTAL ), an ETF with just enough volume to meet our minimum threshold for liquidity. I’ve tried to give the view from 30,000 feet in these two articles about the content of our Un-Beta Portfolio. I promise to provide much more in depth now that the broad outlines are out there for everyone to see, criticize, mimic or simply use in your own portfolio strategy or for your own further due diligence! Disclaimer: As a Registered Investment Advisor, I believe it is essential to advise that I do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as “personalized” investment advice . Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund one year only to watch it plummet the following year. I encourage you to do your own due diligence on issues I discuss to see if they might be of value in your own investing. I take my responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities my clients or family are investing in will always be profitable. I do our best to get it right, and our firm “eats our own cooking,” but I could be wrong, hence my full disclosure as to whether we or our clients own or are buying the investments we write about. Disclosure: I am/we are long AHP, DOC, HTR, VTR, HCN, NHI, LCORX, GLBLX, BPRRX, BGRSX, AQMIX, BTAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.