The Investor's Consigliere

Charlie Munger Slate Essay

Charles Munger of Berkshire Hathway writes a sobering parable.  This may be the main disagreement between him and Warren Buffett.

Disclosure: Long Berkshire Hathaway.

David Swensen Lunch with the Financial Times

Read it here.  Here is Swensen's distillation of the process of money manager selection:

Swensen says his criteria for selecting outside money managers are simple: “The most important thing is character and the quality of people. That’s also the second most important thing and the third most important thing. It’s everything.” Assessing character involves such deep background checks that, says Swensen, “Some of our managers will tease us about having tracked down their high school geometry teacher.”

Such basic research would have protected investors from the convicted fraudster Bernie Madoff, Swensen says: “If you sat down and had a conversation with him about his investment activities and couldn’t figure out that he was being evasive, shame on you.”

David Swensen vs. Funds of Funds: The FoF Strikes Back (and the Consigliere Decides!)

In January I linked to a WSJ interview with David Swensen in which he attacked hedge funds of funds.  Here is the relevant excerpt:

Mr. Swensen: Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can't make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There's also more fees on top of existing fees. And the best managers don't want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers. [Mr.] Madoff also relied enormously on these intermediaries. He wouldn't have had nearly as much resources were it not for fund of funds.

In last Monday's FT, Paul Isaac, the CIO of fund of funds company Cadogan Management, answered Swensen's accusations.  Cadogan has a good track record, and a reputation for being a "non-mainstream" FoF company, down to its choice of office location near the Flatiron building.  When the Madoff news hit, Cadogan put out a statement that it had successfully avoided any exposure, something many of its peers did not do (avoid exposure I mean, not put out a release). Isaac spoke at the 2003 Grant's Spring Conference, so he is a legitimate spokesman for his industry, not just any geek off the street.

Go read the Swensen interview, then read Isaac's rebuttal, then come back and we're going to have a little trial, with moi as judge and jury.  I used to evaluate litigation for a living (actually I was the guy who helped the guy who evaluated litigation for a living) so I'm a trained professional at this, sort of.

Oh, I almost forgot: I went to Yale and am a proud alumnus, consider Swensen my manager selector role model, and, um, I interviewed at Cadogan once, with an emphasis on the "once."  So think of me as the uglier version of this guy.  If this were any state except New Jersey, I'd no doubt have to recuse myself from this trial.  Fortunately, I happen to be from New Jersey.   So let's begin:

First let's summarize Swensen's case against funds of funds.  FoFs are a cancer because :

1)  They facilitate the flow of ignorant capital, as unsophisticated investors who can't pick managers themselves cannot pick manager selectors either.

2)  They charge an extra layer of fees and deliver nothing in return for it.

3)  Fund of fund money is unreliable, therefore the best hedge fund managers don't want it, and you can't be successful investing in hedge funds unless you invest in the best.

Issac does not address these assertions in order.  Instead his first rebuttal one is a clever one:

It cannot be funds of funds per se to which Mr Swensen objects. He runs one. A large endowment like Yale maintains a sizeable professional staff to research, vet, select and monitor the endowment’s investment in a number of hedge funds comparable to a FoHF portfolio. Yale reportedly is unusually successful in demanding transparency, negotiating fees and selecting managers. It does so while incurring relatively low expenses at the university level. That Yale does so well is an argument for FoHFs.

Yes, but . . . we need first to define our terms (it's remarkable how many legal battles turn on differing definitions of a single term).  Per Isaac, a fund of funds is simply a pool of capital that maintains a staff to research, vet, select and monitor investments in a number of hedge funds.  By that definition, Yale's endowment is a fund of funds, as is Cadogan, as is a family office that invests in a number of hedge funds, etc. 

But is Isaac's definition of a "fund of funds" the same as Swensen's?  No it is not.  Let's go to Swensen's own words on the subject, from pages 309-310 of the new edition of Pioneering Portfolio Management. This section of the book is called "USE OF INTERMEDIARIES," and the relevant excerpt is as follows (my emphasis added):

In an effort to pursue an active management program without committing the required time, energy, and resources, many institutions take the shortcut of using a fund of funds or consultant.  Unfortunately, the use of external agents (instead of an internal investment team) leads down a path to suboptimal results, as the interests of the fund of funds manager or investment consultant inevitably diverge from the interests of the institutional investor . . .

Fund of funds managers provide the service of making investment decisions for fiduciaries.  By pooling assets, usually from less sophisticated investors, fund of funds managers argue that economies of scale allow professional staff to manage monies in institutional fashion . . .

In spite of the purported benefits from employing fund of funds managers, substantial risks stem from imposing a filter between the investment manager and the ultimate client . . . Clients unable or unwilling to understand the underlying manager characteristics rely solely on performance to evaluate investment strategies.

Isaac's definition of a fund of funds turns on WHAT it does.  Swensen's definition turns on FOR WHOM and WHY it does it.  Per Swensen, a FoF is defined by its role as agent, a paid intermediary that performs a task (manager selection) on behalf of a principal (an investment fiduciary) who is unwilling or unable to do it by itself.  By Swensen's definition, Yale's endowment is not a fund of funds, as Yale performs manager selection entirely in-house, without the use of any agents, and commits substantial time, energy and resources to do so.  Cadogan, on the other hand, most certainly is.  When you and I and the world think of what a fund of funds is, we think of the Swensen definition, not the Isaac definition.  All of Swensen's problems with FoFs stem from his (and our) definition of it as an agent, so Isaac creates a straw man by creating his own definition.  

Round 1 to Swensen.

Isaac's next argument is that hedge funds of funds can add substantial value to their end-clients:

Although Mr Swensen has a laudable track record, it is unlikely his team is the only one to have added value over the past couple of decades. In fact, as a substitute for equity investments over the past 10 years, the HFRI Composite FoHF Index has performed remarkably well, returning 5.4 per cent a year versus a return of -1.4 per cent for the S&P 500, with a volatility of 6.2 per cent versus 15.1 per cent for the S&P 500.

Those "remarkable" numbers certainly sing a seductive siren song, don't they?  But tie yourself to the mast and let your consigliere set you right:

1)  Isaac's second sentence is a non-sequitur.  Extrapolating from Swensen's common-sense definition, a fund of funds adds value not by outperforming equity markets via investment in hedge funds.  A fund of funds adds value by outperforming (after fees) what a fiduciary could do on its own by investing in hedge funds directly.  Isaac is arguing the wrong thing. 

2)  Isaac errs by invoking an INDEX of FoFs to justify the ACTIVE investment fund of funds industry.  That such a thing as the HFRI Composite FoHF Index even exists is strong evidence that it's possible for a fiduciary to construct a hedge fund portfolio WITHOUT having to pay an intermediary a lot of money to do it for you, and belies Isaac's claim that "index investments in alpha generating strategies are in their infancy and have yet to prove themselves".  Just do your best to replicate the index.  You won't do it perfectly, but you don't have to in order to benefit from saving 1 and 10.  What Isaac should have argued is that there are many funds of funds like Cadogan that add value by exceeding the performance of the index.  That he did not is telling.  That Yale does (see page 23 of the pdf, aka page 21 of the report) is also telling.

Round 2 to Swensen.

Isaac's next two arguments concern Madoff.  Here is the first one:

Contrary to Mr Swensen’s insinuation, the Madoff scandal is remarkable for how many FoHFs consciously rejected investing in Madoff for all the right reasons.

I believe the legal term for this argument is "WTF?"  Given what they charged and their purported expertise, the correct number of funds of funds that should have invested in Madoff is precisely zero.  The correct number of "quality" funds of funds should have been less than zero--they should have led the fight to unmask him.  The actual number was way higher than zero, AND included some of the leading names in the industry (Bramdean, Fairfield Greenwich, Maxam, UBP, EIM, Merkin, etc.). I can't see how the fund of funds industry distinguished itself in the Madoff affair.  I can only see the opposite.

Round 3 to Swensen. 

Here is the second Madoff-related argument:

Ironically, in the post-Madoff age, the FoHF has become an even more important tool for institutional investors. Many institutions cannot afford to put themselves in the spotlight by selecting a specific hedge fund that might in the future have public difficulties.  A FoHF investment represents a diversification tool and a layer of protection for the reputation of the institution.

Several things come to mind when I consider this argument.  I could, for instance, recall how many Jewish/Chinese/Armenian/etc. tax collectors died at the hands of angry peasants while providing a layer of protection for the reputation for the rulers who were reluctant to put themselves in the spotlight by collecting taxes directly.  I could even point out how the Pharisees of Judaea were an important tool for their Roman overlords who could not afford to put themselves in the spotlight and required a layer of protection for their reputations when it came to dealing with a certain itinerant rabble rouser.  But I won't, because I'm not an expert in those subjects and am sure to say something incorrect.  It will suffice simply to point out that you should always look through, and that the imposition of a middleman does not absolve an investor of any of its fiduciary or ethical obligations. 

Round 4 to Swensen.

How does Isaac respond to Swensen's assertion that FoFs represent unreliable capital, and that therefore the best hedge fund managers shun them?  He responds as follows:

While it is axiomatic a FoHF portfolio wants the “best” hedge fund managers, the goal is to construct a portfolio that will give investors the greatest likelihood of reaching a return goal with limited volatility.

There is no common definition of a “best” hedge fund. Certainly, more than 10 per cent of all managers can be potential parts of a given portfolio when the goal, and not just the components, define the objective. The ability to substitute managers, rather than being wedded to an underlying manager, can be useful for FoHF managers seeking to represent their investors’ interests.

Isaac is correct that FoF managers should be judged on their portfolios as a whole rather on the the performance of their component parts, and that theoretically it's possible for a hedge fund portfolio that consists of less-than-top-decile funds to combine in such a way as to produce an attractive portfolio return.  But the combination of the typical 2 and 20 charged by the underlying hedge fund, and the typical 1 and 20 charged by the FoF, makes it almost impossible for the end user to get a value-added product unless both layers are in the top tier of what they do.

Round 5 is a tie.

Regarding Swensen's assertion that fund of funds fees are unjustified, Isaac correctly points out that "the fees charges by FoHF's vary," and that "They key is to find value for fees paid."  I believe Swensen would reply that empirically, most FoFs fail to provide value for money.  2008 is good evidence for that.  It's hard enough to beat the market via direct active investing; doing it via an extra layer of fees is even harder.  Also, it's generally true that the lower the fee charged by a FoF, the more closely it resembles one of the "index investments in alpha generating strategies" that Isaac derides.

Round 6 goes to Swensen on points.

Finally, as the recipient of a Jesuit education (thank you Dr. Stewart!), as the descendant of a distinguished family of talmudic scholars, as a former copy editor, and as an admirer of George Orwell, I must point out this example of Mr. Isaac's tortured language:

The idea that no one but Mr Swensen should invest in only passive vehicles is condescending and limiting.

Strip out all the double negatives and you'll find that Isaac meant the opposite of what is written, i.e. the idea that only Mr. Swensen should invest in active vehicles is condescending and limiting.  Giving Isaac the benefit of the doubt that the sentence was just a typo, it still misstates Swensen's position.  Swensen's position is that those who wish to invest in active vehicles should not hire agents to do so on their behalf, but rather must devote the time, energy and resources to do it themselves.  Be a principal, not an agent.

Final round to Swensen. 

Overall verdict: David Swensen.  Go Bulldogs.

P.S.  In a future post I hope to play devil's advocate regarding Swensen and his record.  Is it really as good as his drooling idolators (I'm wiping my mouth as I write) assume?  Stay tuned. 

  

David Swensen Interview in the Yale Alumni Magazine

Read it here.

I find the blue sidebar on the right a little ironic:  The Editor's Note warns the reader "If you need investment advice, please consult a registered adviser."  Meanwhile, in the body of the article Swensen rails against the retail investment advice-giving industry.

Also note that while Swensen correctly states that asset allocation is the most important factor in determining investment returns for the average investor, it is not the most important factor in Swensen's own stellar record.  According to a 2003 Harvard Business study by Josh Lerner, cited in this Fortune article, "manager selection accounted for more than half the superior performance by Yale relative to the average endowment over the last five years."

David Swensen ProPublica Interview

Read it here.

David Swensen Lecture

On YouTube.

He makes an interesting point starting a little before the 17-minute mark:  If equities and equity-like investments are the correct choice for endowments and others with very long time horizons--and Swensen pioneered the idea that they are--then why own safer cash-like assets at all?

The answer is not just to reduce the total risk of the portfolio, but also to enable risk in the rest of the portfolio.  It's only by holding a liquid, cash-like reserve, sufficient in relation to expected expenses, that the investor is able to maintain its equity exposure through the "terribly adverse market conditions" that are inevitable when you hold risky assets.  Otherwise the investor will almost surely be forced to sell equities, either directly or on a look-through basis, at exactly the wrong time.

David Swensen Interview in the Financial Times

Read it here.

This is not a knock against Swensen, but it seems to me if an article reports Yale's 16.3% annualized return in the 10 years ended June 30, 2008, it should also report the endowment's subsequent 25% decline. 

A 10-year record of 16.3% followed by a 25% decline in year 11 produces a total 11-year annualized return of 11.8%.

David Swensen on Charlie Rose

Via Paul Kedrosky.

David Swensen Wall Street Journal Interview

As someone once said, RUN, DON'T WALK!!!!! to read this interview.  Here is a sampling (I didn't realize he is this blunt):

Mr. Swensen: Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can't make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There's also more fees on top of existing fees. And the best managers don't want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers. [Mr.] Madoff also relied enormously on these intermediaries. He wouldn't have had nearly as much resources were it not for fund of funds.

Consultants make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors . . .

Mr. Swensen: Distressed securities are one of the most interesting opportunities for institutional investors. But returns won't come right away because the credit markets are fundamentally broken. TIPS [Treasury-Inflation Protected Securities] are pretty attractively priced. They promise reasonable returns, and protection against inflation is really important. We may not see it in the next year or two, but the government's massive fiscal stimulus can't help but produce massive inflationary pressures. Stocks also look a lot more attractive than they have for a long time. We prefer higher-quality companies with low leverage.

My first thought after reading the interview was "I think David Swensen has been reading the Investor's Consigliere!!"

My second, and more accurate, thought was "I think the Investor's Consigliere has been reading David Swensen."  No matter: if you do what I do and try to emulate one person (and you can't hope to marry Uma Thurman)--he's the one to emulate.

David Swensen Interview

Via Bloomberg.

Update: Here is another recent interview from US News and World Report.

Double Update:  Here is a TV interview with Liz Claman.  It's very rare for him to appear on TV.  When it happens it can only mean one thing:  He is being forced to wants to promote his new book.