Invest Like the Best with Patrick O'Shaughnessy - Jeff Ptak – The Prospects for Active Management - [Invest Like the Best, EP.16]

Episode Date: December 20, 2016

Joining me on the podcast this week is Jeff Ptak, head of global manager research at Morningstar.  Jeff’s role puts him in the unique position to discuss the state of active management because he gets to see mutual funds from both the bottom-up, through deep diligence on investment strategies and firms, and top-down, using Morningstar’s data to assess industry-wide trends.  Jeff is one of my favorite myth busters and discuss different variables for assessing active managers and mutual funds, but we also cover his favorite punk rock bands.   Please enjoy!   For comprehensive show notes on this episode go to investorfieldguide.com/ptak/ For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

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The views expressed in this podcast do not necessarily represent the views of CFA Institute. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfield guide.com. Patrick O'Shaunisee is a principal and portfolio manager at O'Shaunicee Asset Management, all opinions expressed by Patrick and podcast guest. are solely their own opinions and do not reflect the opinion of Oshamacy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

Clients of O'Shaunossey Asset Management may maintain positions in the securities discussed in this podcast. My guest today is Jeff Patak. Jeff is the head of global manager research at Morningstar. This puts him in a unique position to discuss the state of active management because he gets to see mutual funds from both the bottom up through deep diligence on investment strategies and firms, and top down, using Morning Stars data to assess industry-wide trends. Jeff is one of my favorite myth busters, so be sure to check out a few of the articles he's written linked in the show notes,

which can be found at investorfieldguide.com forward slash Patak, which is P-T-A-K. But we spend most of our time discussing different variables for assessing active managers and mutual funds. We also cover his favorite punk rock bands. Please enjoy our conversation. Okay, Jeff, thank you very, very much for doing this with me today. I've always been envious of people in seats like yours where you have sort of this interesting top down and bottom up view of the asset management business, mutual funds, ETFs. And so maybe where we could start that would be interesting would be to hear what trends in kind of broadly speaking in the mutual fund and ETF space have your attention and interest today. Yeah, so first off, thanks Patrick for having me. It's a great pleasure.

to be able to join you and share our perspective. And so I would say that that's certainly the most prevalent trend that we're seeing right now. And this will be familiar, I think, to a number of your listeners, is the shift towards lower cost mediums for investment, most notably passive and specifically ETFs. And so it seems the tide is going out on active and the money is moving into passive, low-cost investments. And so we've seen a pretty significant shift in market share, you know, just focusing on the U.S. from active, I should say, into passive that is from higher cost investments into lower cost investments.

And so certainly that's something, you know, that we're focusing on. And, you know, but in a sense that that's a bit of a result of other forces that have swept the industry, you know, the opening up of platforms, the unbundling delivery of advice. investment solutions. You know, I think that that's, that's probably spurred the focus on cost, among other things. And that's one of the reasons why investors and those that are representing them have moved towards passive investment. So if there's one thing, that's probably the biggest one that's got our attention. Can we parse that a little bit more? Because everyone, obviously, is living and feeling the move that I would categorize, above all else, as high cost to low cost.

Obviously, that plays itself out a lot and flows into passive. But I'm curious, if there are specific pockets, you know, thinking in the Morningstar Style Box or different asset classes, where you've seen the most flight out of, let's say, active and or high cost and into passive. And if there are areas where you see less of it, where people seem to continue to believe in active management, at least more than other parts of the market. Yeah, that's an excellent question. So I would say that by far the biggest victim, if you want to call it that, or casualty has been large cap and large cap growth specifically. We've seen a very big shift of assets from those styles. And I'm speaking of

U.S. equity styles, large cap and large cap growth, that shifted into passive and Moss. And so a lot of that money has ended up in, say, total stock market, vanguard, or let's call them S&P 500 trackers. So that's an example where we've seen a real meaningful shift. I would say an area that's been a bit less vulnerable to the shift. You know, areas that are a bit less liquid, a bit less indexable, if you will. So good examples would be maybe fixed income, in particular, munis. You know, it's a harder area to index. And it's not quite as liquid as you know. And so we haven't seeing the same sort of wholesale shift there as we have in other areas. It seems obvious that the trend line towards low cost is secular and not something that will,

you know, stop or reverse or ebb and flow. But certainly there will be periods of active being more popular, and that would probably be exacerbated if the cost, the management fees and taxes, et cetera, after tax costs of active solutions come lower and lower. But what sort of catalyst do you think we might see to inspire one of those kind of rallies, if you will, a bear market rally of sorts, in flows to more active management? Yeah, so that's a great question. There's probably three cyclical factors that have been holding active funds back in particular,

especially here in the U.S., and I'm speaking of equity funds. The first is the nature of style leadership. the second is, let's call it market trend, so up versus down. And then the third, which is probably the most technical in nature is dispersion. I'll try to take those sort of briefly one by one. So style leadership, generally speaking, as an active manager, it's not in your favor when your subject style, so let's say I'm a large growth manager,

when my style is leading the way. And why is that? It's because the index to which, I'm compared tends to be more style pure than I am, and therefore it's going to outperform if that style is indeed outperforming. And that has been the case for the simple reason that large cap until relatively recently has been beating small cap and also growth has been beating value. And large cap managers, generally speaking, they are messy towards mid and small and towards value, assuming that they're clustering towards that upper right-hand corner of the

style back. So that's style leadership. Now, trend is probably the most straightforward. You know, generally speaking, we find that success rates for active are a bit higher in down markets than they are in up markets. Now, I think there's a bit of a fallacy which holds that active managers will save you you during a bare market. It's a reason to invest in active. I would probably be quick to disabuse investors of that. We could touch on that later. But we've been in, in a prolonged bull market that doesn't help active investors. And then the third thing that I mentioned, which is probably the most technical of all, is dispersion.

You know, let's just focus on styles. The returns to styles have been fairly tightly bunched. There hasn't been sort of this big spread between them. And so what that means is that if you're messy as an active manager or a different type of style, the payoff to you hasn't been as great as perhaps it's been in the past. And so if those three things reverse, style leadership, the nature of it changes. If we had a pullback in markets, a bear market even,

and if we saw a bigger dispersion between styles, I think those things are going to help active managers. And so that's not going to reverse things. It's not even necessarily going to arrest the shift towards passive, but it could slow it a bit and give active managers, you know, maybe their day in the sun again. You published a really interesting study looking at a group of funds starting in 2006, I believe, and then looking forward 10 years. And what you found was that just about 20% of surviving funds outperformed their reference benchmark, but only 8% of those same funds outperformed if you did it on a dollar-weighted basis.

So if you took investor timing decisions, which tend to be terrible, into account, that number is just about 1 in 12, which makes me think of the dumb and dumber Lloyd scene where he says, you know, so you're telling me there's a chance, even though it's infinitesimally small. So with that number in mind, which is a tough number for those out there trying to pick funds ahead of time, trying to position themselves in active funds, maybe not only that I've done well in the past and have good managers, but can stand to do well prospectively. I still want to touch on what your research suggests are important things to look at when evaluating an active manager. So maybe we could go through a list starting with,

with quantitative measures and then maybe getting into process and more qualitative measures of how you and your team evaluate fund managers. But if you had to list, you know, say three to five things that seem to matter for whether or not an active solution makes sense, what would those be? Yes, that's a great question. So I think at the top of my list, I would put fees. I know sort of what a somewhat on original pedestrian answer that is, given the shift towards low cost, but it is indeed very, very important.

We can get into why that is. But generally speaking, our research has found that, you know, the cheapest quintile of funds in a given category are about three times as likely to survive and succeed than the most expensive quintile of funds. That's the payoff that you get from choosing cheap active funds. I think the second thing that I would focus on is manager ownership of fund shares as well as manager tenure. Here, a manager experience is not a panacea.

We see plenty of experienced managers that have ho-hum results. Aren't all that talented. So that in and of itself is in a silver bullet. It can be reinforcing, though, when you see a manager who not only has been around for a while and plying his or her trade, but also eats his or her own cooking. I think it's a pretty defining gesture. It suggests that they really believe in what they're doing. So that's a second thing that I would look for.

for. A third thing that I would look for is, and this is a bit more technical and some people would think maybe it's obtuse, I do tend to focus with equity managers on turnover rate. This will depend a bit on the style. But with fundamental managers that have low turnover rates, that tends to tell me quite a bit about how they're wired, how their process works, before I even understand how they invest. So I focus on that as a third thing. Then maybe a fourth thing that I'll just throw in as sort of an overarching measure. I want to know something about the fund family concerned. Is it monoline?

Do they only focus on asset management or do they hail from maybe a diversified financial services firm that has a lot of different irons in the fire, you know, in which case the asset management division is just, you know, it falls underneath some big tent, right, with all the attendant risks and concerns. You know, either model can work, but I would say that there's probably, a bit more complexity and challenge involved with the second model. Those are four things that I would probably focus on and getting started and looking at a particular actively managed strategy, let's say.

Let's go a little bit deeper on a few of those. So starting with ownership. I've read studies certainly that, you know, a majority or an alarming number of active managers either don't have money in their own funds or the amount is relatively small. Are there some numbers or some kind of general sense that you could give us for you know, what levels you look for, how common it is for managers to have large investments in their own funds? Sure things.

So, you know, we will follow what's reported in the public filings and the top rung that's disclosed. And I'm going from memory here is, I believe, a million or more that's invested in a given fund. And do us, you know, that sends the strongest signal. We want to see managers that are making that sort of. of gesture, you know, sort of statement of confidence in their strategy. How many managers do this? Why can get you specific numbers? It's a clear minority of managers of funds that have managers that are investing at that level. So we're talking well below 50% of managers, of funds have a manager that is invested at that level. And why don't we see it more often? I would say there's a number

of sort of business and other sort of more humdrum reasons why we don't see it. In some cases, manager maybe is running a pot of money in a separately managed account in which perhaps they have an investment. In other cases, perhaps, they're in a jurisdiction where they invest the money, but they don't invest it in the jurisdiction in which it's being offered to you. And then in other cases, they don't care enough to invest their money in it. Maybe the fees are too high. Maybe there's another strategy that they run in-house that they believe more in. And, you know, in many cases, it boils down, unfortunately, to that. And so that's why we think it's important for managers to have some skin in the game to show it.

What about the firms behind the asset management firm itself? Is there a preference for, say, boutique or manager-owned firms relative to funds that are offered by, you know, much bigger fund families or much bigger asset managers? We're agnostic. So what you would find if you went through our ratings is that we heartily recommend funds from very large, diverse firms, and we just as heartily recommend funds from boutiques. There are different models. Each one has its own set of sort of challenges that attend to it. For instance, with a boutique, it's more difficult to attain scale, generational transfer, depth, breadth, continuity of a team, you know, can be issues that you want to focus on a bit more intently than you would perhaps

in a larger, deeper, broader, you know, more resourced firm. But with those large, firms, right, we talked about it earlier, you know, there's the risk of distraction. There isn't sort of the single-mindedness, perhaps, that you would have in a boutique model. Perhaps the manager doesn't feel the same sort of direct connection with the strategy here she is managing that they would in a boutique setting. And so I would say that sort of the diligence that you're going to have to perform in each of those cases is different. What about that idea of tenure? So it seems to me just intuitively that there would be some sort of sweet spot. that too long a tenure would probably mean that, you know, the person is closer to retirement

and the skill that they've brought to bear may not be around for the investing horizon that the investor is hoping to invest for. Is that true? Is it sort of like a diminishing return that you want longer tenure but not too long? I think that that's one of the paradoxes that you face, right? Because by the time that you can establish that a manager is skillful, you know, he or she maybe in the process of making plans for retirement. And so, you know, I think that that can speak to the advantages of team management. We've seen some firms, you know, Dodge and Cox comes to mind, capital research comes to mind, prime cap management comes to mind, where it's really more of a team motif. And so I think that mitigates some of the pressure of relying as much on a single investor.

perhaps, you know, perhaps is now, you know, long enough tenure that he or she is going to have to hand the baton off to a less senior, a less pedigree manager. And we've seen that sometimes that can be really messy. I mean, I think that probably the quintessential recent example of that is Third Avenue, you know, a very storied investment firm. I still admire that firm in a lot of ways, you know, but it's quite clear with the benefit of hindsight that when Marty Whitman, who is this, you know, legendary investor, still invest, to my knowledge. You know, when he handed that off to his protegees, it didn't go off well. They weren't able to sort of carry the torch. And obviously, that firm has run into significant struggle in recent years.

One of the things that we've noticed is sort of a rise in, I'll call it lumpiness of returns for different strategies that we monitor, that we manage. obviously we're factor-based, so we're always focused on the performance of individual factors relative to the overall market. But I love your research on this idea that winning funds very often look like losers, or in many cases,

some of the best funds over the very long term look terrible for long stretches. I'm hoping that you could use the Sequoia Fund because it's obviously a well-known, well-known manager, well-known story. Maybe give us a bit of background on that and how that fund,

exemplifies this idea that winners very often don't look like winners. Yeah, so I did a bit of research. This is some months back. And really, the impetus for this was a conversation that I had with a friend of mine who I much admire who's in the business. And his point was using Sequoia as an example. If a fund has languished as long as that fund has languished, they clearly have lost the touch. There's a problem there.

And so what I did was I delved in. And I looked at funds with. which, you know, were quite old, you know, had decades of track record under their belt, and had distinguished themselves. They actually had generated, I think, positive excess returns cumulatively versus their benchmark. And I took a look to see, you know, how much time, you know, they had underperformed their benchmark and amassing that sort of success. And what you commonly find is these funds that, you know, you would ordinarily say,

hey, these are success stories. they have beaten their benchmark over an extended period of time. They spent many, many years looking up at their benchmarks. Ten plus year periods, it was not uncommon for that to happen. And so, which brings us back to Sequoia, which is a fund that we recommend not quite as strongly as we did before. It ran into some of its recent problems with Valiant. But I think that's a firm that has a very ingrained discipline, a very research-intensive culture, an extremely committed and motivated group of managers, very knowledgeable group of managers at that,

I don't count them out. And certainly the fact that they've had the difficult run that they've had in the last 10, 15 years, I don't think it is disqualifying necessarily. It's among the reasons why we continue to recommend them. And I think there's perhaps a lesson that. That lesson is that we have to be very, very patient as investors in many cases and act with a great deal of resolve to have success in funds. And for many of us, that's too much to ask for, and for those of us, we should index rather than invest in active funds. The numbers are pretty shocking about how often sort of the base rates, if you will, for even the best top, let's call them top quintile performers by sorted by excess return, how often they have 10-year periods of underperformance. And it just goes to

show that, and you can do this a million different ways, even shorter periods of time, that you look back and you find the best funds and you can always find periods when they did really badly. And this adds to this problem of time weighted versus dollar weighted or investor returns that I'd love to dive into next. So Morning Star publishes what they call investor returns, which as far as I understand is just dollar weighted. I'd be curious to know kind of some high-level thoughts.

on how bad this gap tends to be, the behavior gap, if you will, and whether or not there are areas, specifically within equities, but maybe outside of equities too, where the behavior gap is lower. So are there characteristics of funds or ETFs that have, the investors in those have tended to behave better? Yeah, so maybe we'll start with target date funds, which I think are a success story in that regard. With target date funds, one of the things that we've observed is is positive gaps, believe it or not. And I would caution people not to read too much into it. I don't think that with target date funds, that there's something sort of inherently virtuous about them where people end up earning higher internal rates of return than the funds themselves.

The quirk here is that we had people that were steadily contributing sums to target date funds that were tilted towards equities in the midst of an equity bull market. And in generally speaking, are good facts. That's going to help you to generate a higher internal rate of return. You're going to earn more of the funds stated return. Why does this happen, though, generally speaking, why do we see these smaller gaps with asset allocation products, let's call them, of which target dates are one type? I think that part of it is situational. It's context. It's where they're offered, right? It's a more controlled environment, a defined contribution plan. Perhaps it's part of a broader advisory solution. Maybe you're getting some advice.

Maybe you don't have the benefit of choice. Perhaps it's regimented, right? You're auto contributing. It's set as a default. You don't really have to think about it. I think those are among the reasons why these types of strategies benefit investors in this way. The other reason is they're diversified. They rattle around a little bit less.

What we have found, generally speaking, is that the more an investment rattles around, the more likely it is to spook an investor, and the more it spooks an investor, the more likely they are to inopportunely time their purchases and sales. And so you take those things together, the situational with the more intrinsic, the fact that they're diversified. And I think that helps to explain why things like Target Date funds have worked a bit better for investors over time than say kind of your run-of-the-mill equity fund, let alone a sector fund, which are going to be streakier and investors are going to have a harder time using. So given how hard it is to find managers how wide the behavior gaps tend to be with people constantly chasing performance.

I know you have, I think, four kids. How will you tell them to invest, given all that you know, and, you know, the numbers which are disheartening to say the least in aggregate when you look at the success of investors picking active funds themselves, but then investors picking active funds. What will you tell your kids? Yeah, I would tell them unless they're willing to do the work, which is not insubstantial, as you know, they should index. And I think this holds for, you know, a pretty broad swath of investors. And this is a message that I've tried to hammer home in my own writings. If you're not

really willing to do the work to research up the funds and also if you don't feel like you've got the resolve that you're going to need to stick with funds in what can be some very uncomfortable on-nerving situations, then you're better off indexing. You're likely to achieve a better outcome. That's the first thing that I would tell them. The second thing that I would tell them is sort of hands off. I think the fewer actions you take, you know, trades you make, the better off, generally speaking, you tend to be. And certainly that's the way I invest. I trade very, very seldom. And what it really forces you to do, I think, if you're making some active investing decisions, you have to act with a great deal of forethought. You've got to do your whole.

homework up front, you know, knowing that I wouldn't say that it's an irrevocable decision that you're making, but it's going to be enforced for some time and you're going to have to live with that. And so it's going to make it take it all the more seriously to begin with. So I tell my kids, if you're not going to do the work, index, and if you are intent on doing it, make sure that you can live with that decision for years on end so you don't have to trade, which is something that ultimately can hurt you. So if there's anyone in the world that does do the work, it's you on managers and and active funds of all types,

if I were to play a kind of a fun game with you and say, okay, you have to look forward, let's say 10 years, and you have two choices, and if you win, you win some huge prize, $5 million.

You get to either just buy either a target date fund or a simple equity index, or knowing what you know, and with your skill and experience evaluating managers, get to pick, let's say, five active managers within the, category, let's say the S&P as the benchmark, what would you do? Would you try to, do you think that

you, having done the work, could identify active managers worth, worth that bet ahead of time? Yeah, real good question. I think given the fact that success rates are as low as they are, and I'm a believer in mean reversion, I would probably take that second bet, which is to find five quality, actively invested funds, equity funds, and go with them. I think this has been a great run for passive funds, particularly U.S. large cap index funds in recent years. And I do think there's an opportunity for active managers, quality active managers that don't charge too much, that don't overtrade, that apply a prudent strategy to make hay. And so that's how I would commit my capital. So if you're picking those five, obviously we've talked about some of the

things that would factor into your decision, lower fees, probably lower turnover, skin in game for the managers, hopefully some tenure. Beyond those things, which are mostly, I guess you could measure all of those things quantitatively, what would then be, if any, qualitative aspects of your evaluation? What things are you looking for in a manager's process or any other considerations that you think are important for deciding on what makes a good active strategy? Sure thing. So I think that one of the most important things to me is demonstration of resolve. and maybe I'll go back to one of the earlier quantitative data points that I ticked off in that short list, which was turnover rate.

So the turnover rate in and of itself doesn't mean a whole lot. I think it's really taking the turnover rate and placing it into the broader context of the strategy to understand why a manager trade so infrequently. That's what really can yield some insights into how it is they think about markets and opportunities. You know, when we think of some of the most fabled investors, you know, one of the lessons that they've tried to inculcate in, those of us who follow them is that, you know, it's not action that's important. In many cases, it's inaction, right? It's really, it's acting with resolve, avoiding making big mistakes. And when you

see your opportunity, you sees it. And I'm not saying that a low turnover manager, a manager who trades infrequently exemplifies those qualities. But I think that there's, there's a greater likelihood that you're going to find some of those traits in them. Because again, they approach the investment process. you know, with a certain sense of irrevocability, that what they're putting in the portfolio is something that's going to have to stay in the portfolio, you know, for four, five years on end. And if that's the mindset that they have, they're going to be that much more careful. From there, right, that's when you're going to start to dive in and you're going to pick a name out of the portfolio. And you're going to ask them, why did you add this?

You know, what are some of the other things that you were looking for in it that gave it its moat? those sorts of questions that you would ask in order to sort of, you know, kind of put together a fundamental thesis that describes the manager strategy. But the turnover rate is to me something that's quite, quite important that I often go to when I'm looking at a manager. What do you think about the ideas of holding space and return space to active share and tracking error as useful or not useful measures of looking at a manager? How do you think about those two variables? Yeah, so I think that, I think they can be quite helpful in certain contexts. I would actually go back to our own star rating.

So I think that many people are probably familiar with the star rating that we put out. The star rating is based on funds past risk and load adjusted performance versus their category peers. And it's a quantitative data point. It's backwards looking. And so what we have repeatedly said is that it's a starting point for research. It's not start, middle, and end. it's not something that you should use exclusively. And I have the same sort of, I guess, outlook towards things like tracking error or active share. I think that they can be indicative,

but they're not defining. And so I don't think that I would look at, you know, two funds, one with perhaps, you know, a high active share and another one with maybe a middling active share, you know, and reach any conclusions. I think what it would do is it might help to guide my research. one of the things that probably people I think ought to be aware of, and AQR has done some nice research here, is that, you know, active share can be a bit of a quirky data point. It's quite, quite sensitive to the benchmark that's chosen. And so depending on which benchmark you choose, you can arrive at different sorts of active share numbers and that could lead you to different conclusions about the same security. So you do have to sweat the details a bit. But once I've got an active share number, you know, it can tell me a little something about how to manage. approaches, the investing craft, their opportunity set, how cognizant they are of their benchmark. And once I know that, then I can dig in a little bit deeper and understand how it is. Maybe they narrow down that opportunity set to arrive at a particular set of securities that ends up in the portfolio. So don't let it govern your diligence process. You know, let it maybe color,

inform it in a way and guide you in your research. One of the things that I think is useful about ActiveShare, which is, as you say, a complicated metric and certainly no panacea. It's not, it's not predictive from what we see of excess return. But one of the things that we see is if you adjust cost for active shares, you can find some interesting results. So what look like very low cost solutions can actually be quite high cost when you back out the percentage of the portfolio that's just exactly overlapped with, you know, now a virtually free total market fund, say, for example. And that a lot of the, and I'd like to get into what you think about factors and factor investing or smart beta.

But a lot of the smart beta solutions look relatively low cost but have very low active shares. And so when you back out what you're actually paying for what's different than a free benchmark or virtually free couple basis point benchmark, it's a lot more expensive. And that seems like an interesting use of active share that's pretty objective and clean beyond the more complicated, you know, choice of benchmark, predictive ability and so on. Does Morningstar have an opinion on that idea of kind of active cost? You know, we think that's a useful way to look at it. We haven't built that into our products or our data points yet. We do have active share, but we don't have an expense ratio that's adjusted, as you describe, for the level of effectiveness, if you will, within a portfolio.

But I think that's a perfectly valid way to look at things and try to derive a sense of the value that you are accruing as an investor. One resource that I would point out, we've got a wealth of information, the various tools that we make available to investors, our website, Morningstar Direct and alike. There is a website called ActiveShare. Info. I think you're probably familiar with it as well. One of the professors that popularized ActiveShare, I think, has developed this in partnership with an asset manager. And you can type in a ticker, and I believe at the bottom of the dashboard it shows you is an Active Share adjusted expense measure. So it's a way for somebody to go in there and sort of on the fly if they want to know, you know, this fund versus that fun, you know, when I adjust for its active share, what does it cost me?

You know, this is a way they can do it for free online. I don't have any affiliation with it, but it's kind of a useful site for those who are interested in it. Yeah, I've actually never heard of that. And one of the original authors of that paper was a Notre Dame guy. So I know the professor's behind it quite well. So that sounds like a useful resource. If you're thinking about from the manager side, what, and Mortystar writes a lot about moats at the company level, and I think actually publishes some sort of quantitative score for moats. But if you think about managers as having moats, can you describe what might allow an asset manager or a fund manager to build a moat around their business or process that you think can help them outperform in the future?

That's a great question. So maybe we'll focus on the most sort of prosaic and measurable, which is scale and the benefit that it confers to investors, which is cost advantage. You know, we haven't talked a lot about Vanguard at this point in the conversation, but, you know, they're really the quintessential example of returns to scale. They built a moat by virtue of the fact that they are organized. they're basically mutually owned by the funds and therefore the share holders of those funds. It's an at-cost model. It's very, very difficult to replicate that. So there's an example of a moat in investment management.

Now, how about some of the squishier, more qualitative things that one can do? So I think that you can inculcate a certain culture as an active manager within your firm around research, excellence around commitment to the shareholder. And what you can do in the course of that is attract the right type of client. I know that in some of your recent podcast episodes, you've spoken at some length about Seth Claremont, who in turn has written, I think at some length about the importance of having the right types of clients. Now, that's arguably a bit easier when you've got people that are maybe locked up a bit in an LP, whereas we're talking here about, you know, 40 Act daily liquidity vehicles and mutual funds. But we certainly have seen

examples of firms that have been able to succeed by, you know, practicing what they preach, doing so through thick and thin, and really making sure that the philosophy infuses, permeates every single thing that they do. And probably the best example I can think of that is dimensional. DFA, as many know it. That's the shorthand that's used. And so, you know, You won't go down to their headquarters and find a literal mode around it. But, you know, what they've been able to do is sort of propagate this philosophy and really inculcated amongst the advisors who make their products available to end clients. And they built a very durable franchise around it. I would also point to capital research is another example of a firm that I think has done a really good job of building a durable investment in research-intensive franchise.

that puts the investor at the center of what they do. You know, they're not a particularly flashy firm in a lot of ways. The funds don't trade a lot. They can be a bit quirky in the way they're constituted. They don't roll out new products, left, right and center. They really stick to what they do. But in the course of doing that, they built a following. They built a certain investing identity.

And that's one of the ways they've been able to achieve a certain level of scale. So moving from sort of the most prosaic and meta, measurable, that being scale and returns to scale to sort of things that are more cultural and squishy. I think those are examples of how you can build a moat around an investment management business. Now, the other thing that we haven't talked about is distribution. And certainly there's a moat that you can build that's predicated on distribution and the reach that your organization has. I can think of some organizations like Franklin Resources, for instance, that, you know, have a true global footprint. and this gives them the ability to sell into a number of different markets and verticals around the world.

And that's not something that you can easily replicate. And so there's something to that. There is a moat to that. I think for me, though, that's become a bit more commoditized as more firms has become global. And maybe it doesn't have the same sort of panache and appeal that it once did. Investors are now so cost conscious and so outcome focused that I don't know if they're necessarily as concerned about you being global, what they want to see is that you're conferring some benefit upon them, principally in the form of low cost.

This mention of distribution is interesting because, obviously, there's a tremendous amount of effort that goes into selling mutual funds, probably more effort into selling than research into buying. Are there strategies that you think are either effective and good in terms of how you distribute, that could be sales versus marketing? have there been firms in your experience that do it well or the right way that others might want to emulate? Yeah, definitely. So I think that a firm I mentioned them before, but I think that American funds has done a pretty effective job through the years.

And they've been under some pressure, especially in the ETF Passives age, really post-Global financial crisis. They've been under some pressure and dealing with redemptions. But I think they've done a pretty good job of helping their customers, who have been primarily advisors, to understand who they are as investors, what the value proposition is, you know, and really driving sort of that ethic through the way they introduce themselves to the market. So they're probably, you know, a good example of a firm that's leveraged their distribution in an effective way. I mentioned dimensional DFA before. I think that they've done a fantastic job of, you know, really sort of building this flock of advisors

that really subscribe deeply, fervently to what they do, and then bring that out to the market in a way that ensures that expectations aren't misaligned. Now, they're not perfect. You can see there's some of their products like their emerging markets value fund where the dollar-weighted returns and the total return of that particular fund last time I looked sharply diverged. And that's an indication that perhaps it's been misused. but on the whole, they've done, I think they've done a heck of a job of putting investors in their funds in a responsible way.

You know, and then I would also focus on, we haven't talked too much about the ETF firms. We've talked more about the mutual fund firms. But I think that Vanguard has done a phenomenal job of getting out and really building a following amongst advisors. They're really a phenomenon at this point within that market. I think it was dust sledding at first. You know, there was still a bit of a schism between them and advisors who perceive them as a threat in some ways. And not only have they overcome that, you know, now they have these advisors who are out there

who are fully subscribing to what they do. It's quite remarkable. They've done a great job, as has I shares. You know, I shares is, you know, was, you know, sort of one of the first great success stories, I would say, in the ETF market. and they continue to do a great job of reaching advisors and other institutions that use their products. They've got a number of distributors, wholesalers, distribution partners, who really seem to understand what makes them tick as a firm and what the value proposition is.

So that's probably four or five examples of firms that I think do a particularly effective job of kind of wedding who they are as investors, as investment organizations, you know, to how it is they present themselves at the point of sale. What's the most interesting manager that you've ever done research on? I'm glad you asked that question. I was thinking about that just this morning as I was coming into the office. I would say that the most instructive experience that I ever had with a manager was it was a manager I alluded to before Prime Cap Management. And so for those who are familiar with Vanguard Prime Cap, Vanguard Capital Opportunity, the Prime Cap Odyssey Funds, that's Prime Cap management. They're a Pasadena, California-based firm.

They really got their start. They were an offshoot from capital research. again, that's the advisor to the American funds. They split off some years ago, set up their own shop. I had the opportunity some years ago as a wet behind my ears analyst to cover them. And it was actually a pretty pivotal moment for them. They had just set up their own proprietary family of funds. They were in the process of, I think, doing some renegotiating with Vanguard for whom they

subadvised several funds. And they were also in the midst of a generational transfer all while carrying a tens of billions of dollars in assets. And I spent over a year with two of the partners there, Joel Freed and Al Mordecai, they couldn't have been more generous with their time. During that year plus, we spent a little bit of time talking about securities,

but we spent much, much more time talking about the way the firm work, how they think about capacity, how they think about generational transfer, how it is they inculcate their younger analysts and their up-and-coming portfolio managers in their philosophy incentives. It was just, you know, for a younger analyst who was more accustomed to trying to do holdings-based analysis and understand, you know, what performance attribution was, you know, sort of the more bricks and mortar of diligence, you know, having this kind of much more sort of encompassing

conversation about a firm and what makes it succeed, that was extremely valuable to me. So I owe a big debt of gratitude to the prime cap folks who were very, who were very, generous with their time. That was a great, great experience for me as an analyst. So how did they structure their incentives? I'm always fascinated with incentives basically predicting the future that how they're structured determines a lot of what happens in all walks of life. So what were there for their young analysts, for their, you know, how they, how they compensated people, et cetera. What, how did, what are some interesting ways that impressed you that they structured incentives? They're very long-term focus. They tie their incentives to longer-term measures. So whereas I think it's

typical in the industry to maybe look at a one, a three, maybe a five-year number. You know, with Prime Cap, they're looking much, much further out than that. So that's the first thing. The second thing is a number of the managers eat their own cooking. So there's a direct alignment with the shareholders. Very, very important again. The third thing that they do is they actually have the analysts run a sleeve of the portfolio. And so this is actually, this is something that I think Capital Revenue,

research is popularized to a certain degree. They do a similar sort of thing. But by allowing the analyst to run a sleeve of the portfolio alongside the PMs, you know, they have some skin in the game that way. And also they take some ownership for what goes into the portfolio. So, you know, you take those three things together, which any one of them individually would be somewhat unusual by sort of, you know, kind of run-of-the-mill investment management standards. You take the three of them together that's pretty powerful. One of the interesting ideas is trying to predict maybe the wrong word, but think about what active fees and even how they're structured is going to look like in the future, let's call it 10 years out. And whether or not there is an ideal

way to align the incentives of the manager who has to think about one performance and two gathering assets in the prevailing kind of asset-based fee paradigm that we live in now. And obviously gathering assets is largely about performance. So what do you think? think about that. One, what do you think it will look like? Do you think it'll just largely be the same 10 years hence where it'll be asset based? What do you think about performance fees? Just any thoughts on where we might be going, one where we might be going, but also what would be ideal? What could be ways that we could better align the active manager incentives with the investor? Yeah, another great question. So maybe sort of stepping back, trend in fees, this is not a heroic

forecast at all. Fees are coming down for active funds. I don't think there's any question about that. You know, we talked earlier about what it is that might give active managers a tailwind. They've been facing headwind. That's not going to change the inexorable decline in fees. When we looked at fund fees earlier this year, the average active weighted fee, or I should say asset weighted fee for funds with 61 basis points on an equal weighted basis. It was 117. basis points that if you focus on the top thousand share classes, it's around 64 basis points. And the top thousand share classes where you see about 75% of the AUM. You know, compare that to the going rate for, you know, sort of cheap equity market or cheap

fixed income market beta. I mean, there's still a pretty big gap there. And we see investors are showing no signs of slowing, you know, their migration towards passive. So I think fees are coming down. Now, the second part of your question, how is it that we square up incentives? How do we align those better? And I will tell you conceptually, if they feel like I've been a bit of a voice of the wilderness on this,

but I am actually a big fan of performance-based fees when properly structured. Now, I want to caveat that in Fortyac Mutual Funds, the way you set up a performance-based fee, it's fairly prescribed to you. It has to be a fulcrum fee, so there's a base fee. and then there's a fulcrum that sort of flaps around at the top of that. And typically, I find that's pretty limited in terms of what you can do to really truly incentivize a manager to focus on, say, long-term performance. And why is it?

It's because the base portion of the fee, which is fixed. And generally speaking, you're going to get it, you know, within a certain range over time, that dwarfs the fulcrum amount that you're going to get. So it really does not act as much, I think, of a molder of behavior, so to speak. But the concept of performance-based fee and getting away from the asset-based fee, I think that has to be a part of the future of investment management, especially if base fees, which I just quoted to you now, that's 64, I should say 61 basis points asset weighted. If those are coming down, as a managers are going to have to find another way to bring home the bacon, so to speak.

And so I think a performance-based fee is an equitable way for them to do that. You know, incidentally, this is not, you know, I'm answering this with my characteristic lack of brevity here, Patrick. But one of the thing that I would point out is, so I think that there are many things to quarrel with when it comes to hedge fund fee structures, which generally speaking are ridiculous. But I do like the fact that, you know, there's a pretty big performance-based component. Now, one would argue that when you're getting 2% per annum come hell or high water, you know, you're not going to have to worry too much about whether you get the other 20%, you know, of performance. But I would point out that when you do have a meaningful performance-based component, what it does do is, I think, make you a bit more thoughtful about your strategy's capacity.

And that gets back to sort of thoughtfully constructing a performance-based fee arrangement. If you do thoughtfully construct it and the performance of the strategy really is a meaningful input, into how it is you're compensated ultimately as a firm or as a manager, then you're going to be a whole lot more thoughtful about managing your capacity and you're going to shut the strategy off before Bloat sets in, which is not something that managers to this point have a really, truly impressive record of doing. Generally speaking, manager shuts strategies when it's too late, and bloat has already set in or soon will.

That's one of the reasons why we see mean reversion among, mutual funds. So I think if a performance-based fee can help managers can make them more disciplined about capacity management, that could be a big win for investors. You have a really interesting point about the idea of transparency, which in general has been viewed as a pure positive, that the more transparency, the better. Could you expand on that on why that may not be the case? Sure, and I have to tread carefully here just given the fact that my employer, I mean, And transparency is sort of an animating principle for us. The firm has been built on and I and others here, we believe strongly in it.

Have you said all of that, you know, I think that transparency is wonderful, having that look through being able to monitor. I mean, hack, our team wouldn't be able to do the work that it does without the transparency. It's afforded by managers and also through regulation. But it can hurt us, too. if we're too obsessive about looking at our portfolio and seeing how it's done over shorter periods of time. And this holds true not just for investors in the fund, but the PMs themselves. You know, we've heard, you know, figures as estimables, Warren Buffett. You know, kind of talk about this notion.

And I'm paraphrasing here that, you know, you should be prepared in making an investment for the stock market to close for some period of time starting tomorrow, say for five years, right? approach it with that level of seriousness. And again, to use that word irrevocability, right? You know, I think what he's getting at is being able to watch something sort of squiggle around on a screen is not really what counts. What counts is, you know, the forethought that goes into investment, doing your homework up front. Sure, checking occasionally, especially to rebalance, maybe in an annual basis.

But, you know, but don't use transparency in excess. right, where you're going to be getting yourself so worked up that you're going to be over-transacting. And then back to one of our earlier themes, the gap between, you know, the dollar-weighted return and the actual return of your investments, you know, it's from that sort of gap opens up when you overtrate. And one of the reasons why that happens is because you can, you've got to look through to your investments and you see how they do over a shorter period of time. And it scares you or you get greedy and you make a change. And that's why transparency, you know, it's a virtue. But if we use it in an excess, it can really hurt us.

Some of those behavior gaps are just so terrible to look at on, you know, you pick up the quote on Morning Star and you see these five, six, seven percent annualized behavior gaps over, over pretty long periods. And oftentimes it is these kind of higher flying, in many cases, growth funds or even sector funds that have, you know, an amazing run, money piles in and then mean reversion rears its head. Are there any ways do you think of helping people avoid that problem? And the one that obviously springs to mind is to use the stick, not the carrot, and heavily

penalize people for withdrawals, you know, immediately after they invest, to try to engineer a longer holding period. But of course, that's rife with problems that, you know, there's exogenous variables that you can't, you can't account for with that, that people need the money for some reason and they shouldn't have to pay a penalty. But are there other ways that we could try to stop this, this horrendous behavior gap? And of course, you could argue that the active management community is reliant on stupid investor mistakes to produce opportunities for Alpha. But thinking about that gap, what do you think? Should we structure things differently to discourage people from overtrating?

So I actually feel that entry and exit fees applied judiciously can make a good deal of sense. I am not opposed to those at all. Like you say, I think that it gives investors and those that represent them. something to think about before they go. And now, I'm certainly not advocating for, you know, big front-end loads or, you know, putative redemption fees, which is, which is some of, you know, kind of the direct that you'll see, you know, on certain types of products. I think that that's, that's very unhelpful. In some cases, it can be outright predatory. So that's not what I'm suggesting. But we've seen some very respectable firms, and I would include Vanguard in this,

There are certain of their funds, if I'm not mistaken, where you actually have to pay. It's a nominal fee, but it is a fee all the same to ensure that you're not here today, gone tomorrow. And the more sort of resolute shareholders, the basing shareholders who stay in it, so they don't have to pay for that baggage of you entering and exiting and the fund having to transact. So I really, I have no quarrel with that at all as long as it judiciously applied. you know, in terms of sort of guidelines that we can follow as investors or, you know, in the case of advisors as intermediaries in that process, you know, I think that one sort of telltale, huge warning sign is a big influx of assets into the strategy concern. We've seen this time and again. You know, you, you know, whether we're talking about tactical mutual funds following the global

financial crisis, I can think of a few, you know, pretty popular liquid, alternative funds around 2011 that gathered just torrents of assets. And it really became more of a story than an investment thesis where there was quite a bit of tag along. And so I think in situations like those, we've got to step back, pause, ask ourselves what our thesis is, so to speak for that investment. You know, and hopefully that's enough to keep us out in those sorts of situations. And then the other thing that we have to do is just make sure that we are entering with the appropriate mindset and expectations and that when we're representing clients, we are leveling with them. And if it's an active fund, we're saying, hey, this is not something that we're going to own for just three or

even five years. This is something that we're going to own for some period of time. And there's probably going to be some underperformance along the way because that's part of the price of outperformance in some cases. And so if we do that, then it prevents some of this inopportune buying and selling. What do you think about the value growth paradigm? Obviously Morning Star. You know, it's, I I think the style box dates to 1992 soon after the Fama French research came out, also talking about value. So that's, I mean, in the grand scheme of things, that's not that long, but it's become such a pervasive way of thinking about and categorizing investments, managers, et cetera.

And now we have the rise of factor investing, which is less about growth and more about value, quality, momentum, defensive, some other categories. Do you think that this dichotomy, this value growth dichotomy? of me makes sense. Do you think it will last in this kind of rise of new factors where growth really isn't one of them? How do you think we'll categorize funds in the future? Yeah, that's a great question. We actually, not to be a commercial shill here, but one of the things that we did recently, and this is a credit to some of my colleagues in the quantitative research side led by Lee Davidson, we actually put out a commercial risk model. It's part of one of our tools,

And it actually spans numerous different factors. So we've moved well beyond the sort of, you know, the nine box style box grid that many people associate us with and that we're very proud of. But I think it's an acknowledgement of the fact that, you know, classifying funds and their various attributes, it goes beyond, you know, size and even value growth. We have to consider some other things. And you named a few of those. We've got momentum, quality. We have a few of our own proprietary factors that we've developed. You mentioned moat before.

There's valuation. There's the uncertainty that's associated with the intrinsic value estimate of a particular security, which we also promulgate. And so, you know, these are all efforts that we have made to recognize that, you know, there are more sophisticated ways that we can go and classify securities and try to attribute their performance. performance. And so that's why we put the risk model out and made it available to some of the users of our research and tools. Last two questions, which are a couple of my favorites. The first is if you had to pick, I already asked you about your most memorable experience with a fund manager, but if you had to pick an individual day that is your most memorable throughout your professional career, what would it be? So I would say this was when I was a newly minted analyst back

2002, if I'm not mistaken, I could have my timing wrong. We gathered around a TV in our headquarters and we watched Elliott Spitzer basically unveil these allegations of market timing against a number of mutual fund complexes. And, you know, to this point, I think that, you know, generally speaking, the fund industry should be pretty proud of what it's offered to investors. It's given them access to the markets, you know, in a reasonably priced way, there's always room for improvement. I think the market has seen to solving that problem, given the shift to low-cost investments. But generally speaking, the industry has done a good job. But I think at that juncture, it was fairly Lillywhite.

It hadn't had any sort of widespread scandals. And so that really stands out for me in a couple of ways. First, it happened. And the industry hadn't had that sort of traumatic experience. And then also it was the way we responded as a firm. I'm really, really proud of the colleagues that I work with and was proud of the way they responded. They responded by identifying a number of firms that had engaged in these activities and warning investors away from them. And that was not an easy thing to do.

You can imagine the reaction it elicited from some of these firms, but it was the right thing to do. And I think it was very much congruent with, you know, sort of the investor's first ethic that, you know, we try to make sure that we put, you know, front and center. So it was certainly a pivotal moment in the history of the industry. And it was also a very indelible moment for me and my career here at Morningstar and learning sort of what it is that defines us as researchers and sort of the, you know, kind of the responsibility we feel towards the users that we try to serve. So that's a pretty memorable day for me. And my last question is another one I ask everyone and I'll put a little twist on it and I'll let you choose the way you want to answer it. which is this idea of kindness and curious to know what the most kind thing someone has either done for you

or kindest thing that you have done for somebody else. And you can answer either or both or I guess neither. Yeah, so let's start with the first one. I mean, I think that, you know, probably the kindest thing that someone has done for me professionally. And this goes back to an earlier juncture of my career when I was in public accounting. I started my career at what was then known at Arthur Anderson, and I had an opportunity to catch on with an internal group there called the Professional Standards Group, which was the firm's really sort of resource expert on technical accounting and auditing matters. It was a very, very prestigious group. I was a young kid not polished at all, and they took a chance on me, and I spent the next six years of my career working for these extremely accomplished.

accomplished unbelievably hardworking partners in this group, and they did not have to do that, and they did that. And I got to work at their feed and learned a great deal from them, and they were willing to tolerate me for that half dozen years. So I have to thank my former colleagues at Arthur Anderson, you know, John Stewart, Amy Ropevier, Rick Peterson, the late Ben Newhausen, and so forth, who were in that group at the time. I thank them for doing that for me. It was a very, very nice gesture. You know, and then, uh, sort of, uh, nicest thing that, that I've done for other people, maybe we'll step out of the professional realm here. And, you know, I, I, you alluded to it before, I have a young family for children. And, and I would say collectively, I try to, to make every day

better than the one before it and, um, help our kids learn and, and sort of show them the way. And, and, and lead by example, most of all, by, you know, showing them the value, I hope of empathy and, uh, understanding different sort of circumstances that that people live in, you know, we're very lucky that we, you know, we lead a safe and comfortable life. But, you know, hopefully they're growing up to understand that not everybody's in that same situation. And, you know, one day they'll be able to inculcate their own children in that same sort of mindset. So, you know, that's, that's an ongoing effort. And we'll see how it turns out. But that's, you know, that's sort of my big project of trying to try to give back a little to my children. As a parent, I fully endorse that one. There's nothing better than that. So I have one bonus question. Sure. And your Twitter profile is the inspiration for it.

So your name is a reference to Sonic Youth and your picture is Daft Punk. So if you had to choose, let's say, two bands that you encourage people to check out that they probably haven't heard of before. As a music lover, an avid music follower, who would you recommend? Sure. Oh, that's such a great question. What fun. So maybe I'll focus on it's an L.A. punk band. Their heyday was really in the 80s. And they have a very, very sort of piffy name. The name is X. And the record I would recommend is you can actually, when I bought it, you could get the two records together, Los Angeles Wild Gift of the two of those I'd probably recommend. wild gift. I think that's a great, great record. And then the other one, which is a bit of an obscurity, but for people that are interested in, you know, some of the sounds that came up in sort

of like the alt-rock era, sort of these walls of sound and so forth, you know, you actually, you found some of the inspiration for that overseas. Probably the most, you know, famous of those bands is one name, My Bloody Valentine. They put out a very influential record called Loveless. But there was another band called Ride, which I think some people are familiar with, but they're not quite as well known as My Bloody Valentine. And they put out a record, which if memory serves, is called Nowhere, which I love. And it's a very rewarding listen, real hooky stuff. There's a lot going on in the background, walls of guitar and so forth. I think you'll quite enjoy that one as well. So X and Ride.

Fantastic. Had nerd of either, so I will definitely check them out. Well, Jeff, this has been a blast full of really useful information from someone that sits in a very interesting seat, as I said at the beginning. So thank you, one for your time and all your perspective. I think that everyone listening, whether it's a financial advisor, an investor, a money manager, can find something useful in our conversation. So thank you so much for your time. Oh, thank you. It's my great pleasure. Hey, everyone. Patrick here again. To find more episodes of Invest like the Best, go to investorfieldguide.com forward slash podcast.

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