Odd Lots - Patrick O'Shaughnessy on the Next Big Thing in Passive Investing

Episode Date: September 6, 2021

Passive investing is kind of boring. You dump your money in an index fund and that's it. The industry hasn't really seen big innovation since ETFs were invented in the 1990s. Enter custom indexing. Custom indexing allows asset managers to create bespoke indices for their clients. Interest in the space is already booming, with Morgan Stanley, BlackRock and JPMorgan all making acquisitions in the space. But what exactly is the difference between investing in a custom index versus something like the S&P 500? And why haven't custom indices been done before? On this episode we speak with Patrick O'Shaughnessy, CEO of OSAM and the host of the podcast "Invest Like the Best", about direct investing.See omnystudio.com/listener for privacy information.

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And I'm Joe Weizenthal. So Joe, it's been a while since we've talked about passive investing. And I can't decide if that's just because so much else has been going on in the world, including a global pandemic. Or if it's because passive investing itself seems to have gotten, gotten a little boring. Like, it doesn't feel like there's that much happening in the space. Well, I know I've said it before. And I don't remember the last time we talked about it, but I know I've said it before that in the post-grade financial crisis period, it felt like

there was just this overwhelming message. And there's like through the media and marketing and academic research. It's like, just go passive, just go, you know, index, whatever, forget about your investments. And it really feels like in the last couple years, even before the, the pandemic, but now especially since the pandemic, it's like there's been the like revenge of active management and individual stock selection and Robin Hood and crypto and all that. And it's like this like repressed desire to trade and invest in individual names is just come like raging back. So I guess that sort of asked the question. It's like, okay, well then like, where does where does passive fit in now? Yeah, totally. And the other thing I've been thinking about just on that point about

the message about investing in passive, like when you start to break. it down, this idea of just pour all your money into an S&P 500, ETF, like, spy, you know, something like that. If you think about it, that's basically telling you to invest your money in a technology, like a fun technology that can trace its origins back to the early 1990s. And it's kind of crazy with all the technological advances that we've seen since then that the biggest, or the most prominent advice is to just dump everything in an ETF. Yeah, I like your characterization of that as a technology. And this is something that I think about a lot.

Like, okay, we call, say, index investing, passive investing. And it's pretty passive. But prior to the advent of the index fund and especially like ETFs, it was not like a trivial thing to do. So the academic research might say, buy the S&P or buy some big basket and forget about it. But prior to like some easy way to just sort of automate that, like that was not actually like a strategy, an individual could do. No individual is going like buy all 500 stocks of the S&P 500 and rewaste them every day. And, you know, so it's like there it is kind of like a technological breakthrough that that happened that we sort of take for granted. Totally. So on that note, today we are going to be talking about what a lot of people are saying is the next technological breakthrough in fund management. or the next big advancement, something that is definitely not boring, but does count as passive

investing, sort of, as we'll get into. We're going to be talking about custom indexing, and there's been a lot of action and deals in that space recently. Right. And of course, this gets to the question of like, you know, as again, I think this is something you've pointed out a lot. You could buy this in P500. It's passive-ish, but you're sort of outsourcing the indexing question or the management question to whoever, you know, in that case, the committee at S&P, or if you buy an MSCI index, the, you're outsourcing investment decisions to MSCII. So what is the future of like essentially designing the index? Exactly. So we have the best guest to talk about it. We're going to be speaking with Patrick O'Shaughnessy.

He's the CEO over at O'Shaunacy, asset management, of course. Also the chairman at Colossus and general partner and CEO at Positive Sum. And in addition to that, he is also the host of the Invest like the Best Podcast, so a fellow podcaster. Patrick, thank you so much for coming on. I'm really delighted to be here. I love this show, so thank you for having me. Oh, thank you. So maybe just to begin with, we should start with the obvious question. And I should mention here that your company, OSAM, it has its own custom indexing platform called Canvas. What exactly is a custom index and what does your platform do? Sure. Well, thank you for having me. I love where you started the conversation around technology and innovation. And that's how I think about this entire story in custom indexing is just one

point in the timeline. And I think you raised the right ones, which are, I think of as a co-mingled funds as a technology or an innovation. I think of Vanguard's mutual structure that allowed for much lower cost for investors as a great innovation in this timeline. Ditto for ETFs, I think custom indexing is just the next natural stop in that journey. And when I say journey, I mean better, cheaper, more convenient investing, more tailored investing for each individual investor. So in the past, it's ETFs in general and just index funds in general have been sort of like the Model T. You can have any color you want as long as it's black. And I think that is obviously going to change. And the reason it's going to change is because of technology.

So I always like to look at what I call directional arrows of progress, a term I learned from a friend, Josh Wolfe, and see where the world's going. So we already know that trading is now free, thanks to Robin Hood and all the other brokerages that have followed suit. We know that the cost of operating your own separate account at a brokerage like Schwab or wherever is falling in cost every single year for asset managers like us that work with those. firms. And we know that in the future we're going to have fully fractionalized shares. So all three of those were huge impediments to owning your own basket of stocks directly, not through a fund or an ETF, but directly. And all those cost curves are either at zero or going towards zero or going to be very possible. And in a world where it doesn't cost anything to trade, it costs very little to have a brokerage account and have an asset manager like us or a BlackRock or a Vanguard or whoever trade on your behalf. And you can own fractional shares, what seems really obvious to me in that world is this idea of custom indexing

a term that I'm proud that we coined a couple of years back. And the idea is very simple, which is that why should everybody own the same 500 stocks in the S&P 500? Why wouldn't it be easy to adjust for little things and big things, such as I don't want to own stocks with certain characteristics. For me, I work in capital markets, as you just mentioned my CV. I don't really want to own more capital markets exposure. I've got plenty of that in my human capital and my day-to-day job. I don't want to own tobacco stocks. That's just a personal thing for me. It's a very small part of market cap, but I don't want them. Very easy to adjust for in something like a custom index. Perhaps the most important thing that custom and also direct indexing unlocks is the ability

to do better after taxes as well. What we've learned is that everybody has a very specific and personal tax situation. No one likes paying taxes. Everyone wants a better after-tax return. If you ask me, that's one of the key geniuses of the index fund is that it's low turnover. So you don't have a huge tax bill when you own SPY or own Vanguard's total market ETF or fund or something like this. What you can do when you own each of the underlying securities, let's just stick with the S&P 500, is you can sell positions that are at a loss. And you can use that loss to offset gains elsewhere in your portfolio and actually come out ahead on an after-tax basis. We call this tax loss harvesting. It's been around for a while, typically for

just the very, very wealthy because you need very big accounts. But again, as the costs fall, this opportunity to create losses and create better after tax returns will come to, you know, more mass market individuals as well. So custom indexing is the prospect of why would I have the same strategy as everybody else when my circumstances, my preferences, my preferences are different. They're unique to me. And I think personalization is a big trend, not just in investing, but in everywhere, right, whether it's in clothing or other areas of technology, and that that will come to investing too. And, you know, we're proud to be at sort of the vanguard of, pun intended, of the custom indexing trend. So I sort of hinted at this in the

beginning, and there's always this debate, and you see it on Twitter elsewhere. Is like, does passive investing actually exist? And by that is like, okay, is the S&P, if you buy SPY, is that truly passive? Because, okay, that's only 500 stocks and there are thousands of stocks. A committee had to select them. And the way I think about this question is, is that it's sort of a false binary and that there's like basically a spectrum. And that buying the S&P 500 or buying spy is, you know, just like buying a little bit every month or whatever, say more passive than some other strategy where you try to like pick 20 stocks or whatever. And it sounds like to me that with custom indexing, it's basically just adjusting where you are on the spectrum a little bit. And so rather than going whole hog into some sort of like, oh, we're trying to beat the market, it's, okay, let's take the premise that for the most, We want to just sort of buy something general and stable and diversified, but it can be tweaked a little bit to get some sort of different returns while still maintaining the gist of the benefits of wide diversification and avoidance of market timing. Yeah, I think this, I think this whole

committee thing, whenever I hear the committee at S&P brought up, I sort of laugh. It's just, it's, I think it's a very strange argument for people to spend any of their time on because if, if instead of using the quote unquote committee, you just bought the top 500 stocks by market cap. It's the exact same return. They're not that different. It's the exact same return. And so I think the key thing here is you want to own roughly the market in its market cap weights roughly to get the market return.

And even if you deviate that from that, whether it's by a committee or by a fancy term stratified sampling, which is what a lot of firms like us do, where you own most of the securities in the market, but you don't need to own them all. You know, the last 10 stocks in the S&P 500 make up a tiny minuscule weight even combined. And not owning them will not materially change your overall return. So I think the key here is you want to be broadly diversified. You want to roughly look like the market. But with custom indexing, you can then also make these adjustments.

And yeah, you'll perform a little bit differently. But that's sort of the trade you're willing to make to customize something to your specific circumstances and preferences again. So in my view, all these arguments about like what is passive. are just silly. I mean, technically passive would just be a market cap-weighted total market, every stock in the market for equities globally. But most of the things that people argue about look very, very close to that. So this feeds into something I wanted to ask you, but with custom indexing, what do people actually benchmark themselves against? Or does it not really matter anymore? Like, does your performance compared to a broader index or a specific index, like just not come

into the equation as much. So there's two ways to do it, and they're both very, very simple. One is just to use a broad market index. It could be the Russell 3000. It could be, you know, pick your, pick your broad benchmark that's market cap-weighted and very simple to understand. The second would be sort of a custom benchmark. And this would be used by people who have a very clear deviation from something like

the Russell 3,000. I'm going to make up an example. Let's say someone's port custom index is 40% large-cap, 6,000. 20% small cap, which that's not what the market looks like at all. The market's like 95% large cap, 5% small cap by market cap. In that scenario, it really wouldn't make sense to compare your performance because in this case, you are making a very active allocation decision to be way overweight small cap. So in that case, you might just blend a benchmark and say, my benchmark is going to be 40% S&P 500, 60% Russell 2000 or some other small cap benchmark. But in every case,

You're using simple, easy to understand, broad market benchmarks in some combination or alone to use as your reference for how you're performing. On April 4, 23, around 2 in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering, The Killing of Bob Lee, beginning April 16. I'm really interested in what you said about, you know, if you work in capital markets or if you work in a bank and some sort, and you own bank stock, you're kind of like, you're kind of doing the Texas hedge of betting on a sector that is already probably responsible for a lot of your annual income.

And so it may not make sense. Can you talk a little bit more? I've always wondered about this, whether financial advisors think about this question. And when you, because it's something I just popped into my head before, and that's the first time I've heard someone talk about this, of tailoring a portfolio around someone's, you know, normal income.

Can you talk a little bit more about how that's being used in some of the ways you see that potentially being used? Sure. So what is the market, but a collection of discounted cash flows, you know, theoretically, and maybe there's some problems with that conception. But if you look at the S&P 500, the value of each of those stocks and therefore of your portfolio is the market's estimation of how all those companies will do in the future, discounted at some rate back to today, and that's the value of your portfolio. Well, why should my human capital be any different than that?

I've got, you know, 50 years or hopefully more left to live and work. And there's going to be cash flows that I generate from that. And when I dig into where those cash flows are going to come from, I couldn't be talking about what's one step beyond the Texas hedge? I couldn't be more all in on capital markets, like the equity market specifically, is going to be a large determinant of how I do in my human capital. So if I think of my human capital as discounting my future cash flows into some value today, often that is worth a lot more to people than their brokerage portfolio is, if you actually did the math.

And I certainly think it is in my case. So why would I have more exposure to the same risk profile that determines, you know, a large chunk of my human capital portfolio, let's call it. And I think simple adjustments like that are just intuitive. It just makes sense to me. And you can certainly demonstrate it, you know, if you do some napkin math, you can say, yeah, like I don't really, like, let's go back to 08. If I'm working at Lehman, and it's a ridiculous example, of course, in hindsight, but if I'm working at Lehman, like, it's pretty obvious where my risk is bundled up and I don't want more of that same risk. So if indexing in part is great because of diversification, I think

this is just one way to add another asset to the mix, which is your own earnings. Yeah. So Joe and I are going to have to steer clear of financial data stocks. And actually, that reminds me. No facts up for you. I should just mention that Bloomberg does have its own indexing business in the interest of transparency. So now that I've got that disclaimer out of the way, one thing I wanted to ask was, can you give us an example of like the most interesting or unusual custom index that you've seen in your time in the space? Sure. So, well, I guess the first thing I would say at an even higher level is how popular customization is. So we built this platform. It's a web, it's software. It's a web-based platform. So think about it like building a car. So go to like

Tesla.com and go through the experience of building a car. There's an interior and exterior. You can, you know, tune all these little dials or choose options. It feels like that to build a custom index with a bit more options. So we don't force anyone to do anything. Our default would be that you buy the broad market, right? That you don't do any customization, that you just do low-cost indexing, maybe with some tax loss harvesting.

And we went into this not knowing what people would do with this platform. That's the beauty of platforms, I think, is to be surprised by how they're used. And now we're, you know, a year and a half, getting in on two years in. We're about $2 billion in assets or approaching that number today on the platform.

and fully 80% or so of the indexes that are designed are completely unique, meaning they're not, they have different settings than any other custom index that's been built to date on the platform. And I would definitely, I would have taken the under on that. Had you set the line at 80% will be fully custom, I definitely would have said it's going to be way less than that. There's going to be more clumpiness around what people do. So I guess the first big point is like people really use the customization features.

And we've been blown away by some of the stuff that people ask us if they can adjust for. Some things are in taxes. So they might say, I want to pay $0 in capital gains. Gross. I want you to generate a single gain for me. I refuse to pay taxes. Others have said, look, we're willing to spend $100,000 on capital gains taxes. So do everything you can inside that absolute dollar budget.

One person came to us and said, we don't want to own companies. that produce sugary drinks because one of our key focuses as a family is to avoid or help ameliorate the obesity epidemic. And we think sugary drinks are the prime culprit. So we had to build a custom quantitative screen for that. We've had people say, look, I've got all these, and this is a more advanced feature that wouldn't be broadly available right now, but we can do. We've got this huge private equity portfolio and clearly kind of like the human capital example

I gave, like we've got a lot of risk in these 50 portfolio companies, but we've got a lot of But we don't really know how to map them onto public equities. Can you do that? And that's where, you know, the fancier like machine learning modeling type stuff can come in and create something really cool so that we can avoid public equities that look very, very similar when we model them to the private equity portfolio. You know, that's just four examples, but it's kind of constant.

Like everyone that we meet, every new client that we bring on has some new question in the form of, you know, can it also do X? And so I just think what we're seeing live is a huge, huge latent demand for customization that has gone unfulfilled for a long time. So no one talks about it. But I think you'll see an explosion of these platforms in the next couple of years. Can you talk a little bit more about the sort of, I don't know, maybe it's trading tech or the sort of like other platforms necessary to make this work? Because as I mentioned in the introduction, you know, even if you go back long enough, even buying just the straight up S&P 500 would

would not have been a trivial exercise at all for an individual. No one can sort of like buy 500 stocks and rebalance them, et cetera. And of course, that got productized and now it's easy. But like, okay, let's say I want to buy, I don't know how many financials are in the S&P 500, but let's say I want to buy, you know, 460 of the S&P 500, excluding all the financials. Could you talk a little bit about the tech stack that makes it possible for someone to set that index using your software or any software?

And then how it can, after that decision is made, get the sort of like, you know, cheap trading and replication of that part of the index. Sure. And it brings to mind a really cool idea from a gentleman named Eric Vishria, who's an early stage technology investor at a firm called Benchmark. He uses this term competitive frontier, which is sort of the battlegrounds, if you will, that an industry will fight on and where things will be lost or won. So you have to be good in these competitive frontiers to compete in a changing era. I think those two competitive frontiers for this segment of the market for indexing and, of course, custom indexing, are quantitative research and software development. And those are very different probably than what has won or determined to the winners in indexing writ large for a very long time. And it's the answer to your question, which is that it requires a lot of technology. We honestly sort of fell backwards into this opportunity because we just, by luck, had built so much trading software for our core firm, which is a quantitative investing firm over the last 10 plus years.

So we were a quant firm that was managing active strategies that manage thousands and thousands of separate accounts. To be able to do that at scale across brokerages and across custodians, et cetera, you have to build software. You can't do it manually with a database. So we had built an entirely custom piece of trading software, an entirely custom piece of something called WorkBentrists, like account management and settings management software for all of our separate account strategies. So it requires the technology that I talked about like building a Tesla. That's just the front end that sits on top of these other systems. And so I think that the answer is a lot. It requires a lot.

it's effectively pure software and technology that's required. And the twist on this is that to be really good at this, you have to be good at quantitative research, which is just different than software development. You bring the best software development people in the world, they're not going to be able to do some of the stuff that's required for custom indexing. That's a data science function. And that's the second function that I think will be critically important. So just on the competitive frontier idea, I mean, there has been a lot of activity in the direct indexing space, which we mentioned in the intro, but I think J.P. Morgan bought Open Invest, and BlackRock and Morgan Stanley have also been buying index platforms. How intense is the competition at the moment? What are the sort of variations in strategies being pursued by different players?

And what can make you sort of stand out from the crowd? Like what makes a custom, index platform better than another one. So direct indexing to define that, since we've used the term a few times, I think of as picking a reference index supplied by somebody else, S&P, Russell, MSCI, whatever, and then running a tax loss harvesting strategy on top of it. And sometimes that's just, you know, simple market cap indexes, probably most of the assets in direct indexing firms like a parametric or an imperio, which were bought, as you mentioned, by some of the big players, that it's very simple. You just try to generate after tax returns. You sell positions at a loss. It's a complicated

optimization and algorithm to be clear. So it requires a lot of work on their part. But it's sort of one thing that you can do in a portfolio. I think of custom indexing is the natural next progression in that. So if if we're painting on a blank canvas, so to speak, there's a reason we call our system canvas. If you're planning on a blank canvas, direct indexing is sort of like one tube of paint. It's one of the things that you can do in your portfolio. I think for us, and being competitive first was arriving at the party first or getting the party started. So most of those direct indexing firms can't do anything remotely close to the kind of customization driven by our quant research capabilities that I've described so far.

So you basically get to pick your index and that's your pick. But it's typically supplied by a third party. Our view is it should be first party. We should design these things, not S&P. We can move a lot faster. We can be a lot more specific to the individual. We can use our quant research muscle to do so. So those two competitive frontiers are what we're focused on.

Like if you look at who we're hiring, our last, you know, five hires are three software developers, two quantitative research experts. And if we can keep pushing the envelope on what we can do at low cost, we haven't talked about cost, but these things are very low cost. What we can do at low cost, then we should stay at the forefront of this trend. Can you actually just explain a little bit further, the quant researching component? I mean, you mentioned the two components, trading software and quant. I think I intuitively get the trading software. Talk a little bit more about what the quant research aspect is and why that's so pivotal to make this work.

Yeah, you know, I think this is something way beyond just investing, too. You're seeing data science pop up as something that used to be, no one talked about or knew what it was. Now it's a central function in like every company. And it's not complicated. It's very simple. There's some quantitative outcome, some measurable outcome that matters to people. And I'm talking big picture here, not just investing.

And you build a model that does a good job of predicting that outcome. And this happened in sports with the money ball trend. You know, we figured out that obviously you want runs. You want to score points and you don't want to give up. You don't want to give up runs in any sport. And certain things relate to that. On base percentage was the example in money ball. In public market investing, you want good returns.

but there's other things you want too. So anything that you can target, that could be companies that sell sugary drinks. Well, that's a measurable outcome. It's hard. You have to get data sets. You have to build data sets. But you can build predictive models for outcomes that matter or information that matters to the individual. And every time you do that, you're adding an arrow to your quiver.

So once we did that once, the next family that comes to us and says we don't want to own sugary drinks, we don't have to rebuild that thing from scratch. We have the model already. Same thing for the tax loss optimization. Every time you build a new model, you sort of expand what your platform can do. And quantitative researchers, that's all they do all day. So they say, it's very simple terms. There's three things that matter. There's the outcome that's called the label in the data science parlance.

There's the inputs, the features, what things are going to predict the outcome that we care about? And what is the model itself? People listening probably are familiar with something very simple, like linear regression or a linear model. These are just much fancier models. That's all you have to really know about it. So there's inputs, there's the model, there's outputs. You have to be expert at building those things and those three parts of a model.

And then offering those effectively as services or products to build a custom index in this case or predict what clothes you're going to like in the case of something like Stitch Fix or whatever. It's a function that we just think will be embedded everywhere. What does this mean for ETFs and mutual funds and the sort of traditional players of fund management because I imagine, as you just mentioned, you know, this idea that if you build one custom index, basically you've created a new product that you can then roll out to additional clients. So it seems like a pretty efficient way to create, you know, almost an infinite number of indexes, which on the surface would seem to potentially threaten or at least compete with

ETFs and mutual funds? I think if you narrow to taxable investors where the underlying strategy that's being designed or implemented has an annual turnover of 20 or 25 percent or less, which is sort of the crossover point for taxes, that this is a huge threat to ETFs. In my mind, there's really no reason, especially as costs continue to fall. And it's not like they're that far apart anyway. You know, our lowest price is 20 basis points today. So that additional, let's call it 10 basis points that we might get down to over the next 10 years. I mean, you compound 10 basis points over time. It's not a huge difference. And so we're pretty close on cost already. And if you think about that whole segment of under 20% turnover, SMP 500 would

qualify for that and taxable investors that own ETFs, that is a huge segment of the market. Now, above 20, 25% turnover, ETFs remain and I think will remain thanks to the sort of law tax law that governs them the ultimate app, right? There's just, there's no beating, let's say you want to invest in a pure momentum strategy or something that has 100% annual turnover. There's just no better wrapper than the ETF, because you don't have to pay the ongoing taxes as a taxable investor. So high turnover strategies, I think, will always and should always live in in ETFs for the most part unless, you know, deep customization is really important to the investor, in which case they may go custom index. But below that threshold, and this applies to mutual funds too,

you know, more of which are converting to ETFs or will in the future, I think this is a huge, this is a huge, an important move and shift. And obviously it's counter positioned. ETF providers, other than going into the custom indexing business, cannot compete against this. I mean, it's the wrapper itself, by definition, does not allow for customization. So, Patrick, I want to, you know, I think of you as someone who's just sort of like, the ultimate markets and business omnivore.

And even like when Tracy did the intro, I mean, what was it? You have like four titles that I think she mentioned, including a host of a podcast that's a competitor to ours. You know, we're all partners here. But no, but in all seriousness, you have like an extraordinary, like broad ray of interest. And it's evident to anyone who follows you. And I'm kind of like jealous, I would say, of how open-minded you are and whether it's like VC investing or crypto or NFTs or anything. I think you just like exhibit this sort of like thirst to learn more. And, you know, I said in the intro and I really felt this like my career like as a journalist really

started in the wake of the great great financial crisis. You know, like we were just like hammered home this idea of like passive, passive, passive, passive, buy the index, forget about it. Don't buy individual stocks. Don't try to time the market. Don't try to beat the market. Put some of your paycheck at an index fund every two weeks or whatever and just set it and forget. it and look at your 401k, maybe twice a year, whatever. Okay, so we all know all that. Obviously, we live now in this world of people buying all kinds of stuff and you've like really dived head first into that. How do you think about this question of like, okay, all this academic research says do X and don't try to time the market, but we have lots of people who

are interested in all this other stuff? How do you think about this sort of like tension and how people should think about incorporating sort of more concentrated, riskier, far out on the risk curve ideas and bets into their portfolios? It's a great question. Obviously, an animating one for me, when I spend all my time thinking about, you know, I have my own portfolio. I, you know, I'm involved in a lot of people's portfolios. It's so interesting and important.

I think, honestly, I think the answer is there's a lot of room for all this stuff in, in our lives, in our careers, and our portfolios. And that some large component of low cost, broad market exposure is appropriate advice for just about anybody. And I have to say, like, when I was at, when I was thinking and learning about all this stuff in the early days, the passive thing makes complete sense to me, but it's also remarkably boring from a career standpoint. I mean, like, okay, you can say that and become convinced of it, but then go work and, you know, manufacturing or something. Like, there's nothing left to do, right? You just describe the whole, the whole strategy in 30 seconds. And look, I think that strategy for,

like, literally for everybody or for the vast majority of people is incredibly smart and will produce good outcomes, but it's fundamentally ignoring things that are changing rapidly, where you can access them via an index fund. You know, you can now buy some crypto in these kind of cool index like structures, but you certainly can't access, let's say, early stage technology companies. That's something I'm very interested in. I spend most of my time in investing in building, thinking about software. And I can buy a software ETF, I suppose, but to me, it's far more interesting to build a variety of software companies like Canvas. It's far more interesting to former VC, which I did to invest in early stage companies and help them along the way.

I guess I'm just defined by change and understanding how systems work. And when those two things come together, there's just an unlimited amount of cool stuff to learn about. And so, you know, in 2017, I spent a huge amount of time on trying to understand crypto. And I still do. I just think it's fascinating. I don't, I don't have a huge amount of personal exposure to it. I do have some. a lot more than I used to just because of market appreciation. And I'm just, I just like new stuff that is changing that enables new behavior or new good outcomes for humans and like to have,

like to be at the frontiers of these things. And yeah, I've got a lot of titles and, you know, it seems like I'm doing a lot. But I'm kind of just doing one thing, which is trying to understand what's new, what's changing,

is it interesting or not? What people can help us learn about this? You know, can we expose their ideas to the world? can we share as broadly as we can as we learn. And that's very fun. It's a lot more fun than, you know, by Vanguard. And by Vanguard is very, very good advice still.

I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets. corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars, and policy experts to break down what the rulings really mean. We do this every weekday, then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify,

or anywhere else you listen. On the East Coast, listen as you start your day. and on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. This is something that I think Joe and I both wanted to ask you, but what do you see as the role of crypto in a portfolio? Because you just described having a little bit of it more than you used to. And I think one way that a lot of investors think about it

is as a sort of like lottery ticket where, you know, you put a little bit of money in a, particular token or coin or whatever, and you kind of hold your breath and hope that it's going to be the right one to go up. So how are you thinking about it? One of my favorite investing quotes, I can't remember who said it, but the quote is, diversification is the only rational deployment of ignorance. And I have to claim some, like a lot of knowledge, but also a lot of ignorance on the topic of crypto and what the future of it might be in a, as you said, portfolio. I think traditional there is the operative word. I don't know the answer. I can tell you

what I've done, which is that, you know, when I learned about this stuff, the exciting core, you know, base level protocols that I spent the most time with seemed really interesting to me. And I could, I could understand a future where they are critical components of how the world works, much like HTTP is or SMTP for email. These are other protocols that just didn't have any value associated with them that have totally changed the world. And in this case, the protocols have a value. They have a they have a token or a coin or whatever you want to call it, a cryptocurrency, which quote unquote powers the protocol. And those things can can have and retain value or grow value. And is Bitcoin going to be a thing in 10 years? You know, I'm not smart enough to know.

It sure seems like it will be to me. Is Ethereum going to be a thing? It sure seems like it to me, as something that I know countless people are using on a daily basis. How many products can you say that about with a very clever economic design behind of it, behind it and evolving design? So for me, it was no more complicated than look. These are incredibly interesting technologies. Many of the smartest people that I've encountered and I encounter a lot of smart people in the course of my life are gravitating towards this field.

And you could see how philosophically these are good ideas. that could have and retain values. So I put a small position and have added a little bit and never really sold anything. And that's been my personal stance. It's not advice. It's just what worked for me. But I think of it as diversification. And I think everyone agrees diversification is good at some level, like the S&B 500 that we talked about earlier. You should own that instead of one stock. One stock would be dumb. I think there's an argument to me made that that idea of diversification needs to extend further into things that maybe we don't quite understand yet or we're not sure where they're going to go, but seem to have that kind of promise.

You know, I was talking to someone a few months ago. I think he worked at a, he did, he worked at a macro hedge fund. And he was talking about how, like, they had this very tiny crypto allocation in the fund a while back. But then over like the course of the last year, it became a fairly substantial crypto allocation because of the rapid appreciation. And it got to the point quickly where not only did it become substantial, but on a day-to-day basis or a week-to-week basis, the funds returns were almost always determined by whether that crypto portion. And so I feel like there's like kind of like this weird, like, I get, you know, mind virus aspect where maybe it feels like people dip their toe in the water. And they're like, oh, I'm just, you know,

going to have a little bit because I'm curious. And then, suddenly it like dominates the daily swings in their portfolio and then they can't stop thinking about it and can't stop talking about it. And I'm curious, like, I mean, you talk to people all the time, both on your podcast and then professionally and through the VC. I'm curious if you see that phenomenon where it's like somehow it sort of, they have this like little interest or they buy some on a lark and then it next thing you know, it sort of like dominates their every waking second, like thinking about it and watching the return. Yeah, it's like surpassed, you know, being from Texas or going to Harvard, right? It's like the first thing you mentioned.

I mean, there's a joke that one of my friends who's one of the largest Bitcoin owners in the world said, who's very early in the ecosystem, he's like, look, like, don't worry, everyone wishes they had more Bitcoin, like myself included. And when something, especially Bitcoin's my favorite, because ultimately it's tethered to nothing, right? Like the use case is the value and the value is based on perception. And unlike Ether, which is actually used in a lot of, you know, like a utility in a lot of ways for, for, for, for functional. or for things that happen on the web, Bitcoin is just this kind of like, it's just like a philosophy argument. It's so cool. And I think for something like that, if you own a lot of it, it's hard

not to become obsessed with it. And for wealthy people, I have this idea called balance sheet syndrome, which is like you get too rich. And then all you do is like think about and talk about and worry about your balance sheet, which I think is awful, by the way. And you see that like crazy with holders of a lot of crypto. And it's very, very, very rich. religious ask, you know, if you study mass movements or religions through history, like, there's a lot shared in common here. And, uh, that's not interesting to me at all. Like, you know, when someone, like, it's just not. It's just, it just, it's one of those things that if someone wants to talk about endlessly, like I lose interest very quickly, but I do see it

kind of constantly. I want to ask about one other thing. Another project that you're associated with and that sort of joined Colossus. And you do these like deep dives into like mechanical understandings of businesses. So it's like we think we understand like how Chipotle works or Lulu Lemon works or GM works. And this is something you see that you are clearly very interested in is like, let's really like drill down and like get to know their business models and so forth, and how they became what they did. How has that helped you as an investor?

And what do you think is the importance of that? Because I don't see a lot of people doing that the way you do, like really like getting to know a business well. Talk to us a little bit about what value you've gotten from that exercise. Yeah, one of my frustrations with a lot of investors, even the great ones, is that as they get better and better known, like they tend towards being philosophers versus, you know, on the ground thinkers. I like that.

And I just like getting on the ground. Like there's that amazing quote. It's like one of the painters that says like, you know, art critics are always talking about theory and aesthetics and whatever. And like painters are talking about like where to buy cheap turpillar. And I just like that idea. So I personally have learned a lot more. I did want to, I did, we call these business breakdowns. And I did one yesterday on, on Windham hotels with my friend Lauren Taylor Wolf. And, you know, we spent an hour and a half talking about Windham hotels,

right? Like, who cares? But when, when you dive into Windham, you just learn all this cool stuff about the world, like how all their brands like Super Aid, this kind of lower segment of the market, evolved along with the interstate highway system in the 50s and 60s. And what the franchise economics look like for someone that starts and buys a Wyndham Hotel versus buying a dominoes or whatever, like these very real on the ground things that if you pay 70 bucks for a hotel, like, now I know where that 70 bucks goes and like what the underlying economics are. And when I'm looking at another business to invest in or to build in the future, it feels like I'm just collecting all these individual models.

And I can say, oh, like this looks like this piece of software somehow looks like Wyndham. You know, I doubt that one will happen. But all these points of learning and comparison, you know, Harvard is famous for its business case studies, which I think are very good. And this is just that, you know, for free and in the open and in conversation. So I like the turpentine approach to learning about business versus the very like haughty philosophical, you know, principled approach. And I was a philosophy major. So, you know, I know this takes one to no one, I guess. And that's why we do it.

I just like how stuff works. And I find all of the detail to be far more interesting in a Chipotle than, you know, like the source of its moat. Like I like learning about how the guacamole is made and how you can get the cost of guacamole down by owning a guacamole farm and this kind of stuff. It's just more interesting to me. I, you know, I think for Tracy and I, that price that speaks to us because we, I think some of both of our favorite episodes have been like, let's talk about how trucking works. It reminds me of like Bob Dylan's actually his Nobel Prize speech where he's like, people always talk about Shakespeare, you know, some like great literary playwright, but Shakespeare was thinking about the quote is like, where am I going to get a human skull?

Because that needed to be. And like to put on a performance of Hamlet, York. So like I feel like, you know, that actually like understanding what matters for the person doing the thing is often way more interesting than like the deep theory. I mean, we both talk to Ryan Peterson at Flexport. And you know, you talk to someone like that. And you're talking about maritime law and how it came to be. And what you realize is like, God, everything's just messy.

Like nothing's neat and tidy. Like Aristotle was right, not Plato, you know, if you know your philosophy. And the details matter and path dependence matters. And you just like everything's a compromise. And you got to keep pushing. Like all these great stories like Ryan will tell about their business. He ran head first into it, not a brick wall, a steel wall of just inertia and like weird paper and pen processes. And he learned about how stuff moves around on the ocean.

And it's way more interesting and complicated than you could possibly imagine. And my friend Zach has as Zach Cantor has this amazing article he always sends around called Reality has a surprising amount of detail. And I just love that idea. Like learning about maritime law and shipping invoices and why it matters to the work. and it's just so much more interesting to me than some, you know, broadly applicable concept. Detail is more fun. I love that saying.

That's really good. We're going to have to take that to heart in some future logistics and supply episodes, I think. Okay, well, Patrick, we're going to leave it there. But thank you so much for coming on. That was really great. Thank you guys so much for having me. That was great, Patrick. Thank you so much.

Okay. So that was really enjoyable. And obviously, Patrick is a pro at podcasting and a competitor. So we shouldn't hype his podcast too much, although it is very good. But one thing I was thinking about is, you know that last point he was making about, you know, reality is sort of full of details or all about the details. And I was sort of thinking about that in the context of the custom indexing business itself. So this idea that if you want an index that actually reflects the,

world as you see it or as you want it to be reflected, like you are going to have to drill down into specific companies. And maybe it makes more sense to make your own judgment call on what those should be versus actually buying, you know, the top 500 firms by market cap. Yeah. I mean, I thought that whole conversation is interesting. And he was definitely sort of speaking our language at the end. I thought you were going to go the other way with the point about like, You know, again, that buying the S&P 500 seems like the easiest, like, strategy in the world. But as he points out, like, even that is like an, and you pointed out in the intro, like, even that is an incredible, like, feat of technology, even though, like, the technology

has been abstracted away to the point where we, like, I don't think most people think of, like, buying SPY as a technology thing. But even that, like, just think about, like, how messy that must have been, like, to create a piece of software that can like rebalance 500 stocks every minute or every day. Like even that is like sort of an extraordinary feat of like detail and attention, you know, attention to detail. Yeah. But also it sort of ties into his point about diversification as well, which is like passive investing isn't necessarily very good at identifying the next up and coming thing for obvious reasons. So like there's not going to be some sort of crypto play in the S&P 500. So you're not going to make a lot of money for.

from that. And so you kind of have to go out and seek those outside of the realms of traditional fund management, I think. Well, Visa bought an NFT recently. So now they're now, now they could be a crypto play, I think. Okay. But no, no, no, you're absolutely right. Yeah, everyone's, um, buying Bitcoin for their like cash reserve. So everything will be a crypto play soon enough. But, you know, if you wanted to get in early, you would have struggled without some sort of passive vehicle. Yeah. Okay. Um. Exactly right. Shall we leave it there?

Let's leave it there. Okay. This has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthal. You can follow me on Twitter at the stalwart. Follow our guest on Twitter, Patrick O'Shaughnessy.

He's at Patrick underscore Oshag. Follow our producer, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts at Bloomberg. under the handle at podcasts. Thanks for listening. Hi, I'm PJ Vote.

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