Odd Lots - What David Barse Learned From Watching A Credit Fund Blow Up

Episode Date: October 1, 2018

David Barse was the CEO of Third Avenue Management when one of its credit funds melted down in late 2015. The collapse of the fund touched off a significant debate about market structure, and the appropriate way to invest in illiquid, distressed securities. On this week's episode, we talk to Barse about what he learned from the experience, and how he's investing today.See omnystudio.com/listener for privacy information.

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Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. And welcome to another edition of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Wisenthol. Joe, do you remember what was happening in 1962? I mean, from a financial markets perspective, just to be clear. I thought you were asking me what my personal recollection was from 1960. But no, not only do I not personally remember what happened in 1962,

probably couldn't actually tell you anything that I know about financial markets in 1962. So no, I'm drawing a blank here. Okay, well, you're going to enjoy this then. I find this really interesting. I think you will too. But in 1962, there was a little stock market crash, and it became known as the Kennedy slide. Not many people remember it now, but it was really interesting because it was basically the first crash that happened in a stock market that had mutual funds in it. because mutual funds hadn't really been around in 1929 or in the Great Depression. So that's interesting.

So was the crash associated with something mechanically with the funds? Or is it just sort of like a coincidence that there were these new vehicles at the time? Ah, okay. So this is where it gets really interesting because as stock started to fall on this one particular week in 1962, there was this real concern that all these new-fangled mutual funds were going to end up making the crash worse. Basically, people thought that investors would be able to sell their holdings much more easily because they were in, they were wrapped up in these mutual funds. Now, in the end, that didn't actually happen.

The mutual funds actually came in and bought a bunch of stocks. So they ended up supporting the market and everyone was kind of saved, thanks to mutual funds. But it's clearly interesting because it gets to this big question of how open-ended funds behave when there's trouble. And you and I both like to talk about market structure. We talk a lot about the rise of passive investing, but we also talk about ETFs and sometimes mutual funds. Right. Exactly. And you hear it a lot these days, people warning about ETFs are getting so big and so enormous and there's so many different, they're so liquid. and people are concerned about the underlying assets in them. And we haven't really seen any big structural systematic problems yet. But if you ask people like, oh, what are you most worried about?

Or what could bring on another financial crisis? Even if people are sort of vague and hazy about how it would work, there's like this suspicion that modern wrappers of assets or modern vehicles are somehow going to be involved. Right. That's exactly right. And of course, there's an overriding discussion as well. about how mutual funds are constructed and how the benchmarks that they follow

are actually defined and constructed. And that's something that we've spoken about before. In terms of these worries over mutual funds or ETFs, basically open-ended vehicles wrapped around certain assets, there was one moment in time that happened relatively recently, certainly much more recently than in 1962. Do you remember that one, Joe? Yeah, I think it was, was that late 20,

2015 and everyone started reading white papers about the connection between junk bond ETFs and junk bonds and whether that was going to create a problem. Yeah, that's exactly right. And we also had a credit fund. You know, I think at one point this credit fund was worth about $3.5 billion, the Third Avenue credit fund. And it experienced a bout of redemptions that basically spooked the entire market. Yeah, I remember that. And in the end, the market overall was fine, and we didn't have many sort of big systemic problems. But people sort of thought it's like, okay, this could be like a harbinger. I mean, A, I think people were relieved that it didn't. But it seemed like the type of thing that spoke to a lot of these anxieties, which we've been talking about for a while. Yeah, exactly. So today I'm quite excited about our guest because our guest is actually the former CEO of Third As. Avenue. It's David Bars, and he's not only going to be talking about his experience at the fund and his opinions about general liquidity and mutual funds and ETFs, but we're also going to go into a really interesting discussion about indexes specifically and also his new venture, which is kind of an interesting tweak on existing index investing. I can't wait. All right. So without further ado,

David Bars, welcome to the show. Hey, it's great to be here. I thought when you mentioned 1962, you were going to talk about that was the year I was born. And this was the significance of that. And you came up with this very interesting story that I didn't know about myself. So you, as the year you were born, like me, you don't have any recollection of the Kennedy crash of 1960. No, I do not. But I do have a pretty good recollection of what happened in 2015. Okay, good. Shall we start with that then? And I wish that I could claim the 1962 thing as the result of my deep research ahead of this podcast. But unfortunately, it's just a happy coincidence. Let's start with late 2015. David, do you want to maybe just explain what was going on at that time? Yeah, I mean, look, the name of the fund was the Third Avenue focused credit fund, focused being emphasized here for making the point. that we were a concentrated portfolio of high-yield and distressed securities that you could not get in that format, in a liquid mutual fund format, pretty much anywhere else. We were unique in what we had created for the marketplace. But the fact that people thought of that fund as some representation for an overall market is sort of a misnomer. If you think back to the financial crisis where you had many, many funds gate themselves,

in effect, put up the gates, which there were permitted to do. You really didn't have much of a different story here. This was a fund that was the focused credit fund was set up to offer investors really an alternative to a hedge fund, to a private vehicle. And we were doing it in a public format. So what happened with that one fund really was not representative of what was going on the market because there weren't any other funds like that fund. So how did you have the idea originally before we get to even the events of late 2015? Tell us a little bit about the evolution of the fund itself and how you saw an opportunity to offer access to a concentrated portfolio of these assets in that liquid vehicle.

Okay, so 2008, the financial crisis is coming upon us. We were deep value investors. Pretty much most of our assets under management were in publicly listed equity securities. We had had a historical participation in debt and distress debt, both in public and private vehicles, but had really not had much exposure to that asset class leading up until the financial crisis. But as the financial crisis came upon us, obviously being higher up in the capital structure of a business is a safer way to invest. And our idea was to try and gather assets into that wave, if you will, and do that in a way in which we can participate because we were, like any other opportunistic value investor, that's where we saw the value. really and really were excited about the opportunity. The problem is how do you raise money going into a financial crisis when most people are taking money off the table? And we were

experiencing that with our open-end mutual funds, the equity funds. So the only solution that I could come up with at the time, because I was out pitching investors literally the week before and after Lehman Brothers went into bankruptcy, was to launch an open-end mutual fund because that's what we it's successfully done historically. And it took about nine months to get that done. So it's August 2009, and we file our Third Avenue Focus Credit Fund. And the opportunity was pretty clear, right? You had high-yield trading at 1,200 over as a spread. And so you could pretty much pick your litter. It was like shooting fish in a barrel, quite frankly, because you could buy a very plentiful supply of securities out there that you could buy and diversify the portfolio, even though it was a focus

fund, but diversify the portfolio across industry. And that was an easy opportunity for us. The challenge was there weren't many funds being launched in that format. In fact, I believe we were the only one. And most people, if they were trying to access these securities, were doing it in private funds and hedge funds. So we were very unique. And in fact, I remember going on CNBC to announce the launch of the fund, and a lot of folks took interest in what we were trying to do at that time. So that was the spirit for the launch, the idea, and the opportunity was clearly there. Did it ever cross your mind to start a hedge fund or a private fund like other people were doing? I mean, you mentioned that you'd had success in other open-ended mutual funds, so that was your

expertise, but did you ever even think about it? not just thought about it, attempted it in different derivations, especially since we had going into the financial, I think 2007, our assets under management peaked at close to $31 billion. So we had a pretty broad client base. But those clients in 2008 were more interested in getting their money back than allocating capital. And so raising funds in a private format. And even though we had that kind of AUM, we were in a private fund, what you call a first-time fund manager, right?

Because most of our funds, in fact, all of our funds were in public format, right, in mutual funds or separately managed accounts. So when you launch a private fund, private fund investors like to see track records. And this is why you have many of the successful private equity firms out there launching Fund 17 right now because they've got track records for the 16 prior funds that investors make their decisions on. Unfortunately, we are a backward-looking industry, right? So that was the challenge for us, and it became really almost the only way we could get the money was to do it through this public format. Now, what of the concerns that we were already talking about and that was really

spotlight in late 2015, is this idea of a sort of liquidity mismatch? People want daily liquidity or if it's in an ETF form, they want minute by minute liquidity. But distressed assets, junk bonds, they don't just trade, you know, minute by minute as easily as the same way as stocks do. When you launched the fund, was this something that was on your mind as a concern? Yeah, of course. And so the goal was to get to a critical mass so that you can have size and enable yourself to have a diversified portfolio and not have any heavily concentrated positions where liquidity constraints would mismatch investors' needs or desires because investors in mutual funds have the right to redeem daily.

You know, there are certain redemption fee features that you can put on funds, but that's the nature of the vehicle. So, of course, we were very conscious of that and we wanted to get to size. And we did quite, I think my recollection is that the fund got to about. 700 million in AUM within three or four months, which was sort of an unprecedented at the time raise, especially given the timeframe we're in, right? It's the fall winter of 2009, right? Still not a time when people were thinking about getting back into the market, right? We hadn't even had the green shoots conversations yet. So it was a very successful launch, if you will,

And that helped create liquidity for investors if they chose. And there were points of time, especially as you think about what happened in 2011 with the downgrade of U.S. Treasury's right. You know, you had issues over time where markets were volatile and people wanted to take capital off the table. So we had to be able to manage that through that period. The ultimate demise here was the fact that, you know, I had a portfolio manager in charge of the fund who who made some bad investments. And at the end of the day, in any construct, whether it's a mutual fund or a private fund, you have to be making good investments. That's what you're charged with doing. And when you have investments that turn out to be non-performers, that's what ultimately led to the

challenges with the fund. It wasn't a market issue as much as it was individual investments. So can I ask if you were doing it all again, is there something that you would do differently? Or what's your biggest takeaway from that experience? Well, yeah, I think if you're the learning is twofold, work harder to try and raise a private fund. That's an easy one. And secondarily, if you're going to do something in a public format where investors can access you daily and redeem you daily, then the only way to properly manage risk is to massively diversify the portfolio. So it's sort of what has ended up really transforming into the high-yield marketplace.

You have most high-yield funds are basically benchmark trackers, right? They own wildly diversified portfolios of securities that track the high-yield index. So basically, if you're going to have a daily vehicle, or a liquid vehicle for the public, your lesson now is there's almost no way to do it on a concentrated basis. It just has to roughly, more or less, be everything. That's correct. If investors are going to demand daily liquidity. Right.

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We create customized episodes that can only be heard on Bloomberg News Now. And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast. podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen. When it comes to credit market liquidity in general, we hear so much noise about, you know, trading having become more difficult, the market being more liquid, more ETFs, more open

ended funds that are investing in, you know, high-yield bonds and things like that. Are those valid concerns, in your opinion? Well, I haven't seen it manifest itself in any way that would cause me to be concerned about it. I think you had a point a little less than a year ago, maybe in January of this year, where high-yield was almost trading at perfection, probably maybe unprecedented in terms of where it was from a from a yield basis and and the spread as thin as I think it's ever been and you didn't really have any any issues and and we weathered through what was a pretty challenging energy market a couple of years ago that we're now seeing I think there were articles about it today that energy is now maybe the

largest percentage of the high yield index right now and you're seeing a sort of a row robust demand for securities in that sector. So the market has seemed to evolve itself into a pretty stable place, notwithstanding all of these traditional metrics that might cause concern for folks, but it hasn't done anything to spook the market from what I can see. So going back to a couple of years ago when we had the energy crash and a lot of high-yield debt tied to energy, that was obviously what people were most worried. In your view, the fact that we got through that period that it was pretty smooth, that none of the concerns really turned out too much is pretty good evidence that the market structure roughly works. Yeah. And if you had asked high-old investors what their biggest concerns were maybe a year ago, they'd say health care was going to be the next energy sector and what happened, right?

We haven't read or heard much about that sector getting disrupted in any kind of material way. So I just think people keep trying to look for problems just for the sake of looking for problems. And the market seems to have worked itself out pretty efficiently, which tends to happen. So, David, let's talk about your new venture. I alluded to it in the intro, but it's kind of an interesting take on investing. And I guess the clue is in the name. You know, you're now principal and co-founder at Outvest Capital. Can you tell us quickly what exactly it does, what the mandate is?

So Outfest is really an intuitive, simple, scalable idea for how to do two things. One, take advantage of what we think is the most forward-facing risk for all investors, which is the rate of technological change and how tech is disrupting all industries. And secondarily, the wave of flows into the passive index investing marketplace, which I personally witnessed in my prior role and is something that I think is going to continue infinitum. And so what simply one should think about is it may be more important what you leave out of your portfolio than what you put in, and thus the name and branding of our enterprise is called outvest capital. So this is really interesting. We typically think of funds as trying to

select the very best assets within some sort of broader family, whether it's large caps or small caps, whatever. Your view is that perhaps the best way to go is to more or less buy the index, but try to avoid the losers of the index so that you can gain from that. What is the, is there an academic research or backward looking data that suggests that that, that may be a better approach? So there isn't that we could identify. We wrote our own white paper, which talks to this concept, because if you really think about what you, when you go to business school, you're given Harry Markowitz's book on modern

portfolio theory, and it is pick concentrated portfolios of best ideas. And over time, you will beat the market, right? That's the basis for the way most people are educated today and still today. We take issue with that and actually say that really flip the investment process. And it's more important what you leave out than what you put in because the market has evolved. Index funds are the market today. They are continuing to grasp more and more of what's happening where flows are going. And we decided to launch this concept after simulating backtesting it for a little while.

but we have chosen the S&P 500, the most broadest based domestic U.S. market, where more flows are going than in any other index. And simply by excluding, as you call them the losers, we look at it as we're trying to eliminate from the portfolio those companies that are or likely will be disrupted by technology. And again, technology disruption being a forward-facing risk. And there's no better example for me to share. And I think you guys have talked about this in the past is General Electric. General Electric was the top five company in the S&P from a market cap weighted basis. And now it's market cap is close to $100 billion. Below $100 billion.

Now I'll blow 100 billion. Okay. So, and that's happened in such a short period of time. And I think in May of 2017, the Wall Street Journal wrote an article about how Jeff MMO was one of the great technology innovators in the way in which he'd, you know, taken and transform GE. Well, that clearly hasn't happened. So it's, it's, think about that.

If you own the S&P, you were buying that stock at its weight. Yeah. And if you simply eliminated what kind of outperformance, just for it. from one's security. Now, we do this, we ended up outvesting through our process about 150, close to 25% of the market cap. And we have been able in 18 months of live performance, outperform the S&P by close to 500 basis points. So we're just trying to prove this out, but that's what we're doing. So how do you go about identifying those 150 companies or how do you identify the next GE?

And is the process for identifying something that you want to take out of your portfolio, any different to identifying something under a traditional investment strategy that you would want to put in? So yes, it is. And a number of folks who we've talked to about this, why aren't you just doing a long, short portfolio? Because really the short selling mentality is to do that, to fundamentally select a security you think is going to not perform or underperform. But we're really trying to make this a scalable business, and short selling, by definition,

has been non-scalable. You have, I think, only one fund in the marketplace that's over a billion in AUM. So what our process entails is it's really two-prong. The first is simply dividing the index into industry groups through a technology. taxonomy. In other words, we're not using the global industry classification codes to divide the index. We're using our own industry group determinations. And we've divided the S&P into 34 industry groups, and that may change depending upon how the S&P evolves over time because there are new entrants and companies that leave the S&P from time to time. So we look at industry groups

through our own lens, and then we make a simple determination, is that industry, advantaged or disadvantaged by technology. And if it's advantaged by default, that industry group and the securities in it will be in the portfolio. And if it's disadvantaged, those securities and industry groups will be outvested from the portfolio or eliminated. So that's step one. It's a qualitative determination. It's an active approach, but it's merely making industry decisions, not company-specific decisions. We then apply a quantitative. model that we built to take that advantage group and make a decision whether to own it or not own it. So if it meets the quant screens and the quant screens are a lower bar for advantaged industries,

then they are for disadvantaged. And similarly, if a company is in a disadvantaged industry, the quant screen will either keep it out or kick it back into the portfolio. So you can avoid situations where there are certain companies within an industry group. And I'll give you an example of that retail would clearly be a industry group that is likely to be disadvantaged by technology. I don't think many people would debate me on that. But there are companies within that industry group, like Home Depot, that we view through our quant screen as having certain advantages and therefore it got kicked back in. And this is a fundamental quant screen. So this is looking at financial data of the company and something in that suggests that it's different.

than other retail company. That's right. Now, you mentioned the advantage an investor could have by, say, investing in the S&P 500 and not being exposed to GE. Like, even that would have been pretty good. Is there something that your screening would have picked up three years ago or two years ago or five years ago, and every GE started to enter a tailspin that would have prevented that from getting into the portfolio? And can you identify what that is? Yeah, and indeed, in the case of GE, it was our model that kicked the company out because we actually view industrials, which is the industry group that GE falls into, as an advantage sector. I mean, that's, industrials are clearly looking to technology, whether it's through robotics or otherwise, to improve efficiencies in what they do. So long term, we, we see that

as an advantaged industry group, but the model kicked GE out. And primarily the one particular signal for, for that company was, was revenue growth rate. And so you had a situation where it's declining revenue growth. And it's very hard for companies in publicly reported financials to fudge revenue. They can make all kinds of adjustments to EBITDA and other earnings metrics. But in the case of revenue, it's pretty tough to fudge it. So they triggered the model and got kicked out of the portfolio not long after we launched our fund. You mentioned that you had thought a lot about passive investing, the rise of passive investing.

I assume that means that you've also thought a lot about the benchmark indices and how those are constructed. And in fact, you know, what you're talking about at Outvest is basically tweaking the S&P 500, which is itself a benchmark index. What do you think about the decisions that go into making the indices as they currently stand? Yeah, look, we're having, we're in the moment right now, right, where you have probably the most significant change to the S&P in terms of GIC classification, right? You have a single person, David Blitzer, CEO of the S&P, who has the ability to make these changes. And now all of a sudden we have something called communication services because telecom had only 2% of the index when in 1962, as we started this thing, I think telecom was a significant percentage of the S&P, right? So certainly it was even 10 years ago as compared to today. So they had to make adjustments to maintain the broad diversification of the index from a sector standpoint. That to us is sort of a statement of support for what we're trying to do because we look at the S&P as a diversified

portfolio where people, if they want a diversified exposure to the market and we think all investors, they've shown us that they want to have a diversified exposure to the general market. And in fact, institutional investors really need to have it as most of their investment policy statements require them to have exposure. If they can get that exposure in the same diversified way, like our beta is almost 1.0, even though we excluded 150 names, if they can get that and outperform by the kind of margin that we've been able to generate in a very short period of time, and we think we can consistently do that over time, and consistency is a key word in the asset management industry, they have to pay attention to that. So how the indices change and evolve over time is going to be

a significant impact, I think, on the overall market, but there is no one that we've seen who's approached it as we have. That is flipping this process to think about what to leave out as opposed to what to put in. Can you tell us sort of what, if and what, anything in your experience at Third Avenue or even with the collapse of the concentrated credit fund sort of led to you seeing this opportunity? Yeah, look, I was a a student for a long period of time of my mentor and the founder of third half in being taught about concepts like diversification as a surrogate and a very poor surrogate for knowledge and and investing right because you should know more about research what you can fundamentally

learn about a business invest not business and over a long time you'll be rewarded for that patience and and work right research work yet consistent from the financial crisis forward, we were unable to outperform indices. And so what asset managers like us did was we changed the benchmark that we ended up getting compared to because we looked better against another benchmark than the original benchmark we chose, right? We were an S&P 500 originally measured fund and we changed, right? So what I was informed about there is you cannot, I think you cannot beat the market. And if you can, then you're going to be in a hedge fund charging 2% management fees and 20% of the profits because you're a special individual who has skills that

are more extraordinary. Or you're a quantitative, purely quantitative manager who's come up with some concept that can beat the market. And we're seeing more and more asset flows into those types of vehicles as well. So the informed judgment that I made was I now believe fully that the market is going to evolve with more and more flows going into these types of entities, if just for fees, right, just because fees are much less. So if we can if we can participate in capturing some of that flow, because we've come up with this intuitive concept and we're thinking about a forward risk. This is about technology disruption, which nobody's talking about. You guys will spend all day talking yesterday about what's going to happen with the Fed and people

study it upwards and downwards. But how much time do you spend focusing on Moore's law and how that's impacting decision making and people's rate of change, right? I'll push back a little bit. I mean, I would just say we do talk about this stuff. but we talk about vulnerable industries and we talk about, say, the clash between Amazon and physical retail. The thing that intrigues me most as a theory here is the idea of being able to quantify the disruption risk. And the, you know, we could talk, you know, one of the best performing sectors this year has been the department stores. And so this idea of actually being able to identify in a systematic manner and not just sort of your gut feel.

oh, these guys are in trouble is the part that I find to be, I'm most interested in trying to understand. Yeah. And I would tell you that the fund and the concept is really about long-term secular decline. But it will be technology that will be the triggering for that long-term secular decline. So maybe department stores are outperforming because they were so underperforming. Sure, sure. But I'd argue that that's a temporary blip. And that over time, you'll continue to see deterioration and secular decline, unless they're able to transform themselves.

And there are businesses that have been able to adjust. And it's those companies that adjust that I think will be the long-term winners. All right. Well, David Barr's co-founder and principal at Outfest, thank you so much for joining us. Thank you, Joe and Tracy. I really appreciate it. Thank you. That was great.

So, Joe, I found that conversation really fascinating, not just to hear the thoughts about what happened at Third Avenue, but also to hear his thoughts about diversification and the rise in passive investing, which is something that you and I have talked about quite a bit at this point. Yeah, absolutely. I was going into the conversation thinking, oh, definitely the sort of Third Avenue fun collapse would be the most interesting part. But now I'm really intrigued sort of by the conversation. the second half and okay accepting this reality that we have now of massive flows into passive or passive-ish vehicles. What are the approaches that make sense for now? Because as David said, it's pretty obvious. It's just the sort of concentrated fund management strategy, particularly on the equity side. It's just not working for anyone it looks like. Right. And there's actually a link with, you know, what you said about Third Avenue, this notion that, you know, if you're going to have a public-facing fund, and especially an open-ended one, you better make sure that it's

diversified because otherwise people tend to get angry very quickly and tend to pull their money out very quickly. Whereas if you're investing, you know, in a broad index, it's kind of like that old maxim, that business maxim, you know, no one ever got fired for buying IBM. No one ever got fired for buying the S&P 500 and making, you know, little tweaks to it. Right. Absolutely. And this This idea that maybe you could basically get the exact same beta, the exact same diversification with 350 or 400 of the S&P 500 stocks is pretty interesting. And you're probably not going to get fired for missing out on one of those 100 stocks that got kicked out. And I like the idea that if they did turn themselves around, so maybe like some department store really does figure out the magic sauce to save retail, then maybe it could get back into the fund on fundamental reasons. sense. And I am rooting for Sears. I have a soft spot for Sears. I hope they, they're one of the ones that

can redeem themselves. Who knows? I'm rooting for them too, I think. Okay. All right. Well, this has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Weisothal. You can follow me on Twitter at the stalwart. And you should follow our producer on Twitter. He's Tofer Forehs. His handle is at Forges. and followed the Bloomberg head of podcast, Francesca Levy, at Francesca, today. Thanks for listening. I'm Francine Lacqua, an award-winning journalist, and I've got a new podcast, leaders with Francine Lacqua from Bloomberg podcasts. I've interviewed everyone from Heads of State to fashion icons about the news of the moment.

But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision. Listen to new episodes every other Monday. Follow leaders with Francine Lacroix wherever you get your podcasts.