(Ep.104) The Acquirers Podcast: Ted Seides – Capital Allocator: Investing In Hedge Funds And The Bet With Buffett

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In this episode of The Acquirers Podcast Tobias chats with Ted Seides from the Capital Allocators podcast. He’s also written a brand-new book called Capital Allocators. During the interview Ted provided some great insights into:

  • That Bet With Buffett
  • How Capital Allocators Approach Style-Drift
  • Building A Process To Make Better Investment Decisions
  • Lessons Learned From Dave Swensen
  • How To Determine If Someone ‘Has It’ As An Investor
  • The Case For Active Versus Passive Investing
  • Why Shorting Is So Hard
  • You Never Know What The Market’s Going To Do
  • The Impact Of The Fed On Markets
  • Capital Allocators Podcast
  • Capital Allocators: How The World’s Elite Money Managers Lead And Invest
  • Patience Is A Virtue
  • Ask For Help

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Full Transcript

Tobias: Hi, I’m Tobias Carlisle. This is The Acquirer’s Podcast. My special guest today is Ted Seides. You know him from the fabulous Capital Allocators podcast. He’s written a brand-new book called Capital Allocators, which is based on some of the discussions that he’s had in the podcast. He’s an advisor to investors, he might be one of the greatest hitting coaches for other investors. We’ll be talking right after this.

[intro]

Tobias: I first heard about you through the bet with Buffett. Honestly, at the time, I’d have taken your side of the bet. I love the way you described it in the book where you said you were bored or you’re having a quiet day, to inject some excitement, how did it come about?

That Bet With Buffett

Ted: That was it. We’re going way back now. This was the summer of 2007, and to put the markets into context, I was running a hedge fund to funds, risk had worked for many years, lots of things felt a little frothy, the markets were high, credit spreads were tight. Around that time, we had found the subprime mortgage short. Before it played out, you were sitting on, for us, I would say, I don’t remember 2% or 3% of our portfolio, that was a 10 to 1 risk-reward, where we could look at it and say, “Well, if the rest of the world risk on keeps working, we’re going to keep doing great. If not, we have this incredibly low-cost hedge.” I was just feeling that’s probably the best I’ve ever felt in my investment career. I was like, “Wow, we’re winning on every side. No matter what happens, this is going to be great.”

Around that time, someone sent me a transcript of one of Warren’s talks with a group of students. Maybe it was about a year after he had talked about in his annual letter, the hadrocks and the gotrocks, the whole concept of fees. In this transcript, a student had said– I might not have been at that meeting, or maybe I was getting food downstairs or something, but at some point in time, someone had asked him specifically some comment about that. He made some off-the-side remark that he didn’t think a group of hedge funds could beat the market. I saw the transcript, and someone asked him about it in the transcript. He said, “Well, no one took me up on it, so I guess I must be right.”

I was sitting around, it was in the summer, it was a quiet day. I just thought it was such a cheeky response because hedge funds are so different from the market. The market was trading at historical high valuations. And keep in mind interest rates then were 4% or 5%, you can’t even make the case that valuation multiples should have been higher, because rates were lower in a discounting mechanism. I just thought he made a bad bet. I still think he made a bad bet. He made a bet. I didn’t really care, but I sent him a one-page letter in the mail, regular mail, in part because I had heard so many stories of how legendary he was, and how he responded to people’s letters. I was mostly just curious how he would respond. He did. He sent a little pithy response. “Well, it has to be this and that,” and it turned into a– what was a letter, most of the emails and PDFs and that’s a whole separate story about why he doesn’t have email, that consummated in the bet. Again, it was the summer into the fall of ‘07. I really thought for another good year and a half, two years, that was a really, really good bet to make.

Tobias: The market topped June, July, August 2007– [crosstalk]

Ted: Yeah. 2008. Right.

Tobias: But you put the bet on in 2007?

Ted: No, it started on January 1 of 2008.

Tobias: Oh, I see. Okay, so the market had come off. I don’t think that people would have necessarily thought that we were in the middle of a crash by then because the crash didn’t really come until the back half of 2008 through the first quarter of 2009. You must have been feeling pretty good out of the gates. You’re a long way ahead in that bet.

Ted: Yeah, let me give you some historical context. By February, March of 2009, the hedge fund side of the bet was probably– I wasn’t really looking at numbers, was probably ahead of the market by 50%. In the prior 10 or 15 years, the gap between the market and a hedge fund index return was probably like 1% to 3% per year. The dispersion just was never really that high, because there’s beta in the hedge fund side. At that point in time, yeah, it looked pretty good. In fact, at the end of his 2009 annual letter, I used to have a presentation and I pulled a quote from that letter that I referred to as his concession speech two years in, because he said something, he was comparing Berkshire to underperformance of the S&P. I think he had just gone through his first five-year stretch of underperformance. He said, even in this period, as long as 10 years, and keep in mind, the bet was 10 years, the results can be heavily influenced by the starting or ending point. I think if he ended up losing the bet, we know exactly what he would have said. It sure felt that way at the time. Now Fed came in, the world changed and didn’t end up that way.

You Never Know What The Market’s Going To Do

Tobias: What’s the lesson from that? Don’t do something when you’re bored or don’t bet against Buffett?

Ted: [laughs]

Tobias: What’s the lesson?

Ted: Oh, I don’t know that they’re that– You can take a lot of lessons. I think the biggest one is, you really don’t know what can happen in markets, even if you think you do. Even if the odds are on your side. There was no one in 2009 that would have told you, “Oh, for the next 10 years, a 60/40 portfolio is the way to go. The S&P is going to be up to 18% or 19% a year from the depths of where we were.” That’s certainly one. There’s another lesson separate from investing. I think, if you’d call it that, in being able to watch how Warren chose to communicate about something I knew intimately was really– he’s so impressive in so, so many ways. Just to give you anecdotes about that, we started the bet in– it got consummated in the fall of 2007. The bet got started in January 1 of 2008. At the end of 2008, I think the hedge funds were up, I don’t remember what the number was, 30% or something like that. Carol Loomis wrote an article for Fortune magazine announcing the bet sometime in the middle of 2008. Warren had wanted to announce the results of the bet every year at his annual meeting.

In his 2009 annual meeting when there was incredible scrutiny on him and active management, he didn’t say anything about the bet. In 2010, when he was well behind, he didn’t say anything about the bet. He might have said a little bit, but I think he pretty much maybe said there was a bet and he was going to announce the results. For the next couple of years, the only thing he ever said was he put up the results right before lunch, and said, “Well, I promised I would tell you about this bet. As you can see. We’re losing let’s go to lunch.” It was just a fun joke. He really didn’t say anything about it until the seventh or eighth year when for the first time the S&P had crossed– it took maybe it was that long, maybe six years. Just from the first 14-15 months, it took the S&P, call it five or six years to catch up. Then he started talking about it and writing about it. Then, he basically declared that he was a victor before it was over, which is an interesting thing. Why would he do that and not wait for the other year? I don’t know the answer to that. I do have a supposition, which is fun to share. I don’t think– it’s no reason why it came out public, which was at the end of the ninth year, the S&P was a head of each of the five fund to funds in the bet for the first time. There was one fund of funds that had done meaningfully better than the others. That was the first moment in time that he could say, “Oh, by the way, here are the results and the S&P is better than everything.” There was still a risk that at least that one fund to funds would outperform in the 10th year. It turned out they didn’t because it was another strong year for the market.

My supposition is that he grabbed the one moment in time when he could tell exactly the story he wanted to. Then, as a fun afterthought, when we started the bet, Carol asked both of us the odds that we thought we would win. My partners and I said a big number like 80% or 85% and that had some historical precedent, and Warren said 60%. But if you read everything he said about the bet after the fact, he writes as if it were 100% certainty. I called him once a couple of years ago and said, “By the way, I’m just thinking about reviewing my own decision-making process. What were you thinking at the time when you said you had a 60% chance? Does that have to do with the valuation of the market?” He said, “Oh, I don’t remember.” There’s an element of this expression of certainty he didn’t have at the beginning, it may not have been that thought out. I really came away from it saying, I still think it was a good bet at the time. We hit one node that was wrong one, and maybe my assessment of the probability of winning was too high, entirely possible because something happened, I certainly couldn’t have envisioned. It was a really fun and I’ve spent a whole bunch of time with him, which is really great, too.

Tobias: As I said at the start, I thought you had the right side of the bet. I’m as surprised as anybody else, that the S&P 500 was so strong over this period of time. But the metagame part of it where you get a bet with Warren Buffet, and you get a lot of publicity that that must have been absolutely fantastic, get to spend some time with him too.

Ted: Yeah. The latter part is the part that I derived the most value from. We’ve had dinner together seven or eight times, and I’ve gotten to bring friends out that I thought he would find interesting and all kinds of cool things came out of that. For example, Jack Bogle showing up at the annual meeting was a direct result of my bringing Steve Galbreath, who’s a dear friend of Jack’s out to dinner, and that coming up in the conversation, and Warren saying, “Do you think he would ever be interested in coming?” Sure enough, that led to Jack coming. So, that there are a lot of little things. Yeah, there are a lot of like that that were great. A friend of mine said to me a few years ago as that was ending, “Could you imagine what the publicity would have been if you had won?”

Tobias: Yeah.

Ted: From that perspective, I think that’s right. I think it was a free option. I don’t think that the publicity did anything positive or negative for my business at the time. Part of that was that we didn’t use it as– Warren was out talking about it, we didn’t really say much. Even when we were winning, we weren’t out pounding our chest saying, “Ah, see, we told you.” There are other people in the industry who would have done that, but it’s not really my style.

Tobias: Yeah. It would have been something. Certainly, at the start when you’re winning, it’s great promotion. Let’s talk a little bit about– you’ve got a new book. It’s your second book. This is a collation of many of the topics that you’ve discussed on your podcast over the last four years, podcast’s about four years old?

Ted: Yeah, just about.

The Case For Active Versus Passive Investing

Tobias: You’ve got about four million downloads on the podcast, which is something to aim for. One of the topics that I found most interesting at the start, and it’s a little bit like the timing of your bet with Buffett, but I just wonder if– you tried to make the case for active investing versus passive investing. I tend to agree with you, but I’d like to hear your argument for it.

Ted: Sure. Well, look, let’s start with the case for passive investing because it’s incredibly compelling. In a confined market, let’s talk about active versus passive in something like the US equity market, which is the one that most people point to. We know that collectively it’s a zero-sum game. Always has been, always will be. We also know that like what Michael Mauboussin describes as the paradox of skill, the ubiquity of information, the speed that it’s disseminated, the number of intelligent people playing this game is just way higher than it’s ever been before. Competition’s really high, index funds can work just because of that market mechanism as market’s more efficient. The case for passive management in the US equity market or the US bond market is very, very compelling. Then if you want to look at data, every data that any data set anyone wants to look at is only the last 10 or 12 years and sure looks like S&P beat everything, 60/40 beat everything.

Just as an aside, as tough as it was for hedge funds in the period of time of the bet, which was 2008 to 2017, if the index had been the Morgan Stanley world index, forget about market exposure, adjusted risk adjusted, it would have been pretty close to a wash. Just the gap– and Morgan Stanley world is 40% US, so just the gap of the US and the rest of the world was enough to throw that entire bet off by a lot. That’s the case for passive management. There’s just a few real problems. I love quoting Albert Einstein’s quote, “It’s always endeavor to keep things as simple as possible, but no simpler.” My case is that the concept of passive management, the case for passive management is just a little bit too simple. There’s a few reasons for that.

The first is that unless you’re only talking about US equities and US bonds, no matter who you talk to, people don’t have as much conviction in an index fund outside of those two markets. Those two markets are big and important, but they’re not the whole world. Even Charlie Ellis who maybe two, three years ago wrote yet another book, The Index Revolution or something like that. I had Charlie on the show a couple times. I asked him, “What about in emerging markets?” He says, “No, no, you don’t want an index fund in emerging market. They are too skewed towards large market caps.” “What about small cap?” “No, no small caps really, really inefficient. You want active management.” “Okay. What about Europe?” “Well, you probably don’t want it in Europe either.” So, you get to a place where even if you believe in index funds, you’re still tasked with building a portfolio. You have to make active decisions about what that asset allocation is going to be as long as you’re going beyond US stocks and bonds.

Then you have to ask the question, okay, what do the most sophisticated people do? If you look at– not just in the past, but today, if you look at well-resourced institutional pools of capital, think about large university endowments, and foundations, and sovereign wealth funds, and Canadian pension funds, they all have the opportunity to index and they can do it, and not a single one of them does. That means one of two things. Either it’s the wisdom of crowds, or it’s the madness of crowds. Yes, each pool of capital is different, they all serve different needs, maybe they all can’t win. Even Fran Kinniry who runs the private equity business at Vanguard, I had on the show earlier this year, said, “What people miss about the active-passive debate is that yes, in aggregate the active managers will lose by the amount of their fees, but only about half of them, half of them win.” People want to believe they can win, they don’t want to be passive, and then layer on to that the market pricing exactly as you said, it probably parallels– certainly in the stock market back in 2007, it didn’t play out over those 10 years. Stocks are expensive, bonds are ridiculously expensive.

Most pools of capital have required spending, let’s call it between 5% and 8% per year. I don’t care if that’s an individual or a pension fund or an endowment, they’re all basically the same. If bonds give you nothing, 60%, 70%– your stocks are probably priced to give you 4 or 5, he can’t get there. You have a choice. You can sit cash and wait for better times and hope that over a long period of time, you’re zero now and you’re 10 in the future gets you where you need to be. Or, you can try to do something else. So, I think it’s a period of time where active management, it’s not any easier than it was. It’s more essential for investment success because just being able to access these vehicles passively will not get people the returns that they need to meet their spending obligations.

Tobias: Yeah, good for passive. That’s always been the surprising thing for me. I come from Australia, Australia took a long time to get– I’m not even sure if it’s back to its 2007 peak. Yesterday or the day before Japan got back to its 1991 peak on the index, that’s excluding the dividends. Japan’s an absolute powerhouse business economy. It’s one of the biggest in the world. They’ve got lots of the biggest, most successful companies in the world. Yet, the index has still– it was just so expensive in 1990, it was about 100 times on a cyclically adjusted basis. We saw the same thing happen in the US too. In 2000, we were at 44 times on a cyclically adjusted basis. Now we’ve rallied to about 36 times on a cyclically adjusted basis, which is still historically very expensive. You would imagine that– and it seems like risk has been completely eliminated from the market. You look at the speculation in some of those, the smaller option, core buying for retail options, it would seem to be that we’re at some point in the market where this is always the point where passive is going to look the best, particularly if your index is the US index, and active is going to look terrible in comparison. The risk-adjusted returns on the S&P 500 are absolutely phenomenal.

Every look back period I’ve done for about the last 10 years– That’s not quite right. For about the last five years, including the last five years before that, it sort of had these sharpened Sortino ratios that you could just walk into any allocator’s office and say, “Look at what I’m doing. How much do you want to invest?” What’s the way back for active? Is it do we need some sort of risk event? Do we need some sort of shakeout and why wasn’t March 2020 enough?

Ted: What a great question. I don’t think there’s ever a way back for active because if you really think about the decision-making process of who’s shifting their money to passive money, I always think about my parents. My father is an 87-year-old doctor, my mother’s a 79-year-old teacher. They don’t know anything about investing. Their retirement funds are still in an active mutual fund. They should be investing in index funds. They don’t know how to beat anything. But they’re just not aware of it. There’s a whole bunch of reasons why I haven’t forced them to do it, but that’s fine.

The money in max that has gone into index funds has been so-called less sophisticated money. There’s a lot of it, and that makes the competition [unintelligible [00:21:00] that much harder. I think that if an institution comes to a decision that they want to index a portion of their capital, let’s say they’re done with US stocks, they only want to own the S&P 500 index fund, I cannot imagine what the argument would be to get them to change their mind. Other than a change in staff, people with a completely different mindset. You will have this continued share shift of call it retail money towards indexing, I think that will continue, I think that is a secular change and there is no going back. It doesn’t mean that active management disappears. It just makes it more challenging, because the total size of the pie is shrinking– Well, the total percentage size of the pie is shrinking if markets grow, it might be stable, and you have very sophisticated competitors. You’re also shedding out some of that less naive money. Maybe one of those subtle dynamics of what we’ve seen in the last month or so with called crowd-sourced convexity trading is– well, I don’t know a lot of sophisticated institutions who looked at those stocks and thought they were good value. Some people might have said, “Oh, I can momentum trade this,” but there is clearly still opportunities for people to add value over time. On the short side, clearly, it’s incredibly difficult.

Why Shorting Is So Hard

Tobias: Yeah, that’s GameStop as one of the– GameStop, I thought was very deep value a few years ago. Michael Burry was in it for a little, while Michael Burry would just his 13F just came out, he sold at the end of last year, so he didn’t participate in the gigantic run up, but it had been a three or four-bagger for him by that point. Then there’s the brand-new player in the markets now, Wall Street bets. This is the story, I guess that they’re hunting for shorts and trying to blow out the shorts, which makes– shorting has been an incredibly difficult thing to do over the last year or last decade. Now it seems like you just want to take all the shorts off. I think Bill Ackman had a tweak to that. To that end, he said, “We’ve just taken them off.” What about shorts? Can shorts– is their time coming?

Ted: Yeah, shorts time will come, but we need normalized interest rates. You can walk through the structure of the economics of a short position. You short a stock, or you borrow the stock, you post cash collateral, you get interest on your cash, then you short the stock. That period of time, you mentioned 10, 11 years, it’s been difficult for short and coincides with the Fed bringing rates down to zero. In a 3% or 4% or 5% interest rate environment where your short rebate’s 2% or 3% compared to zero and you’re paying one, that’s 3% per year on your short book that you’re not earning. That’s a big, big part of what’s made it difficult terms into cost. Then there’s this crowding factor. There’s this real question of– I always cite the statistic. When I started my career in the early 90s, a crowded short was considered something like 3% or 4% of the float outstanding. Now, we’re at 140. It’s a different game. The problem is not so much that there are people playing the game, the problem is the path dependency of volatility. You short a stock, it goes against you, it becomes a bigger problem.

Rebalancing shorts when they’re volatile, rebalancing any asset when it’s volatile, can create a drag, particularly in the short side. Same issue that leveraged ETFs have, why they consistently lose money if the underlying is volatile, and it doesn’t matter if they’re going up or down. Shorting is really, really hard. I don’t think that changes that much, because there are so many people participating in it.

Building A Process To Make Better Investment Decisions

Tobias: Let’s just move on to decision-making. You’ve got this great quote at the beginning of your decision-making chapter from Drew Dickson, who studied under Fama at the GSB, now Booth, and he says something like, “If Eugene Fama who came up with this area of study still makes these behavioral errors and Drew Dickson is going to make them, too.” What’s the lesson from that? How do we handle it? How do we make better decisions? What are we doing wrong? How do we get to that point?

Ted: Yeah. I think everyone listening to your show is probably familiar. I’ve had Annie Duke on the show a couple times, and Michael Mauboussin. Gary Klein a little bit different. He’s a cognitive psychologist who created the premortem analysis. We don’t need to go through the behavioral parts of it. Our brains are hardwired to make bad decisions, to use system one brain thinking, and so the question is, you can’t change it, even if you’re aware of it, what you can do is build processes and systems to try to mitigate it somewhat. Some of those, you could think about how you structure a decision-making unit– there’s one thing if it’s, by the way, an individual, and then you can do the same things. A lot of what the investment offices that I talked to their teams, so I structure this around teams. So, there’s a little bit of the structure of the team, how they conduct themselves, and then their own thought process both as individuals and team members.

There’s a structure, Michael says, “The optimal structure for decision-making team is four to six people. It can be effective in as few as three.” But it’s not 10, it’s not a committee. It’s harder with one, you need to get a sounding board. It’s very simple. Then, of course, within that, you’d like cognitive diversity. I always point out that cognitive diversity and social diversity are not the same. Social diversity often creates cognitive diversity, but what you’re looking for is people that think differently, not people that look different, but think the same. Then you can move on to conduct and how do people conduct themselves within that group.

The key thoughts are you want to engender cognitive safety, and you want people to be able to think independently, and a lot of that starts with the leader of the group. So, there’s this behavioral notion that it’s very easy to infect other people with our beliefs. Because of the way the brain works, if I say something, you first believe that it’s true, and then you might assess it. If you’re the leader of a group, what that means is, you don’t really want to express your opinion till the end of the meeting. You hear good decision-makers, people saying, “No, we start with the youngest member of the team, the most inexperienced member team and work their way up.” We start with the introverts first that aren’t known to be the most influential and work towards the extroverts, because you want everyone to be able to express their opinion. Then, it’s really up to the leader to allow different opinions to be both heard and not punished if they differ from the leader’s opinion.

Tobias: I thought Simon Sinek says something similar to that. Very similar process, start with the person who’s lowest on the totem pole or the most introverted, and then don’t express an opinion. That accords with what I’ve heard in the past.

Ted: Yeah, look, this is part of what I did in this book is these are– I don’t want to say fundamental truths. In certain disciplines, when you read how people think about it enough, you sort of say like this is how it works best. No different than if you read Graham and Dodd, and you understand this is how value investing generally, that people think about it works, it doesn’t mean it’s easier to do. Then that last piece, when you’ve got that team speaking the right way, how they think and process information. Annie uses this great phrase from her first book, Wanna Bet? If somebody speaks about something in absolutes, and you say, “Wanna bet?” they think about it for a second and they immediately shift the system to thinking and they say, “Do I really believe that with 100% certainty? Or do I want to put probabilities on it?” That whole notion of thinking about things with probabilities.

The next is thinking about the outside view and base rates, incredibly important. I love talking about that with hedge funds. The average allocator in the business does not believe that hedge funds as a group generate sufficient returns, but they all believe that their group of hedge funds will. It’s not to say they’re wrong, but it is to say that whatever their expected return is on their group of managers might want to be colored by the base rate, which they believe is lower than– or significantly lower in most instances than their own portfolio of hedge funds. By the way, that’s true of every single hedge fund investor. In aggregate, if they are getting the average.

Then, the last is this notion of how you conduct risk assessments once you’ve pretty much come to a decision. Whether you use a premortem analysis or red teams and blue teams, or if one person, even just a pro and a con list and running it by somebody else, there are just ways that you’re trying to create uncertainty, to remove your own overconfidence, and to unearth all the different things that you could imagine happen, that you may not. We started talking about the Buffett bet, did I think that if, in fact, the market crashed, which I thought was a possibility, that there’d be some type of intervention that would never actually let the market stay down for a long period of time? No, never came up. If it had, I still probably would have made the bet, but I wouldn’t have thought the odds of winning were as high.

The Impact Of The Fed On Markets

Tobias: This is a slight segue, but to what extent do you think the Fed is really omniscient here, and to what extent do you think it’s sort of a belief that the Fed is omniscient, and that there have been– the Fed intervene pretty– This is a total side-step. I’m sorry about this. I’m just interested in what you think. The Fed intervened pretty heavily in 2000, 2002, again in 2007, 2009, and it didn’t seem that they’re firing that cannon pretty consistently all the way down. I think John Hussman said he thought it was the change to the accounting regulation that the banks didn’t have to mark the losses to mark it anymore. They could mark it to model and that meant that the losses weren’t showing up as much. That sort of seemed to be the bottom in March 2009. I think there’s this pervasive belief now that the Fed is capable of stopping the market from going down. I just wonder, is that what you believe? Do you think that’s true?

Ted: I have no way of knowing what a pervasive belief is. What we know are the facts of what’s happened with the market and that’s certainly a potential cause for that effect. I don’t know, I’m not a Fed watcher. I do think that most central banks around the world have boxed themselves in a hole, and you’re going to need a long period of time of strong economic activity to allow them to come out of that. The only analog– it may not be a good one for a bunch of reasons, the only real analog is Japan. If you talk to people in Japan, they say, “You know what? Deflation has been pretty good. Quality of life is quite good. This has worked for us for 20 years.” All of these decisions, the Fed, what happens in economic activity, what happens in the markets are all driven by people and behavior. It is hard for anyone to think if the right thing to do is to take the pain now because over the long term, that’s going to be better, we haven’t seen somebody in power in that seat act that way since Paul Volcker. I think we’re in an environment where you can’t have rates too high, because the level of outstanding debt is too high, the interest of the debt will suck up the budget. We’re going to be stuck for a long time.

How To Determine If Someone ‘Has It’ As An Investor

Tobias: Yeah, it takes a long time to work it off. While we’re talking about Volcker, let’s talk about character. That’s one of the things that you discuss in the book. I’m not going to ask you why it’s important. I’m going to ask how do you determine whether somebody has it or not?

Ted: Yeah. Well, it’s very personal for each investor. The two stories I love to say is, you could take a hedge fund manager, let’s say, who is known to be difficult, maybe turns over their team a lot, isn’t the nicest person in the world, but ostensibly does extremely well in the markets. Some investors will love to have a manager like that in their portfolio and others never will, because they believe that what matters is certain qualities of character. The CIOs that I talked to, what you hear consistently is they care about trust, that they can trust the person to do the right thing by their investors if something goes wrong. They care about integrity. Meaning, somebody actually does what they say they’re going to do, doesn’t mean that those two things don’t have to be the same but if someone is not good to their people, but they’re honest about it, that’s okay to some people as long as they have integrity about what they’re doing. Then, a lot of it comes to what happens in the market. How competitive is someone? How intellectually curious are they? How passionate are they or continue to be about what they’re doing? How motivated are they? It’s all soft, it’s hard to put your finger on, it’s obvious. At the end of the day, it’s not the list of characteristics. It’s all relative.

I’ve sat in that seat for 25 years, I can’t count how many managers I’ve met, but after a while, just like with meeting company management teams, you develop pattern recognition. There are subtle differences that you see. For the most part, of all the thousands of managers you meet, you invest with next to none of them. I think I put a stat in the book that– I had never done this before but if you run the numbers on the number of managers that your average investment, allocator investment office meets within a year, just the chance of getting a meeting with that manager is significantly lower than a college senior getting admitted to Harvard or Yale. One of the things that happens is managers don’t appreciate that. They don’t understand how wide and broad the opportunity set is for allocators and it becomes just a business about saying no.

How Capital Allocators Approach Style-Drift

Tobias: Yeah. One of the things that I observe in value in particular, just because it’s been such a long rough run for value, is there’s a progression away from what has traditionally been a value style, which is probably not paying as much for growth, to where growth has sort of been the really significant difference between– growth investors have done very well, growthy value investors have done better than older school value investors. When you see style drift in a portfolio– The way that you described it in the book, I thought was interesting, because you talk about someone who– and this probably happens quite a lot that someone comes in and they’ve got a strategy that works really well in a small– could be a small-cap strategy works quite well. It’s not explicitly small-cap, it just works very well in there. As they grow assets, they’ve got to make some decisions about, do they go into a larger cap universe? Do they buy more of the securities in terms of the number? Do they get bigger positions? And in making those decisions, they are going to change their performance somehow. Is style drift justified in those circumstances? How do you think about style drift?

Ted: A lot of it depends on the strategy itself. There are certain strategies, stock picking strategies, that started small cap that almost by definition will change in some way shape or form. They might change because the manager says, “I want to stay the same as I’m returning capital,” but then you the investor keep your capital with them, so things change. There are other strategies. Think of private equity or large cap equities that don’t. It really comes down to less a statement about style drift, and more a question of what was the allocators investment thesis when they made the investment in the first place. For the same manager, you could have many different reasons why an allocator has invested with them. As long as the allocator does a good job, which they often do of articulating what are the reasons we invest. I used to tell our team, those have to be qualitative, it can’t be– we think they’re smart, unless we’re checking their IQ scores and have decided ahead of time if the IQ score dips, we’re going to redeem. It has to be processed driven because what happens with great consistency is that all track records go through ebbs and flows. When performance gets soft, people then look at their own thesis and say, “Aha, we knew these were risks, they are playing out, therefore we should redeem.” Or somebody else might say, “Aha, we knew these were risks, they’re playing out, let’s add.” Those are two 180-degree different responses. That’s where human behavior comes in and how committees get formed.

I don’t think there’s a rule of thumb in how an allocator approaches style drift in that way. It really has to do with why they think they invested and do they think that particular manager is likely to perform going forward based on the set of conditions at the time.

Tobias: It must be an incredibly difficult process to go through because there’s some well-known stats–I think it’s Mauboussin’s stat that the best performed managers over a decade period will spend two or three years close to the bottom decile of that. You meet somebody smart, they go through that– have some good performance, go through a period of bad performance, then you have to make that decision, do we redeem or not? It seems the wrong decision is to redeem even though all the evidence seems to point in that direction at that time. How do you deal with it?

Ted: Well, the best allocators with the best track records have tenure relationships with their managers that are beyond comprehension to almost everyone who invests. I don’t know the exact numbers. Dave Swensen has been at Yale now for 36 years. My guess is the average manager in their current portfolio, on average, is probably like 16- to 20-year relationship. Most people haven’t been in the business for 16 to 20 years, so that’s how they ride it out. They’re really good investors, everyone wants to say they’re long term, but they’re really good ones stay put. They’re able to ride that out, they’re able to give the managers the confidence that the managers can then ride out positions that they’re going against them. Because otherwise, you’re exactly right, as an allocator, you never know exactly what’s going on inside the organization and it’s very, very hard to make those judgments on a snap basis.

Tobias: As an allocator, you must have to have some look through into what the underlying asset or strategy is doing and then you’re looking at how this person is performing within that, and probably have some idea that you want to act more slowly than precipitously. You want to let the position play out a little bit.

Ted: Yeah. I think that’s fair. Again, everyone’s different. How people choose to go about that process, and the factors that drive their decisions, both on entry and exit of a manager, similar to– it’s actually a lot more similar than different to how managers perceive stocks. Why do you pick those stocks? Why did you enter there? Why did you exit there? Is very, very similar.

Lessons Learned From Dave Swensen

Tobias: Yeah, that’s sort of what I meant, by having the look through, you need to understand the strategy as well as the underlying manager does. Value’s gone through a bad period of performance is because the managers is bad or is because the strategy is just having a bad run. You came through Yale– were you in the office with David Swensen?

Ted: Yeah, at the beginning of my career, ‘92 to ‘97.

Tobias: Any lessons from that that you continue to apply to this day?

Ted: Really everything. That was my formative training in investing. Dave wrote up a lot of it in his book. I remember seeing that book in 2000 shortly after I left, and I pretty much knew what was going to come on the next page, because I lived it with him those five years. But yeah, everything. The biggest lesson I take away after a long time since is that many of those formative lessons that I was taught, almost in an academic way, because when you’re young and someone tells you, “Oh, value is good, small cap is good,” and you take it as faith, you then have to get out and do it for yourself. As I did that, a protégé and since, it’s uncanny how many times I’ve come back to, “Yep, David was right. Yep, David was right. Oh, I tried that. I thought I would– No, he was right.” In some ways, I’m a little more agnostic than he is about styles of investing that I still believe, but I’ve never met anybody like him in my professional career.

Tobias: That’s funny. I had the same experience with Buffett’s letters. Every time I learn something new, I go back and refresh every now and again, I read through like, “Buffett dismissed this in 1983. Here I am thinking I’ve discovered a new for the first time.”

Patience Is A Virtue

Tobias: There’s a little bit of time left. I just want to throw two questions at you that you like to ask to folks on your podcasts. I hope it’s not too cheesy, but I’m interested to hear the way that you answer these questions. What teachings from your parents have stayed with you?

Ted: Yeah, the one I always love to share because it’s part facetious and part true is my mother used to always say, “Patience is a virtue.” The facetious part is she only said it when she was really frustrated with us. She was probably telling herself she needs to stay patient. But in many areas of life, investing included, and increasingly so as I’ve gotten older, you want things to happen. You’d like them to happen sooner. Sometimes, when you feel like you’ve gone through the process the right way, you just have to allow yourself to be patient. Again, that could be true in stock picking, it could be true in all areas of investing, it could be true in aspects of your life or business. That’s one that’s always stayed with me. Again, the inception of it, I wouldn’t say it was sort of the came from the wise parent saying it, but it was certainly one that has stuck.

Tobias: It’s funny– I 100% agree with that. There’s a great line from Tolstoy, where he says, he puts it in the mouth of, Kutuzov, who’s the general who’s fighting against Napoleon. He says, “Time and patience,” basically, that’s all that you need to do, everything that you need to do. I 100% agree that that’s true. If someone had asked me that five years ago, I don’t think I would have said that was the case. It’s occurred to me more recently and I’ve got three little kids. It’s interesting to just see the cycle play out, so I think about what my parents said now, when I was roughly the same age. Is it something that’s always stuck with you? Is it something that you appreciate more as you get older?

Ted: These things all come and go. You’re in the moment, you’re doing your thing, you’re stressed, you’re not. For me, it’s more a response. When I first started asking that question of people, for me, it was almost like a catchphrase that I heard a lot as a kid. Then, you start internalizing it a little bit. It’s more to that than– there are different ways. I don’t have that phrase in part of my daily routine that I say, “Oh, I have to be patient.” [crosstalk]

Tobias: It’s not stitched on a pillow.

Ted: No, but it is one that’s definitely stuck with me. I’ve grown to appreciate more and more.

Ask For Help

Tobias: This is sort of a related question, you probably know what’s coming, because you’ve asked it a lot. What life lesson have you learned that you wish that you’d learned a little bit earlier?

Ted: For me, it’s the notion that you can’t do things on your own and the willingness to ask for help. For whatever reason, maybe it’s how society works or how I was brought up, I had an embedded belief that I had to figure everything out on my own. It was only in the last 5 or 10 years that I got opened up to, “Wow, there’s a tremendous amount of value if you’re willing to ask for help.” If you’ve gone about life in a way that I hope I have a lot of friends and a lot of people that are happy to help. It’s amazing when you start flexing that muscle, how much more, I say you can achieve, but how much more you can get done, how much more efficient you can be, just by being willing to ask for help. That’s one that, “Wow, if I had understood that earlier in my life, who knows what could have happened?”

Tobias: I think that’s a great sentiment to end it on. Ted Seides, with your new book, Capital Allocators. Thank you very much.

Ted: Tobias, thanks. This is great.

[outro]

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