How did you get into money management? I joined Goldman Sachs Group as a vice president in the securities sales division after business school. I was in the Marine Corps before grad school and on my first day at work, I asked the person who hired me, `What's the noble cause?' My boss responded, `The client is the noble cause.' I thought that was a good answer. I spent six years there trying to figure out how to deliver what the client was asking us to deliver.
I found that the multibillion-dollar funds, whether they were family offices or institutions, were consistently outperforming us and I couldn't figure out why.
The head of research at Goldman Sachs then was a fellow named Bill Kealy and he started a program called investment strategy. I was in the first class and Bill brought in speakers like David Dreman and Larry Siegel who talked about how real money managers manage money, as opposed to how brokers manage money. Larry, who then was at Ibbotson, talked about how he had assets that were evenly divided among stocks, bonds, cash, gold and real estate. That portfolio had significantly outperformed the equity market with much less volatility over the previous 20 years.
It was like a light bulb went on in my head and I wanted to figure out how to do the same thing. ... This was the first time I started to think about portfolio engineering.
It made me look more closely at what the great (chief investment officers) were doing at the great multibillion-dollar funds. What I found was that these CIOs had two sources of alpha and we only had one. We only had securities selection; they had securities selection and a disciplined process of capital allocation.
I went to Goldman and insisted that we ought to be managing client money like this, and they said we couldn't for a couple of reasons. I sort of backed myself into a philosophical corner because if the client was the noble cause and we really couldn't serve the client at this wonderful firm, then I didn't have any choice but to leave and start my own firm.
Did you have a clear model for the firm from the outset? We were early adopters of the then-new concept of an open-architecture investment platform. I remember saying at the time that a decathlete can never be 10 specialist athletes. So if we could assemble superior specialists, we would have a likelihood of outperforming. That turned out to be true, but more important than that, is how the capital is allocated. It's this second level of capital allocation that most investment strategies lack, even to this day.
Are you distinguishing between capital allocation and asset allocation? Yes, absolutely. Asset allocation is sort of what the consultants do. You come up with this generic midpoint based on long-term average return risk. But current risk is a function of current price. So you really have to have a new allocation every quarter that looks at risk at that point and allocates assets accordingly. We're contrarian because we're valuation dominant.
What are valuation-dominant strategies? We use the term valuation, rather than value, because we'll buy growth stocks when they're cheap. We'll by anything when it's cheap so we're not just value people, we're valuation people.
A valuation-dominant approach, in simple terms, means that we focus on the valuation sentiment and momentum that is driving the market. We really believe that investing is about price. You've got to buy the future cash stream at an attractive price. Price is the trump card and so we are very price sensitive.
How valuation dominant or price sensitive we are — these terms are almost synonymous — is a function of the client's tolerance. The more valuation dominant you are, the more money you make over the long run, the lower the price risk of the portfolio, but there is more tracking error. If the equal drivers of the market are sentiment, momentum and valuation, if you overweight one of those three, you aren't going to be in synch with the market.
That's the trade-off that clients need to decide: how much behind a momentum market are they willing to (be), because no one cares about how much return you have over the market, in order to get a better long-term result.
So how much of a trade-off do your clients make when it comes to the level of valuation dominance they permit? Most of our clients dial us down.
With what we call our pure-play, 200-proof investment approach, a minimum of four asset classes are used in portfolio construction. You can have all the asset classes and subasset classes we offer, but if you choose only four asset classes, that's a pretty concentrated portfolio with a lot of tracking error. We would make the case that it's actually a very low-risk portfolio, because we're only buying what's cheap. It's an unusual approach, much different than the typical pension fund 60/40 approach.
One of my hot topics lately is that one-size-fits-all makes no sense. Peer pressure can get you into a lot of trouble. Borrowing a page from Psych II: we're asking our investors to be self-actualizing, to get out of the habit of peer comparisons. If you (meet) your liability more effectively than I (meet) my liability, then you are more successful than I am.
But behavioral finance is a huge factor here. Knowing what to do is much easier than getting it done, given the wide variety of stakeholders involved in the process of managing institutional portfolios.
How can institutional investors overcome their own behavioral finance biases? There are two ways to do this.
One is the black-box approach, in which the manager is given complete discretion and the investor has no say in the investment process. The Investment Fund for Foundations, Makena Capital Management and Morgan Creek Capital Management are three managers who have turned this process into a product, rather than a service. What I've seen with these kinds of firms is that they don't get management of the whole portfolio because investors aren't comfortable. Investors almost treat these pooled funds like hedge funds or funds of funds, investing just 10% or 15% of their portfolios.
These firms all are good, but what they do is not outsourcing. Outsourcing is about responding to the client's specific fact pattern of financial risk, operating risk and constituency risk. We design investment programs that have the highest likelihood of meeting our clients' self-defined liability without taking undue risk. The customized process of defining the risks, the liabilities and the investment program really is the best way we know of to help investment committees and boards overcome behavioral finance issues.