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Used car salesmen are everywhere -- including the asset management business. My experience working with family offices in the dual role of consultant and investment manager has given me the opportunity to see a lot of marketing materials and investment strategies over the years. I've always wanted a simple framework that would allow me to quickly assess any investment manager or strategy that walked in the door, but nothing really existed. Necessity is indeed the mother of all invention: I developed my own framework for thinking about manager selection and assessment. In the end, choosing investment opportunities simply comes down to the FACTS. And as Mark Twain states, "Get your FACTS first, then you can distort them as you please."
All about the FACTS
The FACTS framework consists of Fees, Access, Complexity, Taxes, and Search.
"Two and twenty," the proverbial call to run for the hills. Of course, these days 2/20 is more like 1/20, and with an ounce of negotiation it is more like 1/10. With serious negotiation, fees can be "whatever you think is fair, we'd love an allocation." Joking aside, the appropriate level of manager compensation depends on the situation. Nonetheless, here are some questions one must ponder when thinking about fees:
- What are the effective all-in fees? Who pays for service providers? Soft-dollar arrangements? Trading and execution costs? Etc. These fees compound over time, so scrutinize them carefully.
- Do they align investor and manager incentives? Charging an incentive fee can make sense, but is there a clawback provision? What is the hurdle? For example, a 0% hurdle for a positive-beta product doesn't make sense! Do managers invest in their own funds?
- What are the alternatives? Can I clone the manager's exposure via relatively low-cost financial engineering? In other words, is my long/short equity manager 95%+ correlated with a strategy that simply goes long the Russell 2000 Value index and short the S&P 500 index? If a cloning technology costs 50bps and gets 95% of the exposure, the manager needs to either 1) drop their fees or 2) not get an allocation.
Lions, tigers, and bears, "Oh my." Lock-ups, gates, redemption fees, "Oh my." If there is a way for a manager to maintain a positive lock on your capital, you can bet they will be happy to facilitate. Nonetheless, maintaining flexibility and access to one's capital is critical in an uncertain world where opportunities can arise unexpectedly and managers can go from good to bad in the blink of an eye. In some situations, giving up access might make sense, but understanding the cost/benefit of access is an important point to ponder. Some questions to consider:
- How can I access my capital? Monthly redemption with 90 day notice and a promise to send funds within 90 days of liquidation is really 6-month+ redemption. The devil is in the details.
- What is the underlying liquidity of the assets? Do the access privileges line up with the provisions? Monthly liquidity for a manager trading pink-sheets or 5-year locks for a manager trading mega-caps probably doesn't make sense. Also, look for liquidity mismatches between portfolio assets and liabilities.
- Investment vehicle? Limited partnerships are theoretically interesting, but what happens when another LP sues the fund and everyone's capital is locked up? Go for SMA or ETF vehicle when/if possible.
- My ability to tactically allocate assets? After dropping 20% of your capital into private equity, venture capital, and hedge funds with 5-year+ locks you suddenly realize that the markets have blown up and your "alternatives" exposure is now 60% of your capital -- you'd love to scale back, but you CANNOT. Ouch.
Einstein is quoted as saying, "Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius -- and a lot of courage -- to move in the opposite direction." Einstein is right. In general, complexity implies opaqueness, and opaqueness is usually a calling card for a manager who is trying to charge excess fees for a strategy that is easily replicable via a simple algorithm. A good example is in tactical asset allocation. A simple equal-weight asset allocation model beats many of strategies pitched by systematic and discretionary investment shops. Things to consider:
- Why does this need to be complex? Is the complexity a front for the manager? Or does the complexity of the strategy drive the alpha?
- How robust is the system? Complexity is often correlated with data-fitting. If the complex system is slightly changed do results completely dry up?
- Explaining the strategy to stakeholders? Most asset pools have constituents who need to understand and have confidence in the asset pool manager. Outsourcing investment activity to whiz-bang investment managers with highly complex, expensive, and opaque investment strategies does not facilitate communication and/or confidence to the asset pools' stakeholders (e.g., other family members, boards, investment committees, and so forth.). Risk management is also trickier with more complicated strategies. How does one risk manage a machine-learning algorithm trading exotic derivatives with a jump-diffusion model infused with a touch of fractal mathematics and string theory? How effective is the manager at communicating complex issues in simple terms?
Taxes are -- and always will be -- the most important aspect of long-term wealth creation. Over long-periods of time, a drag of 50%+ a year on a short-term trading strategy has a tough time outlasting an inferior investment strategy that defers taxes for many years into the future. Some scary numbers: Starting in 2013, the marginal investor will pay 23.8% on long-term capital gains (20% plus 3.8% surcharge) and 43.4% (39.6% plus 3.8% surcharge) on short-term capital gains. These figures do not include city or state taxes, which can boost these figures much higher (e.g., California). An example: Consider a manager returning 30% a year. Amazing return, but the manager churns the portfolio consistently. After 43.4% tax, this is 16.98%. Another manager churns 22.28% a year -- quite an accomplishment -- but this manager managers to trade longer-term and lock in long-term capital gains each year. After tax, this managers' return is 16.98%. Finally, consider a buy and hold manager that cranks 16.98% a year, but never sells or rebalances the portfolio. After tax, this manager makes 16.98%. All three managers generate 16.98% after-tax a year, but the three managers maintain vastly different security-selection skill levels. Again, alpha doesn't matter -- tax efficiency does. Things to consider when it comes to tax:
- Tax efficiency? Can this strategy be more tax-efficient? Can it ever be tax-efficient?
- Tax externalities? Avoid mutual funds like the plague. Avoid LPs with hidden "basis." Investing is tough enough -- avoid embedded tax liabilities at all costs.
- Does the alpha justify the tax costs? Alpha of 5% a year, with a 10% tax drag, nets out to a -5% benefit. Not good.
- Tax risks? Maybe this strategy is TOO aggressive. Are the tax benefits of this strategy too good to be true? Are there legislative risks that can be assessed? IRS rules can change. Lawsuits can occur…lawyers are expensive.
We've finally gotten the report from the investment advisor or consultant telling us that we need 20% of our assets in hedge funds. Great, let's go hire the best hedge fund managers. Wait a second, now we have to fly around the world interviewing people, conducting due diligence, or we have to hire another consultant which will layer on more fees. And as Ray Dalio quips, "There are about 8,000 planes in the air and 100 really good pilots"—all of the sudden manager search isn't as easy as we previously expected. Once we have the managers, things don't get easier: We have to monitor them each year, do on-site visits, watch for syle drift, etc. Search costs are a real cost associated with particular portfolio allocations. One needs to weigh the benefits of more exotic allocations (hedge funds, private equity, venture, etc.) against these costs. Different questions to address regarding search costs:
- How will I identify managers? Who are we going to pick? How much will it cost to gain this exposure? If we lower portfolio risk via an exotic allocation, but incur 200bps in search costs to attain the allocation, does it still make sense?
- How will I monitor managers? Compared to a '40 Act product, exotic allocations require more hands-on monitoring and hand-holding. Now we need a staff. Or maybe we outsource to a consultant. How much is this going to cost?
- Manager turnover? As a one-time expense, manager search costs might not be too prohibitive. However, consider the fact that managers leave the business and the need to maintain a stable of the top managers is an on-going process.
The FACTS Recap
There is not a one-size fits all manager allocation model. For every allocation and each manager one must assess, the FACTS need to be considered. Our experience suggests that a vast majority of family offices and smaller endowments should focus on lower-cost strategies (<1% instead of 2/20), with high accessibility (SMA/ETF vs LP), easily understood investment processes (simple and robust vs. complicated), high-tax efficiency, and a limited search and monitor cost. Using the FACTS framework will help you make better cost/benefit tradeoffs, which will in turn improve overall portfolio after-tax and after-fee results.
Wesley R. Gray, Ph.D. is a finance professor at Drexel University and the Executive Managing Member of Empiritrage, LLC, an SEC registered investment advisor. Wes is the co-author of Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. He has a BS from The Wharton School, University of Pennsylvania, and an MBA and a PhD in finance from the University of Chicago Booth School of Business.