Talk Your Book: Investing in Corporate Culture

0:00Today's Animal Spirits Talk Your Book is brought to you by Harbor Capital Capital. Go to harborcapital.com to learn more about their human capital suite of ETFs. Happy Haps, HAPI, H-A-P-I, H-A-P-Y, and H-A-P-S. So go check out all of those different forms of human capital, harborcapital.com.

0:20Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:49On today's show, we're joined by Christoph Bleich. Christoph is the president and CIO of Harbor Capital Advisors. We're also joined by Scott Coulson. And Scott is the chief investment officer of Irrational Capital. Ben, a couple of years ago, there was a paper that we were discussing that looked at the number of different investment factors that research professionals use. And I think it was it in the thousands? Yeah, the Factor Zoo, right? It was called? The Factor Zoo. It was at least hundreds, yeah. All right. And a lot of them, there was overlap as being polite. There was the same thing, different name, different whatever, slightly different methodology.

1:25On today's show, we talked about something that is truly unique. It doesn't really look like quality. It doesn't really look like growth or momentum or value or any of these traditional style boxes that we're used to looking at. It's something different. And they call it the human capital factor. And it's based on this very simple idea that if you can measure corporate culture and invest in the companies with the best corporate culture, where people are happiest, most motivated, then it will lead to a better run company, higher earnings per share, better performance. It's not a huge leap. It makes intuitive sense.

2:02I have the word common sense in my blog name. I'm a big proponent of common sense. And this seems like one of those themes and those factors that is totally common sense based. I think where it differentiates a little bit is when we ask some of these questions is that the factors that lead to a good organizational culture or a happy employee base are not exactly what you would assume. Like the simple first level thinking would be like, well, the companies that pay a lot and offer bonuses and offer stock options, people should be, and they offer free perks and all this stuff, people should be happy to work at those places.

2:36And that, like most money studies show that that stuff tends to wear off and you get used to it. And that's not always the best thing for an organizational culture, right? If it's purely money-based, if you just rank them by who pays the most or whatever, but that's not necessarily the happiest place to work. And there's a lot more that goes into it. And we kind of get into some of that on the show. So this is an interesting factor. I think there's a lot of counterintuitive parts about it. So we get into all of it, the construction of it, how the portfolio is made, all that stuff with Christoph and Scott.

3:05So here's our conversation with them.

3:11Christoph, we've spoken about the human capital factor with you all previously on this show. For the audience, just give a reminder, What's the relationship between you at Harbor Capital and Irrational Capital? Cool. Michael, Ben, thanks for having me back on the show. So Harbor Capital, we're an asset management firm headquartered out of Chicago with about $62 billion of assets under management. And at Harbor, we really believe specialization matters in investing in terms of producing strong investor returns. So the way that we express that is we partner with boutique money managers from across the world, across various different asset classes from fixed income to commodities or what we're going to talk about today, which is equities.

3:57And so we look for that specialization to produce strong returns and we offer them through mutual funds or increasingly in ETFs. And I think a great expression of that is our relationship with a rational capital. Irrational Capital are a firm that we believe has created an investment factor that draws upon the link between a company's number one asset, aka their people, and how you can identify businesses with human capital that do a better job of investing in their businesses and ultimately make that investment factor investable. And we offer that in a series of different ETFs. Scott, how did you back into this factor?

4:38Was this something that you thought, listen, we've done research over time and we think that the companies that have better people or happier people or happier workers will produce better results and you didn't know about it? Or how did you figure this out? Managers around the world have long said people are our most important asset. And there's been a number of scholars who've done lots of research on this topic, publishing numerous papers. Our partner and one of our co-founders, Dan Ariely, has spent his entire life looking at the question of human motivation, and more particularly in the workplace.

5:12It began in the laboratory and then shifted to experiments, one production line versus another. But our other partner, David Van Andelsburg, approached him about seven years ago and asked, what if we could measure what you're doing line versus line or in the laboratory across a whole range of companies, perhaps an entire investable universe, and systematically rank companies on their ability to manage human capital. Thus, the thesis was born. David, because of his background in human capital and management consulting, as well as Dan's background in research, they had a great idea of where this data was and went and locked it up for the purposes of financial services, as broadly as attorneys can define those terms.

5:58We took a look at the data and some very smart and talented folks at Yale were the initial people to kind of help us out on that. And they found some surprising alpha in this data. So the thesis was initially confirmed academically. And then we began to dig a lot deeper, looking at the other factor loadings. Can this be explained in various ways? And the answer always persisted that human capital remained as this unexplained source of returns relative to the other factors. And so by systematically ranking companies, we were able to uncover this alpha. Is human capital a residue or is it something that you find explicitly somehow inside of a financial statement?

6:39Like how is this measured? Right. So there's no financial data at any point in the human capital factor determination. Our scores are based on the behavioral responses, the relationship between the employee and the employer. We've all been in a work situation where we've been asked to take a 360 degree feedback instrument, asking us a range of questions from the procedural to the emotional about how we feel about our employer. We use that data to construct the human capital factor. And so this is not something that you can find on a financial statement. It's not on the income statement. It doesn't live on the balance sheet or in the cash flow statements.

7:17This is something that you have to have access to this kind of data in order to determine. The only way to determine if someone is in pain, for example, is to ask them on a scale of one to 10, how bad does that hurt? Similarly, there's no way to know if someone is a highly motivated, highly engaged employee who's aligned with the shareholder, other than asking them a range of questions to determine that. So this is something that Yale is contacting all these companies and employees doing this for you, and you're taking that number, you're taking that data and kind of win them it down, basically?

7:49So the firms that are involved in the data collection are typically firms that engage the HR department at a corporation. They measure engagement typically for some HR metric or engagement sake. And sometimes this data is used for one of two reasons. The first reason would be process improvement. So you take a snapshot of how employees feel, what they're thinking. You do some process improvement and you take another snapshot. The other way that this data is used is for recognition. So you can think of all the lists that might be out there. Best employers in New York City, best place in Boston for women to work, best place for millennials.

8:27It's these HR engagement firms that are doing the work. We simply have relationships with those HR firms. Yale was involved very early on, a professor at Yale to help us verify the data. But that's the extent of our relationship with Yale. We've since engaged research desks such as JP Morgan and have been involved with many others in the financial services industry like Harbor Capital. So are you turning qualitative data into quantitative data? Like you're asking people how they feel in various ways and you're making that into something that you could actually analyze? So while the data tends to be qualitative in nature, for example, a question like, has your manager over the past 12 months provided you with opportunities for your career to grow?

9:12So you're asking someone a specific psychological line item question and reflecting over a specific period. And the research has shown this is the most accurate way to gain this insight. That data is numeric in nature, although qualitative. So typically we use a Likert scale that could be like one to six between strongly disagree and strongly agree. And we use that numeric data then to determine and rank the companies for the human capital factor. So Christoph, where does Harbor Capital come into this? Are you involved in the process at all? Yeah, so, well, we found Irrational Capital at our research firm and that had been putting out this research and thinking about ways of packaging the human capital factor.

9:54But we ultimately decided to back Irrational Capital with capital and launched some ETFs. And so we worked for a period of a couple of years with Irrational Capital, which is going back to earlier in this decade. And we wanted to spend our own time understanding this investment factor. Much like you guys have got some great questions today around how this all works, we have those same questions. My initial hypothesis was this looks too good to be true. New investment factors don't come along very often. Perhaps this is capturing well-known investment factors like momentum or quality or growth.

10:37but it's being packaged as this human capital factor. We do an inordinate amount of due diligence and research and verification and validation, wanting to understand the data and wanting to regress it against everything to really understand, is this capturing something new, or is it just repackaging something else that's already been known? Once we had done that comprehensive due diligence and investment research on them, we ultimately decided to launch three ETFs. The flagship ETF today is HAPI, or it's the HAPS suite. We have HAPI, H-A-P-Y. We have HAPS for small cap, H-A-P-S. And we have the flagship strategy, H-A-P-I.

11:22And this offers a diversified way for investors to get exposure to the human capital factor through an ETF. One of the themes that Ben and I have been talking about in recent weeks is just the difficulty active managers have had this year in outperforming the S &P 500, given how narrow the concentration and leadership has been, particularly with names like NVIDIA and everybody knows the rest of the bunch. But Happy actually has outperformed this year. And like Ben and I were saying, in what universe would somebody have even been able to outperform? What style box would they have had to been in?

11:59And the only thing that I come up with is large growth. If you're not in the big winners, how are you even doing it? So what is it about what you're measuring that has allowed you to outperform a really tough benchmark this year? So let me take the lead on that question. So to be able to outperform in any market, in any asset class, you need to have an edge. And an edge can come in different forms and different shapes. And here, I think the edge is the intersection of behavioral economics, behavioral science, and data. You cannot get this data off the shelf. You cannot scrape this data off the internet.

12:36There's an inefficiency, an anomaly in the market that you can capture if you've got a data advantage. Holistically, it doesn't surprise me that this factor can produce sustainable returns because it has an edge. Now, if you look at HAPI, and we monitor this very, very closely, it can't be explained away by different factors. So if you look at how it does in a value rally, or if you look at how it does in a growth rally, or a quality rally, or a momentum rally, the excess returns are not correlated to any of those underlying factors. The correlation ranges between plus and minus 0.2 to negative 0.2, so it's not correlated.

13:23So ultimately, what is left behind is that idiosyncratic stock selection. It's also weighted by market cap as well. So that sort of neutralizes some of the bets, if you like, that some of the active managers have fallen foul of. But Scott, I don't know if you want to add anything extra. Well, hang on. Before you get to that, Scott, so my thinking would have been, just from a simplified manner, Well, this would have to lean more growth because tech firms give their employees the ability to work remotely and then they give free food and massages or whatever. Maybe some of the places don't anymore.

13:57Is that too simplified? Like what actually makes people happier at work or more satisfied or however you want to define it? That's an excellent question because a lot of folks go to the things that we can measure the easiest. And we can measure salary and we can measure training hours. And we can look at job titles. We can look at the environment, the safety of the environment that they work in, the physical safety. We can look at things like what sort of perks and benefits they have and how much companies are spending on those things. It turns out that stuff is sort of in the realm of what we call extrinsic motivation.

14:33So those are rewards that we're trying to earn from the external world about the job place. And it turns out those things matter very, very little. As long as you're paying people enough to do the job that they've been hired to do, and you give them a reasonably safe environment and so on, there's sort of a limit to how much that can lead to extra alpha for a company. It's really all the other things that are very, very challenging to measure. Pride, purpose, meaning, motivation, career development, your relationship with your direct manager, how much you trust senior management, the level of appreciation that you feel when you go into work each day.

15:14Those things are the things that drive intrinsic motivation that cause people not only to lean in to the workplace, but lean in in such a way that's aligned typically with the shareholder. And so that's where the value creation of the human capital factor comes from. Not just a sense of happiness, but really a sense of pride, purpose, belonging, autonomy, competency, those higher needs that humans have beyond just a decent paycheck. So it's true that the money stuff where you couldn't just simply take these companies give the best pay raises or the best stock options, and therefore their workers are the most satisfied, that wears off like you would assume?

15:51Yes. So one of Dan's more famous studies is giving the three different rewards to workers. One was a small cash bonus. The other was a meal sort of at the level of that cash bonus. And the third was just a text message from the manager saying, like, thank you for all the hard work that you put in today. We really noticed it. And you're doing excellent work. and the cash bonus actually had a negative impact over a long enough timeline because people expect then to be rewarded every time with that cash bonus. And when they don't get it, then it's actually a negative. Whereas just recognizing and appreciating people's hard work had the most impact.

16:34And that didn't cost very much money to send a text message. And so it's not about the money spent and it's not about the perks and benefits. And it's certainly not about the salary bonuses and small rewards like that. We found appreciation in this study to be the most impactful to long-term productivity on a chip production line. Yeah, so then I think what I found fascinating about this topic specifically around kind of compensation and through that data, they were able to validate this. The level of compensation that employees earn is not correlated to positive outcomes in the equity market.

17:11So the answer is not just to pay people more money and expect different outcomes. But actually, there is information in compensation, but it's to do with the level of fairness. So if you have two companies, A and B, company A, let's say they paid more money across the board, but company B, for whatever reason, the employees felt more fairly compensated, company B is actually going to reduce better outcomes. Because intrinsically, there's something in that business that those employees feel more valued, and that then leads them to whether work harder, be more innovative, create better products and services, client, customer services, et cetera.

17:52So there is information in the compensation, but it's like a second or third order that you have to look at rather than what you would just look at, which would normally be just the level. In terms of portfolio construction, is this the type of thing where there's like 350 names in the portfolio or is it really more focused stock selection? So for HAPI, our flagship fund, we have 150 stocks out of the S &P 500. So that's roughly the top 30 % of stocks. It's a fairly high bar to get over. For our other products, HAPS, it's the top 10 % roughly of the Russell 2000, so an even higher bar. And for HAPY, sort of our best ideas type product, it's 75 stocks out of the Russell 1000, so sort of the highest bar to get over in terms of inclusion into the portfolio.

18:38So we let the security selection, particularly in HAPI and HAPS, our market cap weighted products, do the heavy lifting. And the risk management is there for market cap weighting, sector weighting to their underlying benchmarks, some additional caps to protect investors from over concentration. And what that leads to is over the course of 2023, for example, 80 % of our alpha came outside of the MEG7. It came from those other 145 names that were in the portfolio. You're really getting this broad-based security selection, broad-based support for the alpha coming from the human capital factor. It's not just attributable to the one or two names at the top.

19:20If you look at HAPI at 150 securities, The needle that we're trying to thread or the optimization there is, how do you create like an S &P 500 replacement that captures the human capital factor in the purest expression? Now, if you concentrate and own too few securities, then there's going to be other things like sector bets, market cap bets, and things in the industry bets that tend to dominate the returns. And if you own too many securities, then you're going to end up with basically an index-like product. And so the optimization process of trying to run this almost on a sector-neutral basis versus the S &P 500, but only investing in those companies that score well, 150 was the right number.

20:09And since launch, the numbers have kind of borne that out. and from a returns perspective, it's up almost 70 % versus the SP, which is up a little bit less than 60 % in that time horizon. And as Scott said, it's the amount of returns explained by the human capital factor versus quality, value, and momentum that we think makes this such a valuable solution. And is the stock picking portion of this totally quantitative? Is there any qualitative aspect to the stock picking or is this totally rules-based? 100 % rules-based, systematic from nose to tail. And so we take the data in. We have a non-parametric algorithm that basically means we're not putting weights to things.

20:52We're not putting our fingers on the scale. We let the data determine what's important inside the data itself. That produces a rank of companies. There's a hard cutoff for the number of securities. We may have to do some work around weighting techniques and making sure that the sectors are appropriately weighted and the risk management is taken care of. We do have the ability to add sector spiders to fill out the rest of a sector if we end up a little short. And the result is a systematic index that then gets traded and managed by Harbor Capital. How is the story resonating with advisors and clients?

21:29It's definitely causing a lot of interest in this approach. I think it resonates with everybody from a sophisticated allocator right the way through to when I explain to my dear old mom what I do at work and I talk about this factor. It makes a lot of sense to her as well. So it's generating a lot of interest. It's generating a lot of intrigue and it's generating a decent amount of capital as well. If you look across the ETFs, you know, Harbor, we have about 2 billion in ETFs now and about 450 million of that is in the human capital factor suite that we have. You know, we speak to whether it's, you know, RIAs, you know, model builders, gatekeepers, and, you know, a really important piece of this story is it's resonating from a returns perspective.

22:26So this is people that want to enhance returns in their portfolios that believe in this as a source of alpha ultimately or excess returns for their portfolios. That's typically how people have been using it. So if you look at the top holdings, there is a decent amount of overlap with the biggest names of the index. I see probably the biggest outlier that I don't see on the top 10 list is Tesla, but there is a lot of overlap. Talk about how you think about that, how investors think about that. First of all, portfolio construction obviously matters here. So when we look at the top names in our index, that's going to be reflective of some of the top names in the S &P, simply because we have that market cap weighting and sector weighting mechanism to ensure low tracking error so that when you do take risk, you're taking appropriate risk and getting alpha for it.

23:20But the other portion of it is sort of this portion of history that we're in, where the mega cap companies are solving global problems of unbelievable import. Not only are they making the products we all know and love, but they're also building out the infrastructure of the internet itself and also the sort of backbone to everything that's happening in AI. So we see some of that impact in the portfolio as investors are realizing the importance of these things. The valuation is obviously increasing. So we see that in the portfolio construction. We'd also note that there are several other names at the top of the index, like JP Morgan and Eli, that have done quite well, particularly Eli's had quite a run, that are also solving some pretty important global problems around medicine and pharmaceuticals.

24:08And so it's this engaged level of work that employees are building something much, much bigger than themselves, global in nature, and solving technically challenging problems that are at the core of exercising their competency and autonomy. So these are like the ideal type companies that we look for in the human capital factor tend to be at the top of the index and have been for quite some time, companies like Google, Microsoft, NVIDIA. So I guess it's no surprise that the biggest and best performer names screen well on the human factor, at least well enough to be included. And then, of course, as you mentioned, market cap takes over from there.

24:42There's a few big names. I mentioned Tesla's. I don't see Tesla in here. I don't see Berkshire. I don't see ExxonMobil. So it's not the type of thing where you'll weight a company's score and say, oh, this company's a 0.3, so it'll be less. And this one company's a 1.6, so it'll be higher. If it doesn't meet your screen, it's just out. That's correct. We're not interested in offering investors pure beta. We want the beta that we offer investors to be highly like the S &P. So the portfolio construction that Christoph mentioned earlier, 150 names, sector weighted, market cap weighted, gives investors 99 % correlation to the S &P with a beta of about one and a tracking error of about 2%.

25:24So very much like the S &P 500. And so we focus on the security selection to do the heavy lifting. With the human capital factor, it's about identifying these firms. If we were to weight by the human capital factor, there could be some adverse portfolio construction effects, particularly you look at something like small caps. You might be very heavily weighted into a few biotechnology names that are highly correlated and end up with a portfolio that isn't ideal for investors. And so by taking into some of these considerations like risk, we're able to offer an index that is both institutional grade in terms of the investors that have anchored this, that have highly championed this, but also that storytelling for retail investors.