Kristof Gleich – Boutique Managers and Active ETFs at Harbor Capital (EP.411)

0:04Hello, I'm Ted Seides and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at CapitalAllocators.com. All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

0:44Clients of capital allocators or podcast guests may maintain positions in securities discussed on this podcast. My guest on today's Sponsored Insight is Christoph Gleisch, the President and Chief Investment Officer of Harbor Capital Advisors. Harbor is a 40-year-old firm that manages$62 billion by partnering with boutique active managers to roll out active ETFs, collective investment trusts, and historically mutual funds. Kristoff joined Harbor in 2018 and watched as the actively managed mutual fund company had$22 billion of outflows for a third of his assets in just his first year on the job.

1:27He led a turnaround of the business to transition from a traditional mutual fund company to an innovative leader in the active ETF space. Our conversation covers the lessons Christoph learned about culture from his time at Goldman Sachs and J.P. Morgan and his application of those lessons to turn around Harbor. We discuss the challenges of making it happen, the rise of active ETFs, Harbor's approach to standing out in a crowded field, its manager selection process, distribution, and the future of alternative investments in the ETF space. Before we get going, I'm excited to tell you about the 13th Annual Boston Investment Conference to benefit Boston Children's Hospital in collaboration with the Broad Institute.

2:14This year's event takes place on October 24th in Boston and features a ridiculous lineup of speakers, including Boston investment legends Seth Klarman from Baupost, David Fialco from General Catalyst, Nancy Zimmerman from Bracebridge, Will Danoff from Fidelity, Alex Sassardot from Whale Rock, and Gavin Baker from Atreides. And they may all be upstaged by Brad Stevens, president of basketball operations and former coach of the Boston Celtics, and Roland Fryer Jr. from Equal Opportunity Ventures. My good friends Josh Gold and Matthew Sidman created the Boston Investment Conference to bring together great investment minds for a great cause.

2:54It's a fantastic day to do well and do good. Visit bostoninvestmentconference.com to learn more. Please enjoy my conversation with Christoph Weish.

3:09Christoph, great to see you. Great to be here. Thank you so much for having me, Ted. Why don't you take me back to the path that got you into the investment business in the first place? Sure. So I'm originally from the UK, I was born and raised there and studied there. I actually studied physics at university and made the transition from science to finance. I got my first job in the business at Goldman Sachs. So I joined the Goldman Sachs graduate program 23, 24 years ago now, whenever it was, and worked there for seven or eight years, A couple of different roles at Goldman, but finished up the last five years in asset management in a group called the Global Manager Strategies Group, which is where I began to cut my teeth in effectively what I've been doing my entire career since, which is the business or the craft of investing in money managers and allocating to money managers on behalf of clients.

4:11So I began that journey at Goldman Sachs in London within GSAM. I then also spent the best part of a decade at JP Morgan, that small boutique finance firm. At JP Morgan, rather than the asset management side, it was on the wealth management side. But I ran the group there globally by the end that was responsible for research, sourcing, selection, monitoring, and firing of money managers on behalf of wealth management clients globally. So that was a big research team of 60 people,$500 billion of assets under management. And I began that journey in London and JP Morgan moved me to New York. So I moved to the US 10 years ago.

5:01And then about six years ago, I decided that I wanted to shake things up a little bit, make a change of a career and join a small asset management firm. So I joined Harbor Capital, which is where I am today. And we're headquartered in Chicago, a boutique asset management firm with about$60 billion of assets under management. And we focus on investing in smaller and boutique managers. I began in London, transitioned to New York, and now I find myself in Chicago. I'd love to hear from your experience about the different cultures, the Goldman and JP Morgan. I joined Goldman just after it'd become a public company.

5:44I think it went public in 1998 and I joined in the early 2000s. So there was still very much a partnership culture there. It was a very tight-knit firm that was run by the partners. There was a culture of risk management that was very, very strong because it was as if still it was partners capital that was at risk. and so there was this almost like prop risk management culture that was pervasive across every single business line and every single division. How did that take shape? Compared to JP Morgan? So JP Morgan, I think the culture was a consequence of the people that were there. So I always felt at JP Morgan, if you could be your true self, and there were some really big characters at JP Morgan.

6:40And JP Morgan, I think, has one of the best CEOs in history, Jamie Dimon. I think he's amazing. Whereas at Goldman, you had to conform to a certain culture. You would often get the question in meetings, look, this was my first job, so I didn't know any different until years later. But people would say, what do you think the firm would think of? and I'd be like, hold on a second, who's the firm? I thought we're the company, we're the firm. And it was almost like the firm was referred to in the third person. And I think that was because it was coming straight off the back of being a partnership.

7:21And so there was almost two companies that existed. There was the partners and it was the partners firm and then there was everybody else. That was my entry into work. And that was my observation. Both JP Morgan and Goldman have very smart people, really smart people. Goldman was tighter, it was smaller, it was more focused. Obviously, JP Morgan was a bigger, more multi-line firm. But what I came to really appreciate at JP Morgan was the culture was a consequence of its people. And you could really be yourself. And it was a mixing pot of big personalities. So I loved working at both of them, but I think JP Morgan was a better fit for my personality.

8:08So when you then came to Harbor, how did you think about the most important takeaways you had from each that you wanted to bring into what you were doing? One of the things that I learned at JP Morgan was this notion of the competition is outside the four walls of where you're working. So yes, there's some internal competition, but the real competition lives outside. And if you are doing something successful in a business, if you're earning a decent return doing a business, whatever business it is, credit cards, asset management, wealth management, you should be behaving as if competition outside of the four walls are trying to eat your lunch and compete whatever it is that you're doing and they're going to be figuring out how to do what you're doing better, faster, cheaper and so we were always encouraged to try and improve at whatever it was that we were doing and so there was always a culture of continuous improvement at JP Morgan that I took for granted there and it really stuck with me.

9:25Harbour had been in existence for 40 years and when I joined Harbour we were a mutual fund company. We referred to ourselves as the Harbour Funds Group and we offered a select offering of mutual funds that were run and sub-advised by outside boutique money managers. And that's what we did. And that's what we had done since 1986. And we did it well. It felt a little bit like that was what we were always going to do. So the culture I've learned from JP Morgan to bring here was you should continually be pushing and challenging yourself, thinking about your market position, thinking about what the competition is doing, and trying to, in a word, disrupt yourself.

10:15If you're not going to prepare to disrupt yourself, then you're going to be disrupted or cannibalized by the competition. So joining a mutual fund company six years ago when ETFs were on the rise seems like that would be an important inflection point in thinking about the future strategic direction of Harbor. So what happened in those early years when you came in? When I joined Harbour, obviously everything was new for me. It was a new culture. So I needed to sort of get up to speed with what the culture was, what our business was, really understand what markets we operated in, try and understand what we did well, and then make a pretty quick assessment of what we could do, which new markets that we could ultimately compete in.

11:10because when I joined, we were an actively managed mutual fund company with a bias towards domestic equity. And one of the interesting trends, obviously, at the moment is mutual funds are rapidly being displaced as the preferred vehicle by other vehicles, depending on the channel, whether it's retirement, there's collective investment trusts, or what everybody talks about within wealth, clearly ETFs are a better vehicle and a better mousetrap. So we had to embrace the way the world was going, not the way it was. And so that was a big change that we had to make. How did you do that in a 40-year-old organization that was accustomed to doing the same thing?

11:52It was really difficult. It was really challenging because on one hand, you have to respect what made this company in the first place, the cast of characters that made it successful, but at the same time, try and balance that with heading in a new direction. And so I listened an awful lot at the beginning and tried to tease out elements of what we were good at and how we could retain those elements, but point them in a new direction in a positive way. I'm definitely a glass half full person. I really enjoy leading people and I try and do it very positively and in an inclusive way. So I'm much more of a carrot than a stick person when it comes to that.

12:47But ultimately the truth is you have to do a little bit of both. And so I had to spend a lot I'm looking at our lineup of managers and really just be honest with what business we're in. The classic know your product and our product is delivering strong investor returns and helping advisors clients build stronger portfolios. Having that North Star that you stay true to, but delivering it in ways that you haven't been able to deliver it before. For example, embracing new vehicles. When I joined, we only had mutual funds. And now we have almost a third of our business in new vehicles and new strategies that didn't exist five or six years ago.

13:30I quickly began to realize that there were different types of people and where they were in their own journey of change. And I looked at this on a two by two matrix of willingness and ability, willingness to a change and ability to change. And you need both. I tried to identify pretty quickly who was willing and who was able to change and go in a new direction and not only help support that new direction, but help drive and help lead it as well. Because changing a company isn't going to be due to one person. This is a team sport that we're in. And you've got to make sure that you have the right players coming along and helping lead.

14:15So identifying who wasn't up for it, who didn't want to, I had to do that quite quickly. Because if you're trying to build something and you're trying to move in a new direction, and you've got some of the team that just don't want to move in that direction, they can undermine the overall effort pretty quickly and quite invisibly as well. So you have to make some personnel changes quite quickly around those. And then for the folks that do want to move in a new direction, you celebrate every single win, no matter how small that pushes you in that new direction that you're trying to go. And it could be celebrating a behavior.

14:56It could be that you're trying to create a more innovative culture, more outside of the box thinking. And so anytime anyone shows any kind of out-of-the-box thinking or innovative behavior, you wildly celebrate it. You over-celebrate it because you're trying to send a signal back to the rest of the organization of the types of behaviors and actions and activities that you're trying to encourage. There's lots of incremental steps like that. We had to make some tough decisions around some of the external money managers that we're invested in. Which managers did we want to keep? Which ones did we want to replace?

15:38We needed to refresh our lineup as well. And so we needed to embark on quite a expansive new manager search program and find new investors that we could bring into the fold that would offer something that we didn't have before. So as you're conducting this assessment of the internal team, the external manager relationships that will be the right ones going forward, which takes time to do all that. What was happening in the external environment to the assets of Harbor as you were trying to figure out how you were going to move forward? This is not unique to us, but our asset base was shrinking.

16:18The year I joined, I think we had outflows of about$22 billion in that calendar year. That was our knock on wood, our worst year in our history and will never be repeated again. And it's because we were in the wrong parts of the business with the wrong type of vehicles. So generally in the industry, there was a movement away from active investing, and there still is to a certain degree. And there was a movement away from mutual funds. And that was all we had. So it was really hard for us to play defense, let alone offense. And so I wanted to quickly establish new relationships, new managers, new offerings that would allow us to play offense as well.

17:09Ultimately, what we were trying to do is get to the point where, if you like, our more mature business that is in outflows begins to be offset by a newer business that you're building, which is in areas of the markets or is in vehicles that people want. And at some point, those two offset each other. That's when you go through a period of stabilization. But then ultimately, you get to a positive tipping point where the new has displaced the old. And again, knock on wood, I think 2024 is that year for us. and so we've gone from that first year of losing 22 billion of assets which is a big number and now we are about 4 billion of net inflows this year and our low watermark of our asset base I think was about 38 billion and we're now at about 60.

18:07Certainly it takes time. I had no idea coming in how long it would take. I think in investing, there's a long lead time. One of the hardest things in our business is you establish something new, like a new fund or a new ETF, and investors won't typically look at it for at least three years. So you constantly have to be thinking three, four, five, six steps ahead as well. So as you got that inflection moving back in the right direction. Presumably that was in the active ETF space. What's the key drivers of why that structure has become the favored one? It began with a change in the regulatory environment.

18:56So back in December of 2019, the SEC released what's been now called the ETF rule. and the ETF rule was a game changer, industry game changer. And what the ETF rule effectively did was level the playing field for issuers to launch either a mutual fund or an ETF. So let's just go back a few years. Let's say the year was 2017 and we wanted to launch a new fund. to launch a mutual fund for us is a lot of work but there's a playbook for that work there's a regulatory process a legal process investment process a well-trodden path and you can stand up something from scratch within a few months if we'd wanted to launch an etf we would have had to have got something called exemptive relief from the sec which is a little bit like root canal surgery at the dentist.

19:57You want to avoid it if you possibly can. And it can be very expensive, very painful. The outcomes can be uncertain. So it wasn't really an option for a firm like ours. But credit to the SEC, they wanted to create a level playing field. They wanted to encourage competition. They wanted to encourage choice for the investor. And so effectively, they put the ETF rule in place in December of 19, which allowed firms like Harbor Capital or anybody to launch an ETF. And so what happened is you have had since then a flood of new entrants of active ETFs. and one thing that we didn't know and I think that we're now learning as an industry is look post the financial crisis so much money left active management trillions upon trillions upon trillions of dollars left active management and went into passive or index funds and there was a couple of things going on there was the move from active management to passive management and there was also the move from a mutual fund to an ETF.

21:1515 years ago, passive investing was synonymous with ETF investing. And so what's been interesting to see since the ETF rule for active funds is to try and discern, okay, how much of that move was driven by preference to passive investing and how much of it was a vehicle preference from a mutual fund to an ETF. and what we're learning is there's definitely a demand for active management again there's a demand for active management in an active etf wrapper and if you look at an active etf versus a mutual fund there's really three distinct advantages number one is tax so an etf is more more efficient from a tax management perspective vis-a-vis a mutual fund.

22:12Number two are fees, all else being equal. The same strategy is cheaper in an ETF than it is in a mutual fund. And then the last thing is transparency. ETFs are more transparent than mutual funds. I'm not saying mutual funds are opaque, but with ETFs, you have to share what the holdings are of an ETF on every single given day. And I just think sort of generationally or just in society and life, you just expect more transparency and investing is no exception from that. So those advantages and the regulatory change that leveled the playing field led to a lot of new supply that came into the marketplace.

22:53And then now what we're seeing is demand meeting that supply. And so now if you look, we'll take this year, three quarters of the way through the year approximately, about 30 to 40 % of all flows that are happening now are going into active ETFs. And if you look at the size of the universe, active ETFs are only about 5 % of the universe. So you've got sort of 35, 40 % of something going into something that should be taking 5 % by market share. So it's quite interesting watching at the moment, looking at the different types of strategies that you can now get. So when you have this substantial increase in the supply of active ETFs because of the regulatory change and people's ability to go put these products out, how as a provider do you go about gathering assets in a distribution channel that might be different from the institutional distribution channel?

23:54There's a lot of competition in active management and investing in public markets in the US. It's probably one of the most competitive marketplaces that exist. And so what we try and do is we try and differentiate by product so that we have something of value to our investor base. And so when it comes to sourcing new ideas, we are very open-minded, very intellectually curious. You have to be creative. You also have to be cynical and skeptical and equal measures. So we like to think of our offering as different from the competition. And that's really, really important. In an era where so much money has gone into index investing, into Vanguard, into State Street, into iShares.

24:49There's definitely a marketplace for people that want a different experience. And so the way that we think of ourselves is as a marketplace of boutiques. So we go all around the world and we try and cherry pick the best of the best that have a distinct edge in what they do. And the managers that we look for are typically independent. They typically found the lead. And a lot of the financial advisors that we work with are what we refer to as free thinking advisors. They haven't outsourced their investment practice to some generic third party model provider. They actually think having an investment practice is really important and they want to be close to the markets and that they want to be involved in the selection process and how they curate their own investment offering for their own clients.

25:46And so we think independence resonates with independence. And so we deliberately target free thinking wealth advisors. What's an example of a differentiated manager that you came across from being open-minded? I'll share one that I think will make you smile. So we have three ETFs with a firm called Irrational Capital. And Irrational Capital as co-founder is a gentleman called Dan Ariely. Dan is a leading behavioral economist in the world. He's a professor at Duke University. He's a multi-time best-selling author. He and his research firm have created something called the human capital factor. The human capital factor is trying to measure the value of employees, the value of engagement.

26:46The twist with this story, Ted, is I first heard about Dan's research into the human capital factor when he was a guest on your show, which was, I think, about four years ago, something like that. I do a lot of running. I was out for a run four years ago, whenever it was, listening to Dan talk about the value of people. And I was listening to Dan talk about the fact that this isn't measured correctly in investing. And then I was reminded of what I've heard and what I'm sure all of your listeners have heard many, many times before. Any successful business in any industry, in any region in the world says some version of the following.

27:32Our most important asset are what? Our people. And they say it because it's true. People are what makes a company special. People are what makes a company tick. People are what makes a company creative and innovative. And yet, when you look economically, how people are accounted for on a balance sheet, they are not capitalized as an asset. They go through the income statement as an expense every single year. So let's say you have company A and company B, and they do the same thing, same industry, but company A spends lots of R &D in developing its people and company B doesn't. In the short run, company B is going to show up as having a better economic picture, less costs, more profitable.

28:21But what company A is doing is it's investing in its most important intangible asset, its people. And clearly, if company A does that right over the long term, company A is going to outperform company B. So obvious to me and just, I think, intuitive, but coming across somebody outside of asset management, outside of finance with a completely different take and a completely different interpretation, a completely different information and data set, if you like, disrupting how you can invest through a unique approach really resonated with me. And so good example of where you can get an idea literally from anywhere.

29:07But then what that does is if you hear an idea like that, it's a catalyst to then do a lot more research. So we spent a year and a half probably going back and forth with Irrational Capital and Dan and his partners and validating the data. And had they really figured out how to measure this? Was there alpha in this signal? And we did an awful lot of due diligence. I reacted to this favorably initially. And then I thought, well, maybe this is just going to be other common factors repackaged. And then actually what we'll see is quality and momentum. That'll be it. And that'll explain any returns.

29:45But after doing our research, we discovered that there was a nice idiosyncratic piece of alpha left over that couldn't be explained by any other model that we put down to the human capital factor. So we launched ETFs with irrational capital as the index provider. And if you think about we were an active mutual fund company, and yet here we are launching an index ETF, what's going on? That caused, I think, a lot of question marks and confusion internally. I remember getting asked, I thought we were an active manager, we're launching an index fund. Well, I think this perception that exists that index equals passive is wrong today.

30:25It was maybe true 10 or 15 years ago. But the lines of our industry between index investing and passive and active are all blurring. This is a great example where if you look at the human capital factor, it's clearly doing something very different from the S &P 500 or the Russell 1000. Yet we're delivering it in an index, in an ETF that tracks that index, but we're very much trying to produce active outcomes versus market cap-based investing. How does your relationship with the portfolio managers evolve from a situation like that where you've discovered something, done your diligence, and think it's interesting to working together going forward?

31:07We always have to keep an arm's length relationship, but at the same time, we need to partner with the firm. We need to be on the other side and the same side of the table of them. So I have a research team here whose sole focus is on manager research, manager due diligence, investment research. And they and we are only interested in building investment conviction. We'll use rigorous investment process that we go through. We'll have a risk team as well. And then on the other side of harbor, we'll have distribution and marketing team. We keep those separate. And so once our investment research team has made the determination that they have conviction and that they want us to invest in a manager, then we hand the relationship over, if you like, to a more sort of strategic and partnership relationship.

32:11and they would tend to face off more on a day-to-day basis with our distribution and marketing efforts and then it's about okay how do we partner together how do we get the message out there in the marketplace what type of buyer or investor would this etf resonate with and then we build an approach to the marketplace to try and build awareness and then ultimately adoption. And then we try and grow and raise capital for those managers. What have you found effective in building awareness so that you get adoption on these strategies in the space? That's a good question. So this is a big change. 10 years ago, the playbook would be hire a good salesperson that has good industry contacts and then they go out and they distribute and they raise capital for you.