[REPLAY] - Brett Barth – Asset Allocation for Families (Capital Allocators, EP.03)

25:47But that's not a daily quarterly thing and it's at most annual. And quite honestly, it's a very long-term forecast and they evolve pretty slowly for us. What are the buckets of the strategies that you use in your approach? At the top level, we believe that strategies fall into two main categories. They are higher risk, higher returning strategies and stable returning lower risk strategies. And that in the simplest of case, people build stock bond portfolios and stocks are those higher risk, higher returning strategies and bonds are stable returning lower risk strategies. You know, from our perspective, there's lots of strategies that can fall into both.

26:27Within equities in higher risk, higher returning, you can be passive and or active. Your active can be long or long short or private versus public. And so it's those types of differentiations we make in terms of sub allocations. So let's hop right in on that. Active versus passive. If people aren't talking about it or haven't had a conversation about it, they've been on Mars the last couple of years. So it sounds like you use both in your approach. And how do you think about when to allocate to active and passive? When you read about it, it almost seems like, oh, no, no, no, passive has to be the way to go because it's low cost.

27:06You're using both. You always have. Talk a little bit about how you think through the active versus passive decision. Sure. I think active and passive is actually not a binary decision, that there's a spectrum, right? There is on one end purely passive, then you can have factor decisions, value bias or dividend bias. I think you want to be on the ends of the spectrum. If you're going to be passive, you want to be as passive and for us since we're managing money for families as tax efficient as possible. In the middle, you've got – I'll call them index funds and drag. Your average mutual fund that most of whom underperform the market.

27:45and if you think about the universe of them that are fully invested most of the time after fees and transaction costs, on average, they have to underperform the market and they're highly diversified. As you get more and more active, you can have managers who own small numbers of stocks, are very concentrated, are agnostic in terms of their weightings versus the index. And then I would actually argue the most active are long short equity managers where they're making active decisions, not just on the long side of the portfolio, but the short side of the portfolio and how net exposed they are as well.

28:16So we take a core satellite approach where you want to be passive and you particularly want to be passive in the most efficient markets and you want to be active in niche managers where there's a lot of inefficiencies and they've got a structure to be concentrated where there's large amounts of active share to take advantage of those inefficiencies. So today, what are the markets where you are passive? U.S. large cap. You could argue that we're passive in fixed income where we own intermediate duration, high quality investment grade bonds, primarily munis again because we're families. But I would say there's a lot of defense that gets played there on the credit side.

28:58So although they're diversified portfolios, they're meant to kind of perform in line with the indexes. They're also – we are paying a little bit for credit research just to make sure – not to add value, but to make sure you don't step in any Illinois potholes. Right. Okay. So we've got our kind of high return, higher risk, mostly various forms of equities, active, passive, long, long, short, global. The lower risk, which is bonds, bond-like things. Another one of our philosophies is that unlike a lot of high net worth investors, we're exclusively total return investors. What I care about is having more money down the road than I have today.

29:39Clipping coupons is nice. I'd always rather get a dividend or get a coupon, but we're total return investors. And so for a lot of our history where yields have been low, we've generally shied away from things like REITs, which you conceivably could put into that stable return low risk bucket and have decided that things that are less liquid in the real assets and real estate category are more interesting. Given the illiquidity, we have a higher return target. We're taking a little bit more risk. We keep those on the higher return, higher risk side. We're going to take a quick break in the action to tell you about SRS Aquium.

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31:01Learn more at srsaquium.com. That's S-R-S-A-C-Q-U-I-O-M.com. And now, back to the show. You also have the challenge of having 125 different families. Mm-hmm. How have you structured your investing? So you said you want it to look like a single family office, but at the same time, there may be some customization that some of the families would like. Each individual family has a director responsible for that family on our client advisory team here. They'll build the asset allocation and they'll say, okay, for this particular client, if we're going to have an allocation to merger arbitrage, here's the manager we're going to use.

31:46And that's sort of a matrix where the investment research team defines the rows by strategy and which managers are in it where each family is a column. The difference being that we both inherit a lot of managers. We have a lot of sophisticated clients who source and we help vet their own managers. So they don't necessarily have to use the manager we picked for each one of those intersecting boxes. and for clients where access is a problem. It's a$5 million foundation. We're going to have only a few hundred thousand and absolute returning strategies. We'll create a commingled vehicle. We've got clients who either go direct because they want to be customized or because they're big enough to go direct and we'll pull either smaller stuff or where our clients are more interested in not dealing with the administrative headaches of going direct.

32:37Is there a model asset allocation framework that these client representatives start with? There is, and so they are guides, not rules. So there's no model portfolio. Just to give a sense, what do those look like across strategies? Sure. So all else being equal in public equities, we want to be about 50-50 passive and active on the long side. All else being equal, more aggressive strategies, we'll own more private equity, and more long-only equity and less long-short equity. You know, more conservative strategies or more conservative portfolios, all else being equal, should own more bonds and less absolute returning hedge funds as part of that stable returning lower risk mix.

33:26So as the person who oversees the investment management, investment research process here, I actually look at how all of our money is invested on a roll-up basis. And I'd say about 65 % of it is in higher returning, higher risk strategies. But for us, that is still probably a modestly lower amount than most. So if you looked at your average high net worth portfolio, 65 % equities is probably about right. We're 65 % higher risk strategies, but call it only roughly half of that in public equities. So let's dive in a little bit. I mean, as you said, most of your investing, if not all of it, is through third-party managers.

34:05Almost exclusively, yes. Yeah. Where did they come from? Sure. Well, we have a team of people here who do nothing but manager research and diligence. We meet over 2 ,000 managers across the spectrum, literally from wireless spectrum to muni bond managers. So our database - That's 2 ,000 a year. A year. So we've got thousands and thousands and thousands in our proprietary database here. And so quite honestly, the research team meets every two weeks to talk about who'd you meet with and what's everyone working on. So let me ask you a question. Why do you need to meet 2 ,000 managers every year? That's a lot of new meetings.

34:44That is a lot of new meetings. It's interesting that you ask it that way because quite honestly, I get the question the other way. If you were to hire a consultant, one of the pension consultants, Cambridge, et cetera, the world, I'm guessing the number is multiples of that, right? So if what you really wanted was a good database of understanding who all the peers are, what are all the options, tracking all the data, the number would actually be much, much bigger than that. So for us, we're interested in doing a lot of meetings. We learn a lot about strategies that way. We meet as a team every two weeks just to talk about who people have met, what we're working on.

35:19I would say most of our ideas come from managers. You'll meet a manager who will talk about the interesting things they're doing in residential real estate. And they probably aren't a manager you want to hire, but they'll tell you, hey, this is something that sounds like an interesting opportunity. We should learn more about it. Let's talk to other people who are involved in the space. Let's go find other managers that are either directly or tangentially involved, get their opinion. And so I think you learn a lot about by just talking to smart people all day about what they're doing and what they think is interesting.

35:53So there's a lot of value from those meetings, even if we're going to hire 10 to 20 managers a year. That's a pretty small percentage of the folks you meet. And what are the total number of managers that you'd consider core? We have about 50 public market managers that are core. Now, not everyone owns them all, but if you look from munis, after turning hedge funds, active long-only, passive managers, et cetera, private equity tends to proliferate because a commitment you made 10 years ago is still in the portfolio. How many privates do you think? We probably have an equal number of private managers we've committed to over the years, but probably half of whom are at most are sort of active re-ups today.

36:38But we have hundreds of managers, many hundreds of managers with whom we have$1 on behalf of one client because of things we've inherited and things we've done. You know, my son's college roommate's hedge fund I'd like to invest in, et cetera, et cetera. And we're willing to be that customized. And will you and the team follow that one dollar as much as one of your core allocations? We will absolutely follow it. I would say if it's a material investment for a client, absolutely the same way. What ends up happening is it's a small amount of money and the client's often indifferent. It's my son's roommate.

37:18He could be down 50%. I have$100 ,000 investment out of my$200 million net worth. We're not going to ever fire him. I've had that conversation with particularly a lot of former money managers who now have their own family offices. And there's almost a bucket of these are relationship investments. They're not driven by returns. We're never going to redeem. They're just people we know. And you almost separate that out from the normal due diligence process. And to be fair, that's their prerogative. It's their money. We're here to give an opinion. And quite honestly, we'll often say this is not something we'd otherwise invest in.

37:54Usually, this is perfectly fine to invest in, but our bar to make a new investment is a lot higher than it's fine and we'll oversee it. What do you think you have trained your team to do that gets at the kinds of decisions that you'd like to see? Sure. One, we put a huge premium on the quality of people and the consistency of process. So one of the things we do is we ask lots of people at the firm the same question separately. Even though you think you know the answer, asking analysts over and over again, different ones, how do you interact with the portfolio manager? I ask the portfolio manager how you interact with the analysts.

38:38Are you getting the same answers? Are they talking about the same ideas? Are they sourcing them the same way? Are the things that they like and are getting in the portfolio have the same characteristics? making sure that all of those people are not only incredibly smart, incredibly knowledgeable, incredibly articulate and passionate about that, but that you're getting those same consistent answers. The other thing that we found very helpful is just given our networks, there shouldn't be anyone who's such a secret that I can't find at least three or four third-party unprovided references where we can get very detailed, thoughtful opinions on those managers.

39:17If I can't do that and they can't all be positive, we can't make an investment. And where one of those is 50-50 at best, we won't make an investment. And that ties into your thought about quality of people. What are the temperament to such an important and difficult to measure quality of successful investment managers? How do you go about trying to figure out, first of all, what is the right quality of person? There's an obsession that some of these guys have. Well, I think when I talk about quality of people, I mean that in the most basic sense of are they good people? Are they good partners?

39:54Do they treat me as someone who's their partner and whose money they're managing? Are they treating me as a counterparty? Is it someone when things are going poorly that they are still is willing to get on the phone and discuss about what's going on poorly? When they're ultimately successful, are they pawning us off on their investor relations guy because they're too important to deal with me? You know, early on, there's no such thing as a good deal with bad partners. I firmly believe that. Are they – do they view our relationship as a partnership and are they willing to be good partners? As it relates to temperament, I don't think there's one right answer.

40:28I think temperament and approach is one of the ways to get diversification. And so I'll get a question from a client or prospective client. You know, if a stock's down, do you like managers who buy more or do you like managers who have stopped losses and cut their losses? And the answer is yes. I like both. I want people with both approaches. But what's most important is the managers need to know their approach ahead of time and execute on it consistently. Okay. So let's talk a little bit about the actual decision-making process. So your team's out there doing work. You're assessing the quality of the managers, the consistency of their process, how they do the research, How good are they?

41:07And then ultimately, someone has to make a decision. Who makes that decision at your firm? We have an investment committee here that is made up of all of the senior members of our investment research team, as well as a number of other people around the firm. How many people total? There are nine people total on the committee, and you need seven to vote yes to get an idea approved. And separate of that, our chief compliance officer who oversees operational due diligence has a unilateral veto as well. So it's a high bar to get something. And then if you're investing in a money management firm and they told you, hey, for us to make a decision, we have nine people around the table and seven have to say yes.

41:45I was watching the most recent episode of Billions last night. I'm one episode behind, so no spoilers. No spoilers. But when you look at sort of the inner dynamics in any of the episodes of what happens in the DA's office, even these senior people with a great mission have this sort of jockeying for tit for tat, how am I going to get myself positioned to get what I want? So on that, even on the research team, how do you think about seven people independently forming their own view, as opposed to the natural tendency of groups to want to coalesce, treat each other well, their employees, some, if not all, are partners?

42:26So how do you think about that decision-making unit? That's a great question. And it's actually something we've thought about a lot. And one of my partners, Todd Whitenack, who manages the research team day-to-day, he and I have talked about that a lot. I think it's inherent in both structure and culture. First, from a structural perspective, all of the senior people are generalists. And so if you're a hammer, everything looks like a nail. If you're the private equity specialist, Every investment problem has a solution that looks like a private equity fund. From our perspective, all the senior people are generalists.

43:02Now, people know more about certain areas than others. I've got partners on the team who are more expert in structured products. I've got other people who know more about private equity or macro or whatever it happens to be. But anyone can work on anything, and all the senior people are expected to be generalists. And so, one, it's not I'm fighting for allocations for my area. everyone thinks the whole portfolio is their area. Two, from a cultural perspective, this is a tough crowd. There are a lot of very smart, very intellectually curious people who are not along for the ride. And so whenever we're discussing an investment idea, usually earlier stages, if they're skeptical, you've got to get them on board pretty early just to make sure that your time's allocated to that project long before you get to investment committee, right?

43:52Because the scarcest resource we have is people's time, right? You meet all these managers. The question is, who do you go meet the second time? And what do you go spend more time on? And unless you can convince folks that it's worth your time, which is, again, a pretty high bar, it's not something we're going to meet a second time, third time, and start working more seriously on diligence. How have you improved the way you make decisions over time? Interesting. We think that there are two types of hiring mistakes you can make. One is you can hire a manager you wished you hadn't or make an investment you wished you hadn't or not make an investment you wished you had.

44:40And I would say we are comfortable with the latter and really uncomfortable with the former. Yeah, so fine with the error of omission. Right. And so one, I would say our bar has been constantly raised. One of the ways we measure, are we making those decisions the right way is by tracking our turnover stats. You know, if you're firing 30, 40, 50 % of your managers every year, you probably made a lot of bad hiring decisions. And so on average, our turnover has been about 15 % a year. There's been years it's a little lower, a little higher. The highest number has been kind of low 20s. The lowest number is kind of high single digits.

45:19But we look at that data. Now, we do look at that data ex post, right? It's not the old GE where you fire the bottom 10 % each year. But 15 % a year means your average holds about seven years. That means our hiring bar is high enough. Two, to the extent - And by the way, does that change? I mean, private equity is a different animal. But on the public managers, do you find the turnovers higher with a hedge fund manager? Yes, but marginally. I mean, quite often it's managers where it's smaller teams. And so a key departure is more relevant or it's a smaller niche. And so asset growth is something that we're going to be less tolerant of.

46:02or it's a opportunistic investment like something we want to be doing in Argentina or in a particular structured product niche that just happens to have played out. You mentioned small managers. Where do you guys like fishing? Sure. Tends to be earlier and smaller. At the end of the day, managers who are focused on earning a management fee and keeping assets and just not underperforming, your average mutual fund whose job it is to never be below three or four Morningstar stars. so that the 401k consultants never pull the money. I don't ever want to be there. And so we want to be in managers that are driven by performance.

46:42That might be performance fees. It might be their own money. It might just be their own ego. And actually, I think the last, just having the personality where success matters to them is a key characteristic. And you tend to find those folks a little bit earlier in their careers. We also have a bias to that if you're going to be in active strategies, generally speaking, not always, but generally speaking, it's easier to turn 500 million into a billion, although that's no small feat, than 20 billion into 40 billion in terms of trying to find those inefficiencies. And lastly, almost two more points.

47:19One, if you want to be in a niche, those niches tend to be smaller and don't lend themselves to big managers. And the point I was going to make as well as it relates to fees. we're in an environment where returns are hard to come by. That means when you can generate those returns, you want to pay, you want the highest quality folks. You don't want to just be in the lowest fee managers, but you want to pay as little as possible. And one of the ways we do that is guys and gals who are earlier in their life cycle or smaller in their assets, where our asset base makes a difference and we can accelerate them and get our pound of flesh and fees for that.

47:52One of the things we've seen from the endowment foundation world is some of the now persistent performance leaders, the Yales, Princeton's, MIT's, Bowdoin's of the world, the CIOs have been there for a long time. Yale, it's 30 plus years. You also have that benefit. You've been here now 17 years doing the same thing. Many of the people on your team have been with you for a long time. And then you also have the capital behind you. This family capital is very long duration. How do you leverage those strengths in your investment process? Absolutely. I mean, I should bring you to my next prospect meeting because you laid it out perfectly.

48:32You know, being onshore, being long-term, being a thoughtful investor makes us, I would argue, a preferred partner. By actually demonstrating that over 17 years, we have a reputation of being that preferred partner. When someone's looking to launch and they don't want to meet with everyone and they want a handful of high-quality investors, there's very few folks where we're not on that list. What are those action steps that you've taken that demonstrate that over time? I would say the single biggest one goes back to our allocation philosophy, which is buying dips and selling rallies. We have managers who are closed, who are happy to take any amount of money from us over time because when they were losing assets and they were underperforming, we were adding money because all else being equal, we will only invest in things that are transparent.

49:26You have to be able to understand that the process hasn't changed, the people hasn't changed, the opportunity set hasn't changed. So if you're underperforming, it's just because there are periods of under and outperformance. The investment business is not a smooth business. If all the things you loved about a manager and the strategy and the people and the approach aren't changing and they're underperforming, most folks pull money. We write checks. And so there are a handful of managers we've been with for years where they think we have been the best long-term partners because we're the folks adding.

49:56One last investment question. I'll turn to some other things. Where are you finding the most exciting opportunities today? Interesting. I would say the most interesting things we're doing today are esoteric and off the run. There are a lot of folks in our business. There's a lot of money looking for returns. Most things that are, quote, on the run, plain vanilla strategies that have a lot of capacity are quite crowded and their return expectations are modest at best. And so I mentioned wireless spectrum. We've looked at international trade settlements, music royalties, things that are pre-institutional.

50:32I would say are things that we're pretty excited about today. Talk about music royalties. That's a new one to me. What's the play? The play there is it's both a yield and a growth investment. You know, historically - Is it like David Bowie bonds? Very similar. But if you think about it, the music industry has been massively disrupted, right? That historically, artists made money selling albums, cassettes, CDs. That doesn't exist anymore. And that you make modest amounts, very modest amounts of money for streaming. And that the real incremental revenue to owning the intellectual property is from other uses, being in commercials, TVs, movies, things along those lines.

51:13And so a particular piece of music will generate generally a pretty consistent, you know, but not yield. You buy it based on the yield. And then if you can manage that asset better, promote it, get it into television commercials where you get a royalty every time it's on. you can actually really radically increase the yield. So we've got a seasoned manager who's been in this space a long time. The space being the music space or the music distribution space? Both the purchase of music royalties and the management of the intellectual property. I think merging those together in terms of sourcing, diligencing them and paying the right price and then not just being a passive financial investor but actively managing the asset to increase the yield leads to some pretty interesting returns in today's environment.

52:03Really cool. The other thing, by the way, just because I want to mention it is we also think there are a lot of assets that fall between the cracks, i.e. they used to be owned by hedge funds, but they're less liquid. And as hedge funds have put a big premium on liquidity, they can't own them. They're not high enough returning or plain vanilla enough to be private equity investments. The type of investments that used to be on Goldman Sachs or Morgan Stanley's balance sheet back when they were 20, 30 times levered but in a Dodd-Frank world, they can't own. Things like non-performing loans off of European bank balance sheets.

52:40We're talking about things that have a couple-year duration, low double-digit returns. We're finding that in all kinds of different asset classes that are really interesting today just because there's not a natural home for them. and we've allocated quite a lot to that in the last year or two as well. And on the flip side, what are you worried about the most these days? I worry about how the unwind of the post-global financial crisis world is going to be. We now have a generation of investors who think interest rates are only low and that central banks are always there to bail them out. And I don't think that's always going to be the case.

53:18I think in general, as that changes, it's probably a buying opportunity. And generally speaking, I think any modest correction is a buying opportunity. We've actually done some really interesting work on that in the last month or so in terms of when do you want to be overweight potentially or when do you want to be underweight. But if people, i.e. folks on the buy side, this is a young man's game, younger than you and me these days, and they just haven't seen – they weren't even in business in 08, nine years ago now. What happens when interest rates are 4%, 5%, 6 %? That's a pretty high hurdle to own a different, more aggressive strategy where today people are willing to take some, I would argue, crazy risks to generate a 6 % return in high yield and other places.

54:07That's going to be a regime change that could really scare a lot of folks. All right. I always like to do a set of closing questions. They're going to vary from episode to episode, but here you go. What's your favorite thing to do that's a complete waste of time? Play flight simulator with my sons. Wow. You sit there and you fly a plane from airport to airport, and it's interesting. They both love it. I love doing it with them. Is that a computer game? It's on X-Plane for the Mac. X-Plane for the Mac. There you go. Wow. That's a good one. But those are hours I'll never get back. That's true. But it's high quality time with my sons.

54:45What's your favorite or most disappointing recent purchase? I'm not a big purchaser. Oh, I just bought a new Sperry Docksiders that you don't have to tie. No laces. I'm very excited about this. But in the middle of winter. It's contrarian, but there you go. It's springtime. Summer is coming. Okay. Okay. What do you know now that you wish you knew 10 years ago? As your business grows, the demands on your time versus how you'd like to spend your time investing. And I'm not sure I answered that well. But I would say my biggest work challenge today is that I like to be an investor. I think my highest and best use is focusing on being an investor and driving results for clients.

55:29And 10 years ago, we had a business where I could spend most of my doing that and it wasn't a challenge to carve out that time. That as the number of employees grows, numbers of clients grow, just the issues of running a business grow, how much effort I need to make to carve out time to do that. And how about anything about life? In life, what do you know now that you wish you knew 10 years ago? How fast it goes and particularly as it relates to my twin boys, back to twins, who are 11, although they would argue they are almost 12 and would correct me. But Shutterfly does this really neat thing where they will send you an email saying, on this day, eight years ago, on this day, 10 years ago, this happened.

56:11Yeah, Facebook does the same thing. And my wife's done a great job of making Shutterfly albums over the years. So we get a lot of Shutterfly emails and just, I can't believe it was seven years ago that my kids looked like this or it was 10 years ago today that we were doing that. But it's incredible how quick time flies, particularly as it relates to quality time with my kids. Okay. So in your waning days, you're now 100 years old sitting in your very sturdy rocking chair. For me especially. What advice would you give yourself looking back on your life? Again, that how you spend your time is really important and that time is the most fleeting of all assets.

56:50and you should spend it on things that you really enjoy and at which you're the most productive. Fantastic, Brett. So much fun. Thanks so much. Thanks for including me. This has been great time. Thanks for listening to this episode. I hope you found a nugget or two to take away and apply in your investing and your life. If you've liked what you've heard, please rate a review on iTunes or Google Play to help others find out about the show. Have a good one and see you next time. Thank you.