E190: $600 Billion Parametric CIO: Thomas Lee on Markets, Debt & Trust

0:00Tom, I've been excited to chat. Welcome to the How to Invest podcast. Thank you. Thank you for having me on, David. So give me a sense for the scale at where Parametric is today. Scale of Parametric. We are, by the numbers that asset managers are usually measured, we're a little over$600 billion in AUM. We have over 1 ,000 employees based in six offices in the U.S. and four outside the U.S. We manage 220 ,000 accounts, so mostly separately managed accounts. We also manage some ETFs and some traditional 40-act funds and some usage funds in Europe. So we have a, you know, we're a decent sized asset manager that exists inside of Morgan Stanley Investment Management.

0:55So I mentioned we are about 600 billion. Morgan Stanley Investment Management is 1.6 trillion. So we are roughly 37 % of those assets. When we last chatted, I was excited to hear that you had worked at the Federal Reserve. And my first question was, what is inflation and where do you think inflation stands at today? It's funny you ask that today, because as you may be aware, they released CPI this morning and it came in at 2.7 percent, which is an uptick from that's year over year. CPI came in at 2.7, which I think is up over May. May was 2.4, but it was the expected number. Non-core, so if you eliminate food and energy, was, I believe, 2.9.

1:39The numbers in, if you look inside the numbers, you're seeing big jumps in things like audio-video equipment. So it looks, at least the early speculation, is that tariffs are starting to hit, and it's coming through in the numbers. CPI is the traditional, what you see on the evening news, reading the morning newspaper. That's the inflation gauge that the government produces that most people reference. It's also the number that's baked into Social Security payments and other types of contracts. So that's where you see CPI. The number, and it's calculated by using a basket of goods that's fixed for two years.

2:17So it's not really robust or dynamic. And it doesn't include third-party provided services. So, for example, if your employer paid for your health insurance, it wouldn't be factored into CPI. The number that the Fed focuses on, and they've done this for at least the last two decades, is PC, the personal consumption expenditure. That number is calculated through surveys of all goods and services consumed, and it's chain-linked, which means it's more robust. And why that's important, David, is because the natural reaction for people if prices change significantly is they change their consumption pattern.

2:56So if all of a sudden beef becomes very expensive, people consume less of it, maybe consume more chicken or pork. Or if gas becomes very expensive, people drive less. The PC number for that reason tends to reflect more, at least in the Fed's estimate, and they looked at this for a long time, what real consumers are experiencing. And so it's the number that they focus on and it runs generally consistently below CPI. So those are the two kind of main gauges of inflation in the economy. I know all this is mired with politics and public policy, but fundamentally, when you go outside, whether you're buying groceries or your rent or whatever, it feels like inflation is higher.

3:38Why does it feel like inflation is higher than in the two percents? It depends on who you are and what you consume. I mean, everyone has everyone's own inflation experience is based on their personal consumption pattern. So do you rent an apartment or do you own a home with a fixed mortgage? That will affect how your housing is one of the biggest contributors to inflation. Do you drive a vehicle that has an electric engine in it or do you drive one that has a combustion engine in it? That could affect how you look at what groceries do you purchase? Do you eat out a lot? Those are the things that are going to affect how you may view inflation.

4:17Do you take trips? Do you stay in hotels? That may affect how you view inflation versus somebody who doesn't do some of those things. So it's a very personalized experience. I think what the government does is a gauge, which kind of measures, tries to give everyone a sense of where they are, but there's a distribution around that based on your personal consumption. Inflation is very idiosyncratic to how you consume. Just to play devil's advocate, there's either this meme or this conspiracy theory, depending, I guess, how you frame it in the market, that the true, quote unquote, true inflation is not revealed to the public and that it's much higher.

4:53A lot of people in crypto space believe this, but also some very educated people believe this. Is there incentive for the true inflation rate not to be disclosed to the public? Is there an incentive? Well, clearly, I just mentioned that inflation is baked, CPI is baked into things like Social Security and other financial instruments, which the government pays. So I guess you could argue that there's an incentive for the government to try to misrepresent inflation. The amount of coordination that would have to occur for that to happen and the amount of people who would have to be in on this, I mean, just to me doesn't seem realistic that the government could somehow do that.

5:35What I think is possibly, you know, a little bit more realistic, and I think it's only at the margins, and I'm sure you've heard this story before. You used to buy, you know, maybe a pack of frozen corn that was 16 ounces, and now it's 16 ounces, but four ounces are vacant in it or something like that. Same bag, less contents in the bag. So there's always been an argument, are people really shrinking the product, providing you with less, fewer goods for the same price? That's something that would be very difficult to measure. So I guess at the end of the day, I don't believe that the government, I think that it's easy to speculate about that, but it's not something that is likely or occurring.

6:16There's too many smart people in the market who would figure that out if there was something fraudulent happening. And the reason it's so hard to coordinate is because the different Fed branches, individually calculated economists, individually calculated, as well as analysts and macro investors individually calculate. So it's not only different people in different offices, it's also different constituents. Well, really, it's a Bureau of Labor who calculates the CPI, and I think it's the Bureau of Economic Analysis that calculates the PC. then you have a bunch of economists as you point out locally at district banks studying kind of what's going on pricing in their market and then you have economists at universities and other places doing macro studies if those things were offered in a line yeah you'd hear about it so tell me about the five-year five-year forward rate the five-year five-year forward rate is what the fed has identified as a long-term, it's the long-term, it's the inflation expectation five years from now.

7:19So it's what the market is estimating. They compare nominal bonds and tips and say, what is the market projecting for the five-year inflation rate five years from now? Ultimately, that rate, people's, the way the interest rate market clears is heavily dependent on people's inflation expectations. It's not one inflation we've experienced. It's their expectation about future inflation. The five-year, five-year, as it's often called, is a good measure of long-term inflation expectations. It's also a measure of Fed credibility. If the Fed is not credible, that number could be potentially very volatile or higher.

8:00And what we've seen, and if you look at a graph of this, it bounces in a very narrow range. I think right now is around 2.4%. It's been as high as 2.6%. And if I go back to early pandemic or before, it was below two. But for the last couple of years, it's hung between 2.3 and 2.6. So it's a really tight pan. And the Fed credibility, I'm guessing that's not that they could do models correctly, that's they stay an independent organization. It's that the Fed is willing to make the tough decision. As there was a former Fed chairman, William Martin Chesney, or the last name was Martin, who said, you know, he was the Fed chairman from in the 50s and 60s.

8:41He said the Fed's job is to steal the punch bowl away right when the party gets started. And what he meant is, hey, when the economy just starts to overheat, starts producing at a level that's not sustainable, it might introduce inflation, they have to step on the, they have to put on the brakes. They put on the brakes through primarily through the management of short-term interest rates. Those are the market's belief that the Fed will do that. That's credibility that Paul Volcker, if you go back way to the early 80s and the first Reagan administration, you know, after inflation got very ugly in the in the late 70s, Volcker established that credibility.

9:19And it's been sustained ever since that the Fed will do whatever's necessary to prevent inflation from getting out of hand. I've looked up the five year five year forward rate since our last conversation. I think today it's two point three, three percent. And I find that just shockingly difficult to believe, given that at least my interpretation of Doge failing is that essentially one of the tools and the tools for the national debt to be decreased has been largely ineffective, maybe some effectiveness. And now it's just a matter of time before the U.S. has to inflate away the debt over several decades.

9:57It's why is that not a consensus view? And why am I wrong with having that? You're asking some good macro questions. I mean, the U.S. has a history. And we do have, you know, if you look back, I think I want to say the last time the debt to GDP ratio was at this level, we're hovering around 120%, was just after World War II. like 46, 47. And if you look at the U.S. in the early days, we ran an inflation rate around four to five percent. That's one of the ways we got out of that hole. But there were other reasons for running that. We had soldiers returning from overseas. We had a GI Bill. We had building houses and all sorts of things going on.

10:49Why doesn't the market think that that ultimately that we're going to inflate our way out of this debt problem. I think it gets back to the belief that the Fed doesn't allow that. The Fed is independent. The Fed will not allow inflation. The problem with just trying to use inflation to get out of this debt hole is if it has the potential to raise interest rates, and we roll over a lot of debt, so it can make it very expensive. So we have to kind of manage that. If we were to, if politicians were to somehow think miraculously that, you know, we could create inflation and make it easier to pay off the debt with cheaper dollars, they would have to consider what it means for, you know, the amount of debt that we have to roll over on a regular basis and how that could be impacted if the market came to that belief.

11:39I appreciate the macro lesson. I do want to talk about parametric where you're a CIO. You mentioned that you have roughly 600 billion assets. How much of that is high net worth and how much of that is institutional? I would roughly break that down. Roughly one-third institutional, so$200 billion or so institutional, and two-thirds high net worth retail. I mentioned, you know, I don't think everyone in that category would qualify. You know, there's various different definitions of high net worth. But part of what we are doing is bringing, democratizing what has historically been institutional management capability to lower and lower AUM.

12:14So everyone in that category might not qualify as high net worth. So you say that you're bringing institutional tools, institutional practices to the high net worth. What are some examples of that? What are some kind of tools or funds that you've created in the last decade or so that address some of the issues? So, David, if you think about it, institutions have always had the ability, or in my career, dating back to the early 90s, have always had the ability for large allocations to have their assets managed in a custom manner. The benefit was it can be very much customized for them. Sometimes they can negotiate a better fee and, you know, overall just a better experience for them.

12:57That for many, for a long time, was of large institutional institutions. Increasingly, as technology has evolved, as innovation has occurred, I'm thinking of innovation in the way we manage operations, in the way we manage custodial operations, fractional shares, things of that nature. We've been able to provide separately managed account experience to lower and lower AUM bases. within for many of our clients that minimum is$250 ,000. We've actually evolved our technology within Morgan Stanley Wealth, their common ownership, to the point where we can get that down to$25 ,000. So what that means, what are the benefits that brings to clients?

13:43Taxable clients can have the accounts and manage for tax. Clients can have the portfolio customized for factors, for values, for completion. And when I say the word completion, what I mean is I work at Morgan Stanley, part of my compensation is deferred Morgan Stanley stock. I may not want Morgan Stanley in my portfolio holdings to avoid that concentration. So maybe I want my holdings to avoid Morgan Stanley, maybe Goldman Sachs at the same time. I don't want that. So I can have that the portfolio design for that completion around what I may hold elsewhere in my portfolio. All those capabilities now, we are bringing to a lower and lower AUM, and they once were just the privy of the largest institutions.

14:28One of the things that I've learned recently is about having a public position. Let's say you have a company, you invested as a VC, now you have$5 million in Coinbase shares is actually building a portfolio around a long only position, whether it's tax loss harvesting or just like using that to offset losses. Explain that on a simple level. Why would a high net worth individual do this? Let's use a very simple example of what people often call direct indexing. It's the ability to track an index while deferring gains and realizing losses or throwing off losses, which those losses an investor may use elsewhere in their portfolio, maybe to unwind a cryptocurrency position or a concentrated low basis stock position.

15:13That is the value of a kind of direct indexing is I can still get an index-like experience. I can also get some losses that I will maybe use elsewhere in my portfolio, or I can just roll forward and I will defer gains. More recently, that's been extended where people are willing to, or some people who have maybe extreme positions, maybe they have a low basis in concentrated stock like Amazon or NVIDIA, are willing to employ a short position on top of that. So you can generate even more losses. The issue that people always have to keep in mind is we're not eliminating a tax liability. Think of these portfolios as a sponge that's just absorbing it.

15:53So if you at some point want to liquidate that portfolio, you will experience those taxes. Many people say they don't want to liquidate them. The end game for that group is ultimately death and step up. Long short, that gets a little more complicated because you can't step up a short position. But sometimes people get confused. They think we're eliminating taxes. We're not doing that. We're just deferring them. And deferring them can be a benefit for investors, particularly if that deferral goes to the end of their existence, at which point they get a step up for just a direct indexing account.

16:27Could you not unwind those short positions towards the fund end? Or what's the practical difference between the lack of step up and basis in the short position versus the rest of the portfolio? The way I would think of it, David, is, you know, it's a, again, using my sponge analogy, you can maybe shrink that long short down. But at some point, if the person wants to liquidate that portfolio, they're just going to have that concentration of gains in there. You can't completely eliminate it. It's going to be, there's going to be some taxes to pay. If there is a, if there is, as we talked about, someone dies, then there is a step up basis on the long, but the short never gets that benefit.

17:06So tell me about the hyper customization of finance. I think the best way to think about this is to go back in time and just look at this arc. So we go back to, and by the way, there's a great article in the CFA Institute has produced, it's called a monograph called the title Beyond Active and Passive, discussing the hyper customization of finance. If I remember the author's name, I'd say it, but if people want to dig into this further, go back to the earliest pooled funds. I think the first ones they find on record are right before the inception of the US, 1774. and they were a reaction. This was in the Netherlands.

17:39This was a reaction to a credit crisis that occurred as a result of the British East Indies company. So back then, if you wanted to invest, it was just one stock. You thought it was diversified because they had business all over. If that company failed or something happened, there was no way to get rid of it, and most people's wealth wasn't concentrated in that. The first pool fund on record, or at least I'm aware of, was 1774, And the idea behind that pool fund was strength through unity and access to diversification. We pool our assets, we get unity and diversification. For the manager of that pool, you get scale.

18:19So that's kind of the early onset. And these were closed-end funds. So you didn't have a lot of liquidity. You had active management risk. Roll forward roughly 150 years. 1924, you get Mass Financial. Boston comes up with the first open-ended fund. So here you've got a daily NAV. So now you get liquidity. You still have active risk. And it took probably 30 years for those open-ended funds to overtake closed-end funds, but eventually they dominated. So by the 50s, they were growing faster than them, and then they dominate them. Then you get to, you know, I'd probably say 1976, but if I want to be honest, Wells Fargo was doing this in the late 60s, indexing.

19:06And in 1976, August of 76, again, our bicentennial, John Bogle rolls out the first, Vanguard does the first index fund. It was like$11 million they scraped together and created the first publicly available index fund. I mentioned Wells Fargo had one earlier, but it wasn't SEC registered, not available to the general public. So you have this evolution happening where things are getting generally better and better. By the way, that Vanguard, I think, is the largest, maybe the largest mutual fund today. It's$1.5 trillion or something of that nature, just enormous. But then as you get into the 90s, you get ETFs, basic ETFs, and then the ETF market explodes, and you get all these plethora of ETF offerings, which shows the demand for customization.

19:49Technology continues to evolve. And then as you get into the, you know, Parametric opened its first SMA in 1992, very difficult to manage. But as technology got better and better and better, what we used to do, you know, when we'd have discussions with advisors or their clients talking about the benefits of separately managed accounts, it used to be missionary work. now it's just become commonplace because people are seeing, hey, what used to be the benefit of unity and diversification, I can achieve that now through the evolutions of technology and innovation in an SMA. And the big benefit that I get through customization is I can tailor everything to my specific needs.

20:34Again, mentioning those things I stated earlier, tax factor, completeness, whatever the case may be, it can all be tailored to my specific needs. And so in that hyper-customized world, I own more securities, individual securities, less funds. Again, with fractional shares, I can do that with smaller and smaller bases. I can do it within, I can do a multi-asset portfolio, fixed income. All that can be achieved because of building on all the innovation that had occurred previously. And so as I think about that natural evolution from the very first funds to where we are today, it seems to me the only way we're going to move forward is through continued customization.

21:14And it's what people have come to expect in other parts of their life, whether they're ordering from Amazon or whatever their streaming service is. My kids don't watch any TV anymore. Everything's streamed. It's very customized to their specific needs. I think that's going to be the expectation for individuals' investment. And ultimately it's going to be a scale business and not everyone's going to make the journey because the technology involved in doing it is extremely complex it's nothing you buy off a shelf most of it's built internally parametric's been at this for 30 years as i mentioned earlier we're managing roughly 400 billion in smas i think that hyper customization that demand for hyper customization is the tailwind that are back you know i could be wrong but that's my belief so fascinating kind of evolution in that first you had economies of scale, you had everybody pooling their money.

22:03And because of that, they could invest and make efficient investments on a per investor basis. And now they could get diversification as well versus investing into one asset, like in the 18th century. And then today you actually have technology that basically divides it into almost infinite slices. But in order to divide it like that, you need a heavy investment into research and development and technology that's able to offer that kind of unbundling of the shares into everybody's individual account. Exactly. So you needed innovation. And again, innovation occurred in a lot of places along the chain, operations, custodial product.

22:48I mentioned fractional shares, the ability to trade fixed income in small, small lots efficiently. And then you need that technology to get to the point where, like I said, we can track and manage almost a quarter of a million accounts and they're all customized to specific guidelines, you know, created by the advisor or their client. One thing that's counterintuitive about that is it seems like the technology, especially, and I'm sure there's been some regulatory regulatory change as well that's allowed things like fractional share. But why is the technology so expensive to create in order to fractionalize shares and create these small SMAs?

23:30It doesn't seem like that should be that complex. I can manage 100 accounts maybe with a simple little macro or something. But when I start to get to 10 ,000 accounts, 50 ,000 accounts, 100 ,000 accounts. When I'm tracking a million tax lots and I have to do a data, the scale drives the complexity. That's what really gets challenging. Said another way, when you take away all human in the loop, it gets infinitely complex. I don't know if I'd say infinitely, but it's significantly complex. Not theoretically infinitely, but significantly. Yeah, where parametrics gravitating to is, you know, several years ago, it was portfolio managers looking at a portfolio and punching keys to optimize it and manage it.

24:31Increasingly, we're managing portfolios by exception. So the system knows those first steps that the portfolio manager is doing and saying, okay, here's what I suggest as the optimization. And the portfolio manager can then look at things much more efficiently and process them much more efficiently. So it's management by exception. Skeptical person may say that that's nice that you could have an ESG overlay. Or as you mentioned, you have Morgan Stanley shares. You might not want to have Morgan Stanley within your portfolio. These feel like edge cases outside of the tax part of it. Give me some very common use cases where people are using this customization to drive returns either pre or post tax returns.

25:15Yeah, somebody can say, hey, I want a concentrated AI portfolio and we'll create a simple basket of, you know, factor based AI centric names. They'll go through and say, yeah, we agree. And we can manage that portfolio for it. or I want to concentrate on whatever factors you may want. That would be a mainstream case. I don't know if completion is necessarily an edgy case. I think a lot of people think about it more. They understand they don't want to own more of where they maybe work and get vested securities. And you're right. Tax loss harvesting for taxable investors is the one that's most quantifiable.

26:00That is not edgy. We don't use the phrase ESG. We use values-based investing. ESG has become kind of a political football. But I do believe we're still in a world where there's still many people who want. And by the way, those values that they reflect might be the anti-ESG values, like whatever factor these screens are selling, I want to buy. We can design that portfolio for. Growing up, I thought managing money meant paying bills and balancing a checkbook. But as you know, that is only a small piece of the financial puzzle. Managing your money takes more than just checking your bank account every once in a while.

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27:08It's like having a financial advisor in your pocket. Write your own money story with Monarch. Use code INVEST at Monarch.com to get your first year of Monarch core half off at just$50. That's 50 % off your first year at Monarch.com with code INVEST. Do you believe in the efficient market or the mostly efficient market hypothesis? Yes. I generally believe that markets, particularly in the short term, are generally efficient and they're always driving efficiency. I do believe in the very long term, because so much capital is based on the short term, there can be inefficiencies, but it takes patience and a long time to exploit that.

27:48I'm a big believer in the mostly efficient hypothesis, which is basically saying I'm waffling a little bit. But a use case in that is when my mom calls me and she said, she says, I read somewhere. I saw a video that Palantir or Uber or Microsoft is good or bad. I'm like, great. As long as you're investing in the public market, if it is efficient, you can you can essentially you can't make alpha, but you also can pick randomly. I can make a portfolio of stocks that start with the letter A, and I shouldn't do that much worse, in theory, at least, than the S &P 500. So anything that could drive this behavior of people investing more in the markets overall, and in most cases, is actually very pro-social behavior.