E391: $17 Billion CIO on Taxes, Private Markets, and Building Wealth

0:00So Ron, you're the CIO of LNW, which today has$17 billion under management, mostly taxable investors. You've been investing for over three decades. When it comes to investing, what's the biggest difference between taxable and non-taxable investment? Well, there's an obvious answer, which is taxes, but let's put a pin in that for just a second. I think it's an appreciation that not only do you have to be a great investor, but you're dealing with humans and they have emotions. And so you have to have a high EQ. You need to be a psychologist, an educator, an exceptional communicator with those types of clients.

0:38So understanding managing wealth for humans has a multifaceted role, especially since humans get pretty emotional about their money. Reminds me, I had the CIO of McKenna, Larry Cochard, also famously an endowment CIO. And he said, one of the most underrated thing about building portfolios is making sure that portfolios aren't only good coming in, but could be held through long periods of time. That's exactly right. I mean, from an investment psychology perspective, one of the greatest challenges in working with individuals is getting them to stick to a plan. So I often refer to the investment policy statement as a business plan.

1:16A lot of individuals spend more time planning their vacation than they do thinking about their portfolio. And the reality is they should be very disciplined about managing that portfolio with our help, of course, and creating the structure around it through the IPS and really focusing on the levers that we feel we can exert some amount of influence over to narrow the probable outcomes of that portfolio over time. So I said, put a pin in taxes. The reality is, taxes are a draw on the portfolio. And so if we can effectively minimize taxes, we're keeping more money in the portfolio that compounds over time.

1:57And that's a lever that if we pull it, we have a high degree of confidence of what the outcome is. So the name of the game for us in wealth management is trying to narrow that dispersion of outcomes over time, but focusing on the decisions where we have high batting average, where we think we have a high batting average of success, of knowing the outcome. What are some of these high batting average opportunities? First is taxes, right? We know how to minimize taxes through direct indexing with a tax management quarterback. We have clients with concentrated stock positions, low-cost basis. There are strategies that enable us to diversify that position while mitigating the tax impact.

2:34Asset location as well. So put the high income producing or tax inefficient strategies like hedge funds in your retirement plan, in your IRA, and keep your equities, which have an implicit tax deferred component to them, keep them in your taxable account. Fees are another lever that we can pull. That's an easy one. We're a$17 billion shop. We can negotiate fees with asset managers. If we can drive down those fees, that drops right to the client's bottom line. And those dollars stay in the portfolio and they compound over time. Taxes are really upstream of compounding. It reminds me, Warren Buffett was asked, how did he amass so much wealth?

3:15And his response was, I started investing really early and I lived into my 90s and invest into my 90s. And everybody kind of disregarded it as this throwaway statement. But if you actually look at his wealth over the years, you could chat GPT it, you'll see it really is basically just compounding 20 % over 70, 80 years. It's almost like that exercise when you're in your 20s and you look at Roth IRAs, you're like, well, if I put in $4 ,000 a year and I just keep compounding at 12 % over 40 years, then it's going to be this large number. Warren Buffett has institutionalized that through Berkshire Hathaway.

3:52And the way he did that is through a tax favored structure and obviously good investment. I'm not taking anything away from his investing. But the structure in which he invested is probably one of the most underrated aspects of how he's compounded as well. You mentioned taxes as the main difference between taxable and non-taxable investors, of course, but how does that play out in portfolio construction? Are these fundamentally different portfolios? I'd say there's a lot of crossover between the two. But again, for example, global equities. If you're going to allocate to global equities, you're likely, if you can, going to allocate to a tax management direct indexing strategy.

4:27You're not trying to find investment alpha. You're trying to find tax alpha. So you hire a tax quarterback and you make sure that that tax quarterback is trying to minimize tracking error to the benchmark while minimizing taxes and holding that tension is their expertise. I mean, it's definitely different than working with institutions. Additionally, on the fixed income side, you're going to invest in tax exempt bonds, not taxable bonds. These are simple blocking and tackling strategies. Hedge funds. If you're an institutional investor and you're not worried about taxes, you don't care about the tax inefficiency.

4:56Hedge funds generate a lot of ordinary income. So as I said earlier, you want to allocate those strategies or locate those strategies in your tax deferred accounts if you can, as an example. Is there an argument that if you don't have these tax deferred accounts, you just shouldn't be in certain asset classes? No, I wouldn't say that at all. That's a binary question. We look at strategies on a net of fee, net of tax basis. So if a strategy can generate a return that justifies its fees and justifies its tax inefficiency because of its role in a portfolio, so you have some hedge funds that when you put it in a portfolio, you're looking for it to be less correlated with everything else in the portfolio.

5:41That's accretive to the overall risk return profile of that portfolio as what I like to call an ingredient in that portfolio. And so while taxes are consideration, they don't drive the decision-making. We're looking at taxes as a drag, but we're also looking at the contribution of that strategy to the portfolio's risk return. It goes back to what we were talking about, which is the sustainability of the strategy. One of the roles that hedge funds and specifically diversifiers play in a portfolio is it could help off balance some of the volatility in the market. So if the equity markets are down a lot and you have something that's uncorrelated or sometimes negatively correlated to the market, you're cut from doing this very destructive activity, which is selling at the bottom.

6:23Yes. In fact, we call the allocation hedge funds diversifiers. We've created that asset class, if you will. But underneath that umbrella, we have hedge funds as well as private credit. But the roles of that allocation are twofold. One is, to your point, they're somewhat of a shock absorber as it relates mostly to equity beta drawdown risk, which most clients have a significant amount of equity beta in their portfolios. So you want that offset to equity beta. But also you want strategies or ingredients populated in that diversifiers allocation that can be opportunistic as well, that can take advantage of volatile markets.

7:01So I wouldn't say that hedge funds sole purpose is simply to mitigate equity drawdown risk or to be uncorrelated with everything else. It's also to be opportunistic, especially when investors are heading for the exits and there's a risk-off trade. You want strategies in your portfolio that can take advantage of that. You want to be a net liquidity provider when everybody's looking for liquidity. And you want to take advantage of the fact that most investors are plagued by all kinds of emotional and cognitive biases, which drive them to poor decision-making. Speaking of hedge funds, portable alpha is all the buzz today.

7:39How would you define portable alpha? I'm laughing because it was all the rage pre-global financial crisis when I worked at another employer where that other employer, and I'll keep the name out of the discussion, became very enamored with building products and porting credit alpha onto equity products. And I was the sole dissenter, the sole voice within the organization articulating a question of maybe we've spread this portable alpha across too much of the portfolio, across all of these different products, like it was immune to risk. And so when you ask me about Portable Alpha, it just reminds me after 36 years in the business, so many of these cycles, some of the mistakes that were made, they come back in a different form.

8:32So I'm not necessarily, because of my previous experience, I am skeptical about the concept. And I think to a large degree, that's a reflection of the fact that a lot of the players in investment management today, they're just young. They just haven't lived through multiple cycles. I have. I've managed money through multiple cycles. And so I have the scars to prove it and lessons learned. A lot of people like to think about these cycles as purely economic cycles, but there's a narrative component and a human component, meaning human beings, even high IQ human beings could oftentimes make very predictable errors.

9:09For example, something becomes hot, they productize it, they ride it up, they don't see the long tail risk in it, it blows up. Everybody forgets about it for 20 years and then it becomes all the rage. You have these very human cycles that show themselves over and over again once everybody in the market has forgotten about them. You've just articulated the value of having an advisor like L &W because I've often said in my career, the greatest detractor for a client reaching their goals and objectives is the fact that they're human, that they are subject to emotional and cognitive biases. If you add their money, which they get emotional about, and sprinkle on a little volatility onto that equation, you have humans that are making decisions that are primarily based on emotion and primitive urges, primitive biases.

9:57And so as their advisor, we have to protect them from themselves. And part of that equation is, as I said earlier, building the business plan, the investment policy statement. But that's just a part of it. It's really understanding how individuals think and answering their questions before they ask them and playing offense with communication with them, setting and managing their expectations. Especially when times are good. When equity markets are raging on the upside, nobody wants to talk about their portfolio. Everybody's happy. They don't want to talk about risk. There's a pro-cyclical nature to a client's assessment of their own risk.

10:36When markets are inflated, they're risk-seeking. When markets decline, all of a sudden they become risk-averse. And so as their advisor, we need to be very clear with them up front on how that portfolio could react in different environments. One most important point is something I learned a long time ago, is you want to express that scenario analysis in dollar terms. Tell me about that. I can tell you about that by way of example. I met with a prospect, gosh, I want to say about 20 years ago. And she had$20 million. And I asked her, I said, do you mind if I ask you two questions? She said, of course.

11:13I said, well, if you give us the privilege of managing your money and fast forward a year from now, your portfolio is down 10%, how would you feel about that? And she looked at me, she goes, I think we could tolerate that kind of risk. She was in her early 60s, if I remember correctly. I said, look, let me ask you the second question then. Same scenario. You entrust us with your$20 million. We invest it. A year from now, I sit down with you and tell you that your portfolio is down$2 million. How would you feel about that? She said, we can't tolerate that kind of risk. True story. I didn't know whether she would fall for it, but she did.

11:45It's because 10 % sounded like a small number to her, but$2 million, she then could do math at that point and realize, you know, that's several years. It's like eight or nine years of her lifestyle. And so if I stopped at asking the question the first way, I would have been fired after a year. So it's so critical when working with individuals to really communicate in a way that they understand it. More often than not, people in my chair are trying to sound smart and they're trying to obfuscate what they do by using terms the client doesn't understand. I and L &W, we take the opposite approach.

12:24Our goal is we're trying to get that client to understand their plan, to understand their investments in a way that they can relate to, to protect them from themselves. And that means communicating in a way, meeting them where they are from a communication perspective. It's interesting because phrasing it as$2 million versus 10%, not only is it clear, and not only to keep that client, but also kept that client from doing the difficult thing. I had the former CIO of CalSTRS and they had this competition for the best investment idea. This was in 2021. And the idea that ended up winning for the best investment idea was preparing for the next crash.

13:00Like, what would you do? And the best analogy to this is the military. Why does the military play war games all the time? It's not because they can't do it through a model or they can't predict these things. it's because they are trying to wire into everybody down from the generals down to the to the foot soldiers what it means to be in a nuclear war what it means to be in the most dramatic situation so that when they happen hopefully not if but when they happen you're not in this panic mode because going back to this human bias all things being equal if you're not prepared for something you are just going to go into this fight or flight expert calls have always been one of the most powerful ways to build conviction, but today investors are asked to cover more companies, move faster, and do it with leaner teams.

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14:59All of it lives inside the Elphasense platform, trusted by 75 % of the world's top hedge funds alongside filings, broker research, news, and more than 240 ,000 expert call transcripts, turning raw conversations into comparable, auditable insight. Take advantage of AlphaSense AI-led expert calls now. The first to see wins, the rest follow. Learn more at alpha-sense.com slash how I invest. You hit the nail on the head. By the time the crisis happens, it's too late. So So the good news is the equity markets go up historically 70 % of the time. So 70 % of the time when you're in a client quarterly meeting, the client advisor should be revisiting, defining expectations, managing those expectations, running through scenario analyses framed in dollar terms.

15:47Hey, I know your portfolio is up from$20 million to$25 million over the last couple of years. I know you're feeling good about that. But how would you feel if the portfolio drops, I don't know,$5 million? Would you lose sleep at night? Oh, yeah, I would lose sleep at night. Well, maybe now's the time to start thinking about trimming some of that equity exposure and allocating other parts of the portfolio. Too many advisors in our industry fail to understand that every quarter, that's an opportunity and I think a necessity to re-educate, revisit expectations for the client and assess their, gauge their risk tolerance, given that, especially in positive market environments.

16:27Because like I said, when markets are dropping, it's too late at that point. Now the client is consumed by emotion and they want to drive decision-making that's probably going to be suboptimal for them. Reminds me of the Stanley Drunkenmiller quote I heard on another podcast, which was, nothing looks as cheap as after it's gone up 40%. And hearing Stanley Drunkenmiller, arguably the greatest trader of all time, hearing that it's difficult for him, was actually really gave me space to take a step back and think if the greatest trader of all time has difficulty managing his emotions, maybe the name of the game is not becoming world-class at emotions.

17:05And maybe it's really a portfolio construction question, or maybe you could put some guardrails. One of the things I love about venture, for example, is its illiquidity. A couple of years ago, I spoke to a couple dozen crypto funds, and they all more or less admitted that some of their best investments were just because they're illiquid. I call it the virtue of illiquidity. Sometimes you could structurally go into an asset class. Liquidity is seen as this end-all and be-all, this positive thing. And then some people will argue, well, you get an illiquidity premium, so you should be more illiquid.

17:37But I think it's further than that. I think illiquidity could also protect you from - There's no question that the design of the product being illiquid does almost eliminate behavioral issues. Now there is a secondaries market that may actually pierce that protection. But I do want to get back to Drunkenmiller and the idea of even such a professional investor can have these issues with their own biases. I tend to be a left-tail thinker. My dad lost his parents when he was eight. He was orphaned. I grew up in a household where you're always worried about the worst case scenario. And I know that about myself.

18:13And so what I've learned is in investing, you can't be necessarily only focused on the left tail unless I was just focused on shorting. And also one has to be an optimist to be an investor, generally speaking, that most of your assets are going to be, the success of them over time, compounded over time, has to be based on some form of optimistic view of the future. But understanding my own bias is, I'd say 75 % of the way there in terms of mitigating it. The rest of the way there is what I've infused in my investment team. And that is every person on my investment team needs to feel comfortable being vulnerable to disclose their own bias.

18:58So over the years as I've built investment teams, I try to build such a deep level of trust amongst those people so that everyone feels comfortable being clear about their bias so we can hold each other accountable. How did you institutionalize that? It's a lot of hard work. I mean, it's just relationship building. You know, it's being present. Is it leading from the front? It's absolutely leading from the front. It's volunteering vulnerability. It's admitting when I'm wrong as soon as I feel like I am wrong. Or changing my mind in the span of a one-hour conversation where I had a health review and my team convinced me otherwise.

19:35It is expressing that vulnerability. I've told the story of my upbringing and in some cases I get a little tearful about that. It's not manufactured. It's real. It's leading from the front that way so that my team's a safe space and that yields far better investment decisions because I've had teammates who I would call pathological optimists. I'm the left tail guy and they pitch me an idea. I start looking at all the things that can go wrong. They say, your left tail's raging. I get it. Those are all good points, but let me give you the positive argument. The last thing you want on an investment team is one loud voice, one strong personality making all the decisions because they are subject to their own behavioral biases, just like Drunken Miller admitted to.

20:19So it's so interesting. Even with two people, I'm more optimistic and my business partner is more cautious, but we both know our biases. And the funny way to explain that is when I get optimistic or I get excited, that's fine. But when my business partner gets excited, I actually get excited. So you could have this meta understanding and this shared language that you talk to internally, like to your point, and share your biases. It's an extremely powerful thing. And everybody wants to pretend like they're perfect. They have no biases. And that could lead to these systemic issues, especially when there's a power imbalance.

20:55That is exactly right. But also what you reminded me of is one of the elements of our investment philosophy is humility. I think too few people in my chair have humility. They're overconfident. If we're going to talk about biases, overconfidence is certainly one that plagues, I think, folks in my seat, or at least they feel they need to show overconfidence. And what I've learned is there's actually a lot more power in showing vulnerability and admitting a mistake, especially when you're working with a client. That breeds a lot more trust than always trying to come up with a rationale for what why a portfolio underperformed.

21:36That's especially the case when you're managing tens of millions or hundreds of millions of dollars. These people did not make that amount of money through random chance. There's always some skill involved. And sometimes when I'm eating at these dinners at these private wealth groups, and I could see the chief economist predicting every single narrative that happened in the last 20 years. And I'm looking around people eating dinner and listening that. And I just think that might feel good to talk like that, but it can't possibly build trust. Not at all. In fact, another part of our investment philosophy is we can't predict the future.

22:11No one can. And so our focus is not trying to predict the future. Years ago, because I was young in the business, we were spending all this time trying to come up with our own macroeconomic views and what's going to happen with inflation, the US economic growth, the levels of the equity markets to try to make tactical trades. We thought, I thought at least 20 plus years ago, that the more decisions you make as an investment professional, the more value you're adding. It's actually the inverse. The less decisions you make, as long as you're making decisions related to your high conviction, your high probability outcomes, that's a much better strategy than trying to make too many decisions, which just increases decision risk, increases the risk of getting things wrong.

23:02And so less decisions, more impactful, more material decisions where you have a high degree of confidence is a far better way to manage money than trying to be tactical, which I haven't found really anyone who's very good at that with a high batting average, especially in wealth management. And that's not even taking into account the friction of trading, trading fees, taxes. Exactly. That's exactly right. So I call myself a reformed tinkerer. And I think investment professionals generally are tinkerers. And in wealth management, there are some folks who believe that in front of a client, you need to always be recommending a change in the portfolio.

23:43But not making a decision is a decision. And sometimes that's the hardest decision to make, is not necessarily doing anything, especially when markets are raging and there's hurting mentality towards the latest and greatest trend like AI or prior to AI was Bitcoin or cryptocurrencies. And so really working with clients, getting them to understand not every quarter, we're not going to make a decision every quarter. At best, we may be rebalancing the portfolio to stay disciplined, but we're not looking to move levers around all the time just to showcase value. The great value that we bring to the table is minimizing that desire to make decisions at the wrong time.

24:31Just to play devil's advocate, isn't there a principled agent issue here in that you're incentivized to make changes, you're incentivized to take action? Because at some point, the underlying client, whether it's an endowment board or whether it's a high net worth individual, they're going to be wondering, why are we paying him so much money to make a decision? What you've hit on is a fundamental challenge and issue with our industry, and that is how we frame our value with clients. Not often enough do we, in the sales process with a prospective client, do we explain to them the multiple facets, the multiple drivers of value that we bring to the relationship, of which one of many is our proficiency at managing investment portfolios.

25:19But we also add value in tax strategy, whether it's on the investment portfolio itself or from a financial planning perspective. I've gone on record as saying, as part of my job as CIO, we're trying to collect nickels and dimes for clients. But if you do great planning for a wealthy individual prior to, let's say, a liquidity event, you could be picking up$100 bills for them in terms of tax savings. So looking at all the different value levers that we can pull for that client and framing those value levers with the client up front tends to minimize the risk that there is that principal agent problem where all you're thought of is the investment tinkerer, the investment decision maker.

26:06So unless I'm making decisions that are concrete, I don't have value. We've, I think, become very successful at L &W at elevating the conversation. So we're very clear. We think we're very proficient on the investments, but we're going to make a lot of other decisions and we're going to prevent you from making bad decisions. We've talked a lot about the taxable investor, but in many ways, as crazy as it sounds, the taxable investor is a new phenomenon. What do I mean by that? As a percentage of the institutional market, it's always been much smaller. Now today you have tens of trillions of retail coming on board.