#118 - Jon Hirtle: The True OCIO Playbook

26:18Jon Hirtle:You've got to visit them on site, see what it's like. Number one is people. Number two is process. Say, tell me how you manage money. Now, this is where we do a lot of differentiated research because we believe most portfolios are simply a factor portfolio. They're a collection of factors. So if you, I said before, I start with the Russell 1000 growth, okay? Growth, that's a factor. Then I say top half by ROE. Okay, that's a growth factor. That's another growth factor. That's return on equity. Then I say strong balance sheets. Okay, that's quality. So all of these are factors that I can screen for simply in today's world.

26:59Jon Hirtle:I can create an ETF that has all of these factors. So the most straightforward way to think about it is if a money manager says I have five screens, three of which I just mentioned for a growth manager, and then I pick 50 stocks. We look at those five screens, we create a custom index, and we compare the manager to that over time, his holdings to this portfolio. What we find is oftentimes there'll be a very high covariance, like 0.95, 0.98. So 95 % or 98 % of the movement of his portfolio is really described by the factors that he listed before he ever picked a stock. The fact that he has 50 stocks is not a killer, but it indicates that he's an asset gatherer and doesn't have high conviction.

27:49Jon Hirtle:He might have a style that doesn't generate high conviction. But what we want are managers that have high conviction, that are beyond a factor portfolio. In other words, we're looking for, we duplicate, if we find that custom index and we find a manager that doesn't have a high correlation with the index, then we dig deeper. What's going on here? Where's the returns? And what we want is a series of returns that we cannot describe. We don't know why. This guy's got, he's got the, he's got it. Something's going on. And he has to have done it long enough that it's not just random. That's a big deal.

28:25Jon Hirtle:Like statistically, you've got to do the work so that you believe that there's something here that's better than random. He just didn't luck out. So there's a process. There's a knack. There's an art to it. Very few managers pass those tests. Then you get them on board. It doesn't mean it's going to work. And it doesn't mean it's going to work every quarter. So you have to continually underwrite the manager, whether he's succeeding or not succeeding, to believe that all those things are still in place. And I guess when you go through trying to explain where the returns came from, whatever is unexplained is effectively that special sauce.

29:01Jon Hirtle:That's the true alpha. Now, another thing here, this is a little wonky, but some of your readers, some of your listeners might get it, might like it. So very high information ratio for a manager using CFA speak is about, you know, maybe a 20 % on tracking error. So tracking error is how much on average you vary from the index you're being measured against. So most consulting firms don't want the manager to vary more than two points to 200 basis points from the benchmark. And that's a function of ERISA. You know, the Employee Retirement Income Security Act of 1974, which made corporate officers liable for the prudent management of pension fund.

29:42Jon Hirtle:Well, liable, as in go to jail, liable, right? So that created a whole industry. the pension consulting industry, which really became a CYA industry more than an ROI industry. So I get it. That's pension land, but not for families, not for endowments. So that notion of CYA, when it seeps into the families in the endowments, is a big mistake. You can't have differentiated outcomes without differentiated behavior. If I have a 200 basis point tracking error on average, and I get 20 % return on that because of a high information ratio, That means I should, over time, on average, beat the benchmark by 40 basis points.

30:21Jon Hirtle:What's my fee? 40 basis points. I'm back to the index. So all those factors line up to make, and then there's a couple more. One is that after Enron, Reg FD made it illegal for what we used to think of as great research, is now no longer kosher. You can't do it. You go to jail. So getting an information edge is harder than it's ever been because of the law. Ever since, you know, time began, people used to go to Wall Street in the 30s to get inside information. And the tightness that has tightened and tightened and tightened over time. So today it's almost, it's very difficult to get some sort of special information.

31:02Jon Hirtle:So really the sauce, the value added has to be in what you do with the information. You can't get an informational edge. You have to have some way of thinking or some horizon or some assembly that is unique to you and adds value. And it's extremely rare. So most active managers in most portfolios are being paid active manager fees, but they're not adding any alpha. So it's wasted money on behalf of the client. And we're not going to do that. So, you know, money saved is money in the client's pocket. return money we're going to get it we need it it's key but it's still on the come every penny we can save goes right into the client's pocket so we're never going to pay active fees for a manager that when you analyze them properly is really a closet indexer of some sort what you're describing is that there's a material qualitative aspect to underwriting some of these managers but how do you think about performance as it relates to that?

32:12And what I mean is performance obviously matters, but it can also mislead you, right? How do you prevent past performance from tainting your qualitative assessment of people process and their edge?

32:23Jon Hirtle:So people process portfolio. So given this process, show me your portfolio. Show me your portfolio through time, not just returns analysis, but holdings-based analysis. and then as the performance matched up to what you did. In other words, there are going to be times this process shouldn't work, right? Yes. Okay, let me look back through time, and sure enough, it didn't work when it shouldn't have worked. There are other times when it should have worked. Did it? Yeah. Okay. So those are the kind of things where you don't, the past performance is, you know, it's definitely something you catches your eye.

33:04Jon Hirtle:But for example, over the last 10 or 12 years, before just recently, all the tech stocks were dominating everything. So if you owned tech stocks and maybe you had leverage, you could have very high returns and have absolutely no alpha, no manager alpha. You just owned, you know, like an ETF, a tech ETF. We could have done it. Anybody could have done it. So, and then the other thing that's weird about the last 10 to 12 years is that there's been an unusual amount of, you know, most recent performance continuing. So the recency bias that has plagued most investors through history, meaning I bought what went up last year and I got clobbered because it went down.

33:46Jon Hirtle:That hasn't happened for a decade. You know, until just recently, tech stops went up every year, every year, every year. So the most simplistic kind of trend following actually worked for 10 years. So that's misleading. But anyway, the performance itself will catch your eye. And then you have to look in and see where is the source of the performance. And that's one of the things we think we're good at. One of the concepts that you alluded to earlier is being mindful of tracking error or how much risk the manager takes relative to their benchmark. and you're focused on managers who take more risks so that there's more alpha potential.

34:27But how do you manage career risk when a high conviction manager underperforms long enough to test client comfort, understanding that it's their capital, not your capital?

34:37Jon Hirtle:Well, first of all, remember, Alex, we're managing total solutions. So if I'm managing a football team and I got a guy who's a wide receiver and he's kind of a problem, but every once in a while he catches a long pass and wins the game. That's sort of my problem as the coach. In other words, the total team progress is the client's worry. Like we got to win, right? How are we winning? And this is the notion of what does a CIO do? We're managing tracking error at the portfolio level, at the program level, not at the manager level. You can't have outperformance without tracking error at a manager level in public markets.

35:21Jon Hirtle:So we understand where we're going in. We think the tracking error might be as high as 4%, 5%. So he's down 450 basis points below his benchmark. And clients say to us, what's going on? This guy's down 4.5 % below his benchmark. And we say, yep, that happens. We knew that going in. This is completely within the range of his long-term performance. And we We don't know if it's going to work, but we still have conviction that one of these days you're going to see them 600 over and you're going to be happy we still have. So it's the notion of the role of that niche role in the concept of the whole team.

35:59Jon Hirtle:Very few people understand because they don't have the experience of running a multi-asset, multi-manager, mission-driven portfolio. It's its own skill set. It's kind of like being the writer director of a play on Broadway. each one of these managers is just a character actor and we're producing this show on behalf of the producer uh you know the the money people the people who put the money up and it's our job to make it successful so each one of those managers is an actor we're the writer director and that's why the cio position is so important and each of them has some cone of expected outcomes through time.

36:41And I suppose what you're analyzing is what has happened within that cone of outcomes that should be expected, not knowing how it's going to mean revert over time, but that should be part of your expectation. Exactly.

36:54Jon Hirtle:That's well said. Are there a few investors you most admire? And for those, what have you learned from studying them that have shaped your own approach? Well, I'm start with Warren Buffett. I wish I had something more novel, but he's a cash flow guy. What's different about Warren Buffett is that he only invests in things that he sort of feels like he understands. So he's directly buying securities. We have a much broader opportunity set because we can invest with managers who we believe only invest in what they understand. So it gives us much more breadth, but the discipline of knowing that it matters what you pay for things.

37:38Jon Hirtle:You know, there is no asset in the world that's a good investment at any price. I don't care how good the company is. There's almost no asset in the world that isn't a good investment at some price. Which brings me to one of my second favorite investors, Howard Marks, okay, who is another, you know, value-oriented person. Now, the thing about value is interesting. It's one factor. Like people say, are you a value shop? Not really. We're a valuation shop. So we care about the price going in. But if we think that we're having a really fast rising earning stream, rapidly rising earning stream, then we're willing to pay a high multiple for an asset.

38:20Jon Hirtle:So it's relative valuation, but we care about price. So those are two, um, actually have a book. Uh, I have a, we have a lot of bookshelves in our office and I'm trying to kind of create the, um, you know, the great book, the great book, uh, curriculum for investing. Yeah. And, uh, there's a lot of Warren Buffett in there. There's a lot of Howard Marks, Charlie Ellis, Peter Bernstein, you know, people who really think about the fundamentals of investing. And then on the academic side, Harry Markowitz and certainly Daniel Kahneman. So it's a, I'm friendly with, I was in, you mentioned I was in the Marine Corps.

39:00Jon Hirtle:I'm friendly with Jim Mattis and his book called Call Sign Chaos. He doesn't have a bibliography. It's more like a reading list on the back of his book. And the sort of implication is if you're in the armed forces and you haven't read these books, you're functionally illiterate. So many people in the business haven't really thought through the fundamentals of the decision. They're caught up in the moment, as you mentioned at the beginning of our session. So some of these backgrounders really make sense, really help you to think this thing through. The other common thread that I've observed over the years across many of the great investors you described as well as others is they tend to have a very simple framework and you know there's a lot of noise in the world and they're they're have a remarkable ability to distill the key ingredients to just a few factors and they and they always go back to those and they can zoom in when needed but they typically have a well-rounded zoomed out perspective you don't have to swing at every pitch I mean, you can be patient.

40:05Jon Hirtle:You can wait. What's your mission? Your mission is not to win every quarter. Your mission is to win the game, win the war. So you've got to think about the fundamentals and investing is different than gambling and speculating, certainly different than gambling. You know, God forbid that everybody would, I hate it when people say we're betting on X. I get it, but we're making probability-based decisions, which does have a, you know, something similar with betting. But it really is about investing in going concerns. Think about the company, not the ticker symbol. Think about the companies underlying this, what they do, who works there, why is it a good business, what should its valuation be, what is it doing to change the world.

40:58Jon Hirtle:All those things are real. They're not ticker symbols. They're not, it's not roulette. This is investing. And so we want to draw a bright line between investing and certainly gambling, but even speculating. The thing about speculating is it's interesting because speculating is a term that is used too loosely. Certainly investing is also. I mean, in the popular press, they talk about investors, you know, throwing money at Robinhood or something. That's not investing. Meme stocks is not investing. But, you know, when you think about speculating, speculators in a commodity sense play an important economic function because they're the ones who will take the risk from the producers at any moment in time.

41:44Jon Hirtle:In other words, they will buy futures when a corn producer wants to sell futures so that he can ensure he's going to be in the corn business next year. So the speculator is taking risk from the producer. That's an important economic function. It's like insurance. It's really part of an important economic function for our economy. Other kind of speculators are when you're speculating about the cash flows. like your conviction about the earnings is less and less certain. So at some point it becomes speculative. But you don't say there aren't any cash flows. You don't say I'm just buying it because it's going up.

42:22Jon Hirtle:That's not speculation. That's gambling. So that notion of investing is so fundamental. And speculative investing has some appeal to it. And gambling, in my opinion, should have stayed in Las Vegas. In the investment management business, I think of a spectrum between asset gatherers on one end and return generators on the other end. How do you think about that spectrum and where do you sit on it and what are the warning signs that a firm is drifting towards asset gathering? Yeah, well, you're right, Alex. That's a good way to say it. We like to, I like to say people that are investors versus people who are in the business of investing.

43:03Jon Hirtle:You know, like you're an investment business. There are a lot of people who are investment business who are investors at all. They don't even invest. If you really push them and say, do you eat your own cooking? Oh, no, but we have this new product and we think it's going to be great. You have your own money in it? No. Okay. And then, you know, it blows up and they move on to the next one. So investors are very different than people who are in the business in the industry. This goes back a little bit to our first point about product shops versus non-product shops. I mean, when you create that product, somebody has to buy it.

43:41Jon Hirtle:The company is going to suffer if somebody doesn't buy the product. Is it a good idea? At some point, that's no longer driving the issue. It's more like, is there demand for it in the marketplace among laymen? Can it be pushed onto the marketplace because it's hot? Those are not investment ideas. is. So it's sometimes it's pretty obvious. I mean, one of the things we've seen, for example, in the private credit space lately are the very large firms who have big private credit pools have to underwrite big deals, and they have to underwrite a lot of them. So in our view, their standards drop. Just to fill the pool, they've got to accept things that better investors with smaller funds would not accept.

44:29Jon Hirtle:So that, I mean, it's funny to see, that's a good question. Like, how do you know they're asset gatherers? Well, if they have a trillion dollars, that's probably an asset gatherer. That would be one giveaway to you. So size of the pool matters. Venture funds, for example, when you're in venture capital, it doesn't, venture funds, venture investing is a very sort of focused, one deal at a time, a little bit of money making a big difference. When you get very large venture funds, it's kind of counterintuitive. So once again, why would you have a fund that big? Because you're not worried about making the money on the returns, you're making the money on the fees.

45:13Jon Hirtle:So who's assembling the pool and are they making the money on the returns or are they making the money on the fees. So that's another way to look at investors versus asset tanners. And my sense is you can't just listen to the narrative because most of these firms, to get big, have very good marketing groups helping them. So you have to study the almost the objective data and follow the evidence of what camp they fall in. If I think about my 44 years in the business, complexity and noise has exploded on the upside. So when I started, you know, we got our information from the Wall Street Journal.

45:59Jon Hirtle:I mean, literally, there was no CNBC. There was no, you know, there was no cable news network. There was no CNN. No internet. No Bloomberg, no internet. We actually had quotrons on our desk, which was tied to a mainframe. So dummy computer. and a very simple world. Goldman Sachs used to produce our research pieces, used to be published on different colored copy paper, like pink, blue, pale green. And the reason we did, and they were just from a copy machine that's stapled together. So when we go to a client, we could see on their desk, if their pink sheet was right in the middle, we could see where it was on the research, the stack of pink, you know, copy paper.

46:44Jon Hirtle:So, and really, when you think about it, the world was a stock bond cash world. And you'd go to an investment committee meeting where the family, they'd say, you know, we're thinking about trimming Procter & Gamble and adding more GE. That was sort of the discussion. No derivatives, no international, no private equity, no hedge funds. You know, the whole world has exploded in complexity and noise. meanwhile governance has not changed at all you still have well-intended laymen for example whether they are families or an institution maybe meeting once a quarter gets together and tries to manage the system the way the same way they managed it back when you had somebody saying i think we're going to the bank comes in and so we're going to trim procter and gamble and add some GE.

47:33Jon Hirtle:It's so hard. In other words, like when you look at what you just said, how do you figure out what's an asset gatherer and what's... This is not hard for us. We're full-time professionals. We have$26 billion. We have 100 colleagues. We have all the data in the world you could use. That's a first order mistake that we will not make. Now, there are other mistakes we're going to make for sure, but not that one. So those are those first level mistakes are hard for lay people who are doing this part-time to understand and to manage. They're not hard for us. This is one of the reasons you need, you know, an independent office led by a qualified CIO.

48:10I think another big aspect of it is, and we talked about this earlier, is when you talk to a money manager, they sound smart. So if you're a layperson coming in and you don't talk to thousands of them, the first few you talk to are going to say, wow, they're brilliant. And that can mask whether they're an asset gatherer or a return generator. Whereas if this is what you do all the time, you have a very different spectrum from which you compare those people.

48:34Jon Hirtle:Smart is not an edge, by the way. You know, like you and I talked about that earlier. Yeah. Smart is, you know, it's what do you call it? Table stakes. To get into the game, you got to be smart and you got to be hardworking. So both of those things are table stakes. You got to look beyond that. So we talked about this earlier. Culture is crucial. We've heard that culture eats strategy for breakfast. How do you define culture inside a great investment organization? Well, you got to know who you are and you got to define it and you have to work at it every day. So we think about making it personal.

49:09Jon Hirtle:Number one thing, this isn't, you know, this isn't abstract. It's client money. It's our money. Everybody, we are invested right alongside with our clients and it's personal. Our success or failure is going to have direct impact on our clients' lives and their families and their institutions and their well-being. So we make it personal. Second thing is we've got to embrace the magic of teamwork. So teamwork, it's not just there is this alpha component to it. There's a magic part, one plus one equals three. So you've got to be able to collaborate and push each other. You've got to be able to challenge each other.

49:49Jon Hirtle:You've got to expect that your colleagues are curious, doing their homework, showing up on time, flying to India to visit the manager, flying to Singapore to visit the manager, go to San Francisco for a long week when they'd rather be home with their family, doing all the work they want to do so that we collectively can win on behalf of our clients. The third thing that we really think about is to serve with courage. So that means, for example, internally, we have to be able to challenge each other in a constructive way. Number one, I want to go back to make it personal. We're very, I don't want to make this sound too challenging.

50:25Jon Hirtle:We care a lot about our colleagues. But if somebody's not doing well in their job, it doesn't do them any good to pretend they are doing well in their job. you know, they might do well and better in a different job. And we owe it to the firm and to our clients to be candid with people on how well they're doing their job. So that's serving with courage. We have to be able to give someone a tough review. We have to fire them when it's not working and hope, you know, ease them out of the firm, help them find a different position. We've got to have the courage to do that. We have to have the courage to talk to a client and say, you're wrong.

51:01Jon Hirtle:This is a bad idea. I don't think you should do this. And if he says, well, I hear you, but we got to do it because of this. So what can we do half of it? We've got to push back. We're not salesmen. We're trusted advisors. We're trying to lead the client to success, knowing what we know. We take this seriously, right? We're trying hard. So you have to be able to serve with courage. That's our third cultural pillar. And the final one is we want to be driven to win. You know, we're Americans. We like to win. We want our clients to win. We want to make good decisions. We're in the decision-making business, and you don't get them all right.

51:39Jon Hirtle:There's no question. Jack Meyer, who used to be the CIO at Harvard, said the best money managers in the world get it right 53 % of the time. Now, it's what do you do after you make your decision? Once you figure out you're wrong, how do you treat it? How do you constantly me underwrite that decision and modify the decision three times. So it's not as simple as being right 53 % of the time. It's how you size your bets, how long you stay with them, what you do with them. So that notion of being driven to win, trying to overturn that next stone to find that next manager, even though you know the vast majority of long-only managers are not going to be generating alpha, you don't stop looking.

52:22Jon Hirtle:You got to find them. And in a private space, which we haven't talked a lot about, that's a whole other effort that you really have to be able to fund because that's really where so much of the alpha lies is in private markets. You know, a statistic I like to think, there are about 4 ,000 publicly traded stocks in America. There are 8 million private stock, private companies in America. That's 2 ,000 times. It's like people don't realize how many more private companies there are than public companies. And all those are opportunities for the private market. So what you said earlier, Alex, how's the world changed?

53:00Jon Hirtle:That's a big change. There are fewer and fewer public companies and more and more successful private companies. So investing in private space is a very important part of an exceptionally strong program. And the information is not as readily or easily accessible as well. That's one of the reasons it's juicy, frankly. If the information were easily available, then you couldn't get an edge. But if you're good and you have experience and you have relationships and you have processes and you're willing to do the hard work, there's a lot more opportunity in private markets than there is in public. It's like 100 years ago when people used to go to Wall Street to get that inside edge that actually exists in the private markets.

53:41Correct. There is an assumption that the four pillars you described, structure, philosophy, execution, and culture, are potentially independent. Where do firms most commonly break down, and why do you feel that culture may often be the silent culprit? I mean, I actually think that they break down almost at every point.

54:04Jon Hirtle:a lot of them are excluded because of the structure so the structure itself causes them to make bad decisions because they have a quota they're trying to make their boss happy they got a new product or they don't have any of those things but they are relatively young and there's somebody above them that's telling this is a great deal and that guy has a conflict because he's trying to make points with his boss. So structure is key. Philosophy, a lot of people, you know, if you talk to serious investors, generally they have logical philosophies. And so you have to say, does it really suit our mission?

54:46Jon Hirtle:And certainly most people are used to talking to what I would call sub philosophies. You know, how do I pick growth stocks? That's interesting, but it doesn't solve the whole problem because you can't have, that's like a one cylinder engine on a, it's bumpy. You got to have them. You want to have as many cylinders as you can. So that you have a smooth ride on your way to your destination. So that, that, and then, you know, execution is every day, you know, you can have everything right. And if you're dropped the ball and they hit you in the hands with it, you got to try harder. So every day you've got to execute.

55:21Jon Hirtle:And a lot of times people misunderstand bad performance that could be just bad execution. Philosophy could be good. They just didn't drop bad job in executing. Or it could just be randomness. Either way, either good random or bad random. Another famous book that I didn't mention, but Fooled by Randomness, which is by Nicholas Talib, is really one of the most important books, I think, in the business. And so this notion of randomness can really confuse people. And then the culture is what pulls it all together. So you've got to have that culture where you care about your clients and you care about each other.

55:58Jon Hirtle:You've got to have that culture where you're constantly pushing for a better philosophy. I always say to our team, is this the best process in the world? Because if it isn't, let's change it. So we want to be the best process in the world. We want to be the most highly capable independent investment office in the world. So you've got to have the culture that really wants that. and then you got to try hard every day to execute. So the culture, as Peter Drucker said, eats strategy for breakfast. And what's interesting is the way you described all of that, you could have said the same thing about the Marines.

56:32Jon Hirtle:That's true. Only thing about the Marines is there's no second place. So you've been in the industry for several decades and have witnessed its evolution firsthand. We touched on this a little bit earlier. And I think of it as the industry has evolved from brokerage and product sales gradually towards advice and gradually towards independent advice. How do you interpret that evolution and what do you feel the next stage looks like? It's a good description. I hadn't thought of it that way. I think independent advice is, to me, that is, as you meant, it's like an evolutionary next step. So now what I find is that most of the independent advisors, well-intended, don't have the horsepower they need.

57:15Jon Hirtle:So that's, to me, you know, in our world, what we're saying is that we want purely independent advice, but we want real power. We want to be powerful. So most firms, when they transition to powerful, become big, they start selling products. They end up, you know, in my opinion, kind of going to the dark side. You know, they basically said, we're going to become asset gatherers now. And because there's a lot of money to be made there. Merck makes more money than the Mayo Clinic. It's fundamental, right? One's a service business. The other one can get ultimate product leverage. You know, you can get leverage.

57:55Jon Hirtle:You just add more pills, right? So the business, they're both in healthcare, but what are you? Do you aspire to be the Mayo Clinic or do you aspire to be Merck? And I don't think those two blend very well. So I think this notion of bigger firms that remain independent and provide advisors with power as well as that independent advice is what I would hope the industry is headed toward. You could argue if you were to start the industry from scratch today and forget all the legacy that has pre-existed uh that's effectively potentially the most uh optimal design uh that should exist if we didn't have everything that we grew from that's well said i mean we do have all that baggage but i also think it's the proof is that everybody who has the money to do it any way they want uses the independent office model so you know one's a deductive case and one's an inductive case You could make the case why independent model works step by step by step by step.

59:04Jon Hirtle:And the other one is, you know, gee, if every, you know,$10 billion fund in the world does it this way, maybe there's something to it. You know, the$10 billion firms don't give, they don't use Goldman Sachs. And, you know, I don't want to beat up on these guys. I love Goldman Sachs. It's where I learned my trade. But it's a different model. They're Merck, right? I mean, and same thing with JP Morgan and same thing with everyone else. JP Morgan's got a lot of capability. There's no question. And we read some of their things. And that's, once again, a great firm. Wrong model, right? That model is for people who want the convenience of one-stop shopping.

59:43Jon Hirtle:And they think good enough is good enough for investing. Our view is if clients think good enough is good enough, they shouldn't come to us. But if they don't think good enough is good enough, then now we can talk. So I do think that there's logic behind this. You know, a$10 billion fund might give money as a role player to Goldman or JP Morgan or do a hedge through Goldman Sachs. But they would not use them as their CIO because it's the wrong structure. And sometimes good enough may feel good enough during a bull market. that if you go through a bad stretch, you know, it could be five, 10 years where you have a choppy environment, then good enough may not feel good enough.

1:00:29Jon Hirtle:You mentioned, Alex, and you asked me about, you know, Warren Buffett, when a tide goes out, we see who's swimming naked. It's interesting. We've had basically 12 years of great markets. So people who have been in the business 10 or 12 years who say, how long have you been in the business? I've been in the business a decade, right? They've seen one market. so now could that market continue yeah probability wise it could i mean i think it's a low probability but even if it were 80 to 20 in other words 80 it's not going to continue 20 it is going to continue 20 happens 20 of the time so it could continue but it seems unlikely what is more likely is a rotating market right because you know going to howard marx the cycle things get they start to do well, they go up in price and there is no asset.

1:01:20Jon Hirtle:It's a good investment at any price. People start to take profits, move into the other thing and they go down. So if you look at most asset classes and subclasses and managers, they cycle through time. And we've had an unusual decade here because of, you know, lots of circumstances where technology stocks have dominated everything else in the world. Speaking of technology, how do you see AI impacting the investment industry over the short run and the long run? Well, I was, as an anecdote, my wife and I were hiking in Italy and we met a guy. It was a nice small group and I met a guy and he was talking about his partner.

1:01:57Jon Hirtle:I said, are you a lawyer? He said, no, I'm in the tech business. And it was Michael Intrader who started CoreWeave, right? And so he's running CoreWeave. So I had a week, you know, having a beer and talking. We were hiking. And one point I said to him, what inning are we in? And he said, the first batter hasn't stepped up to the plate. So I think that's a fair way to say it. I do think it's transformational like the Industrial Revolution. Our notion on it is that the stocks themselves, the tech stocks themselves, may be a little ahead of themselves, but that doesn't mean that there's not going to be a huge productivity increase on all the companies that are learning how to use AI.

1:02:39Jon Hirtle:And we've seen that a lot of ourselves, and I know you have too, Alex, where we're trying things out But industrial companies are going to be using it. So it's really going to be a transformational impact on earnings. There's going to be societal impacts as well. And that's a whole other set of questions. But the first thing we want to talk about is, as I said earlier, buying those future cash flows. And so we think, for example, it's important that the charities we work with are exposed to AI. because, you know, at some point they're going to be called on for social support for people who are dislocated from this.

1:03:16Jon Hirtle:We don't know how that's going to play out, but we know that they're going to be better off if they have more money to support their communities. So on one hand, we're thinking AI is going to increase earnings. It's hard to predict it. I love one of my favorite quotes is there are two types of forecasters, those who don't know and those who don't know, they don't know. You know, so I think you can't predict. You can only prepare. How do you participate? We're participating publicly in the public stocks. We're also participating in venture capital. And so we think we've got our bases covered and we're trying to be smart about that.

1:03:53So that's what we think. In terms of private markets where we talked about there being potentially less efficiency and more alpha opportunity, let me ask you about a couple of asset classes there. just to get your perspective. So obviously private equity benefited from a long period of falling rates. If we head into a period of higher for longer, what changes? And does that potentially shift the advantage away from financial engineering toward true operating skill?

1:04:23Jon Hirtle:Good managers have always had true operating skill. There are three ways you make money in private equity. You buy it well, you make it better, you sell it well. The buy it well and sell it well is oftentimes out of your control because that's what the market price is. The only thing you can do reliably is make it better. And, you know, we've had terrific returns with people who are make it better people year in and year out. And they're careful or they try to buy it. They try not to overpay. And they try to use the right kind of financing. Now, you mentioned earlier, Alex, if interest rates, if we don't have those low rates, what's going to happen?

1:04:59Jon Hirtle:First of all, we had a long period of time in private equity when we had high interest rates. You know, I have a very close friend who took a company public, a company private, for example, when the prime rate was at 20%. It did very well with that. So it's part of the model. There are fewer deals that make sense. The returns on equity are likely to be lower because there's less leverage. But the return on equity in the public markets is likely to be lower because they also have higher interest rates and less leverage. So what we want is for the private markets in our program to beat the public markets by, I mean, literally, we shoot for five percentage points.

1:05:39Jon Hirtle:We want to be five percentage points better. Now, our history is actually better than that. And, you know, we have to be careful about talking about private markets because a lot of times listeners might not be credited and so forth. So, but my point is that there are inefficiencies in those markets that should, if you go for the right operators, allow you to consistently outperform public markets. And that's the next step is the right operator. So you mentioned adding value. The right operators all add value. And the bigger the companies are, the harder it is to add value. So, you know, we like companies that, you know, you might buy a plumbing supply company in Louisville and, you know, for a good price and add five more plumbing supply companies onto it, roll it up into a business, fix their IT, correct their financing, put in some management, and then sell it up market.

1:06:31Jon Hirtle:So that is the kind of stuff that, you know, you really can make a good living at day in and day out better than public markets. So I think it's really relative. In other words, if the market's up six and our portfolio is up 11, that's almost better or more significant than if the market's up 15 and our portfolio is up 20. You know, the relative difference is still there. So I think it's going to be, you know, it's dynamic, but it's still relative to the public markets. I think the inefficiencies, if you're with the right operators, are something we still believe in strongly. Private credit has hit the headlines recently.

1:07:14Do you worry about bubble-like conditions and where are you most focused from a risk standpoint?

1:07:20Jon Hirtle:Once again, it's down market. We don't want to be with the big operators. We think those big operators are stretching to fill up their pools, and they're not doing the proper amount of credit analysis. So the default rate in our private credit portfolios is extremely low. And default, as you know, is just a missed payment. It doesn't mean they go away or go bankrupt. It's just if they miss a payment, that's a default. So we have extra debt covenants. Our underwriters, our managers are very careful about recourse and debt covenants such that we feel very good about the portfolios that we're with.

1:07:59Jon Hirtle:And we like it much better, for example, than the public high yield market. So now that might not always be true. If the public high yield market got very cheap, then we might not feel that way. But for a long time, the public high yield market has not been particularly cheap in our estimation. And we think in our space, we've got better credit, better covenants, and strong returns. So the thing I would say, Alex, is you got to remember on private markets, Like the difference between a good manager and a bad manager in public space is like two points, two percent, 200 basis points. In private markets, it's 25 points, 25 percent.

1:08:41Jon Hirtle:So the idea of working hard through your relationships and your due diligence and spending time at meetings and talking to managers so that you can get into the top quartile of managers. that's a very different experience than the average in private credit or the average in private equity or the average in venture capital so averages in these private markets which is what the media tends to talk about they'll say well the average the average doesn't mean a lot when you're talking with a market with this kind of performance distribution yeah it seems like the narrative has carried over from the public side where you have much greater efficiency low dispersion low persistence of outperformance has carried over to the private markets where you have greater dispersion, greater persistence of outperformance, and less efficiency.

1:09:33And I think in some ways it's easier to identify alpha because you can see the difference as opposed to having a greater trust factor in the public markets.

1:09:44Jon Hirtle:I like to think of it as beta markets and alpha markets. And private markets are alpha markets. So they're really dependent, so dependent on the manager. So manager dependent would be another one as opposed to alpha, but that's what we mean, manager alpha, right? So another way to say that you and I will appreciate some of our listeners, if you think about a bell curve, in public markets, it's a bell. You can see it. There's a cluster around the mean, substantial. In private markets, it looks more like a gong. You know, there's very little cluster around the mean. So making comments about the mean is almost meaningless.

1:10:20How do you think about the opportunity in private real estate today, particularly in an environment where interest rates are generally higher than cap rates?

1:10:29Jon Hirtle:Yeah, private real estate is always interesting. A lot of our clients are kind of overcommitted to private real estate already. But it's another one of these inefficient markets. It really matters what location you're in, what type of real estate you own. It also is a factor that we have to look and say, given the returns we've got in private equity and credit and venture in particular, most clients have a liquidity budget. They only feel good about having 30 % of their assets that are illiquid, something like that, 30, 40 at the most, maybe 30. So are we going to cannibalize that illiquidity budget with real estate?

1:11:08Jon Hirtle:And so the answer is maybe if the opportunity is compelling enough, but it's got to compete with venture and private equity from a good standpoint of returns. And some do, but many do not. I'd like to close with your economic and market outlook. And I know you spent quite a bit of time thinking about this. Just high level, do you feel like we may be entering a regime change given where the world has been and potentially where it's headed? We do feel like we're going to rotate. You know, we think that the tech stock world has gotten a little ahead of itself. That doesn't mean we don't believe in these tech stocks.

1:11:49Jon Hirtle:We do. We just think they're too expensive. And we think that the amount of if you can get a return on equity for all that money that's been invested, you know, the billions and billions and billions of dollars that have been plowed into AI has to get a return. So we think that there is a, that it's going to be hugely impactful on the world, but we would, we do feel like rotating more into traditional investments. So we do think there's a regime change that we're underway with. with. You know, everybody says, you know, investing's never been this difficult. Investing's always difficult. You know, I remember when I started in the business in 82, Business Week had just had a cover called The Death of Equities, a famous, you know, Business Week cover, The Death of Equities.

1:12:36Jon Hirtle:And then the bull market started in August, and it was one of the longest bull markets in history. But it was hard to invest in 82. And by the way, when the market took off, there were these doomsday people that said we're setting ourselves up for the next great depression elliot janeway people like that had huge followings all these predictors of doom coming right around the corner and so what you think about investing is always the markets are always struck at equilibrium every time i buy something somebody sells it to me every time i sell something somebody buys it from me so that the positive and negative energy is matched you You know, the price rises.

1:13:12Jon Hirtle:If all of a sudden the news is good, well, the stocks immediately rise to a new point of equilibrium, which just as hard to buy and sell as it was yesterday. And it's that next piece of information that nobody has yet that actually moves the markets. So we think it's always hard. You know, the world is AI is very disruptive. We're still in the middle of the disruption of globalization, which we're still digesting and indigesting and things like that. So we want to stay fully invested, though. You know, we don't believe that it's time to take money out of the equity market. And we want to be more careful where it is.

1:13:53Jon Hirtle:So we want to be a little more global in our orientation because we think if you get this rotation and you're going to see banks and industrials doing better, then you're going to see Europe do better. because that's what they have as banks. They have big global companies that are often financial and industrial. So five years ago, if you looked at our performance versus Europe, the differential in a lot of ways was just that we had the tech stocks and they didn't. If you took the tech stocks out of our S &P 500, our performance looked just like theirs. So if we're going to rotate into the industrials and the financials, for example, and the consumer durables and companies like Visa, things like that that have a moat around them, but they're still very good businesses, then you're going to see Europe do better on the margin.

1:14:40Jon Hirtle:So we want to be global. We want to be careful. We want to be public. We want to be private and want to be mission-driven. And I think we will succeed. Well, John, this has been a fascinating conversation. We covered a broad range of topics. I appreciate you sharing all your insights with us. I learned a lot and I'm sure our listeners did as well. Thank you, John. It's a pleasure to be here and look forward to staying in touch. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org.

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