#46 - David Hou: Industry Insights

25:43But yes, I think you're right. I think there is a sweet spot and there is a optimal size. Okay, so we talked about what it should look like. So if you were to redesign it, how would you do it? now let's take a look at how it actually is. So there are about 300 ,000 financial advisors in the U.S. Would you describe what the landscape looks like for our audience so they have a sense of what that world looks like? Because a lot of people aren't that familiar with it. Even advisors may not have a good sense of the landscape. You know a lot of advisors, you know the industry, you've worked at different places.

26:18Would you just give us the lay of the land in terms of just high level so people have a sense of what it looks like? Well, I guess predominantly today, it's advisors that are at large brokerage firms. That's what dominates the industry. I think it has changed over the last 20 years because there have been more and more advisors or brokers from those companies going to be independent as we have, of course, or they may have gone into some of these channels. There are some companies out there that have channels where you can be an independent employee, but you can still custody your assets on their platforms.

26:51I think Wells Fargo has a platform like that. LPL has a platform like that. I'm not intimately familiar with them, but I believe that there's a hybrid model that you can go to. But the vast majority of the advisors in our industry are still in the brokerage firms. And there's good reasons for that. At the end of the day, we're independent, as you all know, we're independent advisors and Evoke advisors. We're independently owned by our partners. But a lot of people don't want to do that. Most people that I talk to are like, I don't really want to run my own business. I want to be inside of a firm that can help me with a lot of resources.

27:24And there are a lot of resources that these big firms have that we as an independent RA don't have. So there are advantages of being in a brokerage firm. And I think a lot of those people who are there are there for the right reasons. So that's the biggest slice of the industry. A smaller slice is going to be people like us in the RA independent channels. It's getting bigger. If you look at, obviously, years ago, there were none of these big RIAs that you see these really sizable large RIAs out there today, whether it be Fisher Investments or others that everybody knows. It's grown a lot. And I think it's going to continue to grow.

27:57I think we're in a really nice spot in the industry where a lot of growth will still continue to nurt to the independent RIA space. How would you describe the typical financial advisor and what they're good at and what they're not as good at? Well, obviously, most of them are really good salespeople. You have to be, I don't say salespeople in a negative bent. Sales is a part of every industry. It just is more so in our industry. Because you have to get clients. You have to get clients, yeah. Yeah. Everybody knows when you join a firm, you have to provide revenues or else you don't have a job in a few quarters.

28:36So yeah, it's a very sales oriented culture. And again, I don't mean that in a negative sense. It can be a negative, obviously. It can be very negative if you're just sales oriented, but it's a sales culture. It is a transactional culture in some ways in nature. So I think those would be two descriptions of sales, transactional. On the other side of the coin, it's also very relationship oriented. It's also very partnership oriented. I know many advisors, again, both on the brokerage community and RA community, that are unbelievably good people that do absolutely the right thing for their clients.

29:14And so those people are pervasive in our industry as well. It's a mixed bag in a way, but it's a great industry. I think of it as there are three key players in the industry. There's the advisor and their team. There is the client who has the assets. And then there's the investment managers, the professional investors that are picking securities. So we talked about the advisor side. Let's talk about the clients. What would you say are common blind spots that you've observed among clients? I think that one of the pitfalls that a lot of people don't see is that when you start working with an advisor, there's something called risk creep.

29:56And risk creep, essentially, if you're in a brokerage side of the industry, that riskier and riskier products pay more than low risk products. I doubt if many transactional advisors have called any clients to say, hey, you should buy this treasury bond. Maybe during a bear market. Maybe during a bear market. But you can see online everything, what a treasury yield is. So there's a real no incentive to go and sell somebody a treasury bond. But there is incentive to sell somebody a structured product. Or there is incentive to sell somebody a preferred underwriting. And there is incentive to sell somebody in the 2007, 6, 5 subprime mortgage CDOs.

30:39But let me ask you, isn't the greatest incentive to keep your clients and have a good reputation so you can grow your business? So how do you reconcile that with selling product and getting paid more? I don't necessarily think the advisors are doing this because they're not interested in their client's success in investing. I think sometimes the firms will tell them this is a really good product. It's not that they're trying to do something nefarious. It's say, hey, I've had all my training and my on-the-job training as well. They have continuing education, all the firms, and they have sales meetings where they say, hey, this is really interesting.

31:16This is a new development, whether it be an AI infrastructure build out or whether it be infrastructure, whether it be clean energy, whatever it is, the firms train advisors to adopt those things. So it's not necessarily the advisor not trying to do the right thing. It's just that risk creep is a subtle thing. What happens is products that are riskier pay more. So the firms are incentivized to create them. And that's what happened in the subprime mortgage crisis. At one point, I recall when we never bought any subprime mortgages, but I remember at the firm that we work at the time, I think there was a 5 % upfront commission to subprime mortgage CDOs.

31:56So that is risk creep. That is where a portfolio that started out very diversified, perhaps a client's portfolio over time got more and more risky because there is an incentive to do that. And so it can subtly happen over time. it'll probably happen even without the potential conflicts of interest because as markets go up investors and clients they see that and there's a natural tendency to want to buy the thing that's done the best right and sometimes if you bought something very risky early on in the process of that playing out let's say we have no idea today whether or not all these ai companies that are coming to market and opportunities that are coming to market is going to be highly successful in the next five or 10 years or not.

32:45But there's a strong belief that some of these are going to be huge winners. So you got to pick the right ones. But there's certainly whenever there's that kind of promise or speculation that's going to pay off, there's going to be a lot of product created. So it's just the way it works. Unfortunately, I think clients would benefit from taking a step back and just saying, okay, where are we in that process for this, whatever somebody's trying to encourage me to buy? Where are we in that process? And do I think I should invest in it or not? And maybe you do with a little bit, maybe you measure yourself, but I think the client has to be part of that discussion.

33:21A lot of this is challenging because it's not that clear. So you could have products that come out that have a compelling story and you invest in them and they go up a lot. And they could also go down a lot. There is no clear lines about what is a good investment, what's not a good investment. It's just a very fuzzy area. And so you could see that it would persist for a while. So I think your point of going back to what are the incentives? Are you a fiduciary? How are you thinking about the details? All those things are the core of where the advice comes from. And it's just difficult in an industry that is not that transparent.

34:00If you go to a surgeon and they're a bad surgeon, it becomes very obvious that they're very bad. In the world of investing and advising, it's not that obvious whether the advice is good or bad. It takes a long time to filter through that. And it can be subtle. So in this environment, again, as we've talked already, U.S. equities have done really well. And so I can tell you that when we talk with clients, nobody really wants to focus on reducing or diversifying their U.S. equities. And maybe they shouldn't. Maybe me as an advisor, I have been trying to tell clients today, hey, we should take a little bit off on the U.S.

34:38equity side, especially if it's in a tax-exempt vehicle. You don't have to worry about the taxes. And emphasize some areas that have been overlooked, whether it be non-U.S. equities, perhaps international, or it could be fixed income today, whatever, where people tend to have lower allocations than they have historically. And so I think just human instinct is a little bit hard to do that. The insight as an investor is to go and say, okay, let me take a step back. Let me just think about this big picture wise. Let's look at the data. The data over the last 10 years is X or the last hundred years, it's Y.

35:14And so there are these big long timeframes of significant outperformance and significant underperformance. So let's look at all the data so we can make an educated longer term decision. I think another way to say what you just described is that the investment industry is a little bit unique relative to the rest of the world. Because in the investment industry, cyclicality exists where there's these warnings. Past performance is not indicative of future results. Those warnings are oftentimes ignored by the advisors, investors, clients. And usually the best returns in the future can be found in the worst returns in the past.

35:52and nowhere else in the world does that really exist. If you have a high-performing employee, you don't assume they're gonna do poorly in the next cycle. There's correlation, past returns and future returns. Whereas in this world, it's very counterintuitive in that way. And that can be very difficult, especially because there aren't these clear lines, there's no clear inflection points. It can be very difficult for clients to see that because they're zoomed in, they're not zoomed out. And so you could see why those issues would persist. it's even deeper than that Alex in some ways think about like there have been investment managers out there Nobel laureates who have espoused that value outperforms growth for decades true and I think in the returns don't quote me on this but if you look at the returns over the last 10 or 15 years of growth it's caught up a lot to the value index I think it may be ahead now.

36:51Because the difference is so significant. Right. If you just take the pure, I would say, Russell 1000 growth, Russell 1000 value. And so it's interesting because you look back on a thesis that was true for 30 some odd years, maybe longer. And now it's maybe not true anymore, or it's certainly questionable. It's comparable. The indexes are about the same, I think, if you go back to. And so, wow, if that happens, think about that 30 some odd years gets dispelled. I'm not saying that value doesn't outproport growth or vice versa. I'm just saying that the differential is certainly not as big as it used to be, or maybe the opposite now.

37:32And so that's how hard investing is. Yeah. And it's complicated by two factors. One is that there's not really enough data to make a science out of this world. Data is very limited. It's very environment dependent. You could have a certain environment where certain data and connections exist, and then you change the environment and those connections are almost the opposite. So that's issue number one that's unique to this world. And issue number two is that you have investors and players who impact markets. So if something becomes known because a Nobel laureate said so, and the data supports it and sounds compelling, then it may cause it to be false going forward because it's already known and in the price.

38:14And so that complicates it even more. And so that's, I think, one of the reasons why, at least to me, it's such a fascinating industry because you're never going to learn it all because it's constantly changing. And at the same time, it makes it difficult to explain it to people, explain it to clients. And so it's just really challenging. It is very challenging. And then you throw into emotions into it. Then you throw in client emotions, advisor emotions, the manager's emotions, and it's that much more complicated. Well said. So we've talked about advisors, we've talked about clients. The last player in this game are investment managers, the people picking the securities.

38:51And typically the setup is client hires advisor, advisor recommends investment managers and the allocation. Would you give us some insight into what the investment management world looks like and maybe some common pitfalls that investors should think about? When I started in the industry at Goldman, they trained all the advisors to be essentially portfolio managers. So we went through intensive research classes. Picking stocks and bonds. Yeah, exactly. Being a portfolio manager. And I quickly realized that it's very hard to outperform the markets, just the indexes. It's not like rocket science.

39:32I mean, if you just go online, you'll see that outperforming the indexes is incredibly challenging. But then when you throw into it the taxes, the transparency, the additional transaction costs, fees, I believe it's virtually impossible for somebody to outperform. Now, you look at firms like Citadel and Millennium and all these other legends in investment management. Obviously, some of them have outperformed for very long periods of time. But I just think that for us to be able to identify those managers and to be able to catch them in their tenure of their outperformance is just extremely hard.

40:14Why do you think that is? Because the market is just so damn efficient. And what do you mean by that? Data is synthesized so quickly. It's just the ability to outperform really is just very hard. I think it's virtually impossible. But if you have a thousand investment managers, there's varying degree of skill among those managers, just like in any industry. So why wouldn't it be fair to assume that the smartest ones have some edge over the average ones, even if all of them are smart, but there's going to be the top 1%. why would you not think, assuming you can identify them, but the top 1 % should actually outperform?

40:53I think they could outperform and they have. Some of these managers, again, that we just named, they have outperformed, especially if you think about on a risk adjusted basis. But I just think it's very hard to perpetuate for long periods of time and to get access and to be able to access them is very difficult. When they become very successful, it's hard to access them. And then when large dollars are gathered into these firms, it gets that much harder. What's amazing about a couple of the banners I mentioned sitting on Millennium is that they've been able to do it even with large amounts of dollars.

41:25It's really interesting, but it's hard to access them. And they are certainly not as transparent as owning an index fund or something like that. Also, when you throw on the phenomenon of heartbeat trading on the efficiency of the ETFs with heartbeat training, which for the listeners, they should look up heartbeat trading online. You can read it on Investopedia. When you throw on that level of tax efficiency, I just think that you're better off using those passive ETFs that will capture the market beta of those returns. Now, we do use active managers for a portion of our portfolios. Now, why do we do that?

41:59I use them because I tell my clients, I don't think over time that this grouping of managers will necessarily outperform the markets, but in a down market, they will significantly protect you on the downside. So if you look at those managers of ours in 2022, when the market was down 18 % on the global indexes, those managers were far better that were net as a group, slightly positive. And in 2008, many of those managers that we mentioned, Millennium and Citadel, those managers were far better return performance than the index. So over time, I think the active managers can serve a role of protecting on the downside so that people say, well, not all of my dollars are in this beta basket that is dropping during COVID 40 % or 30 % during the month of March.

42:44And that's helpful because it goes back to what you said earlier, which is emotions are at play as well. It's not just math on a piece of paper. These are real dollars, real people who may work on a chicken farm and they worked really hard for that money and they see it disappear and it's going to incite some emotional response. It's not reasonable to expect them to tune it all out and say, oh, don't worry about it. It's a long-term investment. And so if you can protect on the downside, that has value beyond just the returns over time because the dollar returns may be better than what we see on paper.

43:20No doubt. That's the diversification factor that we always harp on, be very diversified. And so that would be the second bucket would be some of this active managers that do protect on the downside But we have to give up. What what do we give up? We give up the fact that it's less transparent It's expensive less tax efficient Less liquid But if you're willing to suffer those four or five negatives It can protect when the markets are very very turbulent We talked about the industry We talked about not having too many clients not having too few clients What about the size of a firm in terms of a wealth management firm?

43:57Is there a sweet spot there where you're not too small, not too big? How do you think about that? Yeah, it's interesting. So you have to be big enough to garner resources. So at the end of the day, if you're a small independent firm with a few hundred million dollars under management, it's hard to be able to have as much resources to do the research function to be able to afford a lot of software programs that we use and the compliance and other things that we need to spend money on. As a smaller firm, it's hard to do. I would say it's impossible to do adequately. On the smaller end, that's one of the limiting factors.

44:35On the higher end, as you get too big, you have too much money under management, it can be a hindrance. Performance, obviously, we all know that large amounts of dollars can be a negative to performance. And so there is kind of a range and I don't know exactly what size is ideal because it depends on what you're doing, what you're investing in. If you're only investing in the public markets, perhaps it could be a larger size. If you're incorporating into private markets, niche markets, size is going to be a limiting factor. So it depends on how your firm is constructed. For us at 25 billion today or so, I think it's a good size.

45:13I think we have enough resources to be able to support all the infrastructure and do a good job and also to incentivize very capable people to join us. As you know, we're going to hire another research person here coming up soon who is very seasoned and I'm amazed that he's willing to even come work with us. Those are the positives of having a large enough base to be able to afford the resources and then you can get to a certain size where obviously it becomes challenging to continue to perform well. We've talked about the industry and you have the advisors, you have the investment managers, and you have the clients, the people with the money.

45:49Some of those people with money bypass the system. So they don't use an advisor. They don't use investment managers. They may just manage money on their own. Do you have any advice for those people? Lots of high-level advice. I just spoke with somebody who was referred to as a physician who clearly has spent a lot of time analyzing the investment markets. This gentleman was knowledgeable about everything. He could be an advisor. He was that knowledgeable about it and very thoughtful, very opinionated. I forget what medical profession he was in, but clearly spending a lot of time reading about investing.

46:28But most people are not going to do that. They don't want to do that. They don't want to take the time. If it was my advice to those type of folks, I would say, try to really understand what you want to achieve, what you want to achieve, meaning your portfolio, what you're trying to accomplish. Really figure out what kind of risk you're taking in that portfolio, how much risk you're taking, what kind of risk you're taking. Are you comfortable with illiquid investments? I don't just mean on the illiquidity, but what is the objective of what you're investing in? They really have to spend a lot of time understanding what they own.

46:59I would look at this passive versus active debate and try to figure out whether or not they agree with one side or the other. Maybe the answer is like us, we see it both ways. We want to have elements of both. So I think there's a lot packed in there, but I would talk to advisors and just get people's views. Even though if you don't want to work with an advisor, you can talk to them so you can learn from them. Maybe it seems a little disingenuine, but to learn off of their dime, so to speak, but I think that's okay. You might learn something. I'm always open to talking to anybody about what we do, how we do it, what I think about the way we do it.

47:32Just gather data, get a lot of information and make sure you incorporate all that going forward. David, ever since I've known you, I've respected your approach to leadership and your intuition around managing people. Would you talk to us about how you approach leadership? I think I lead by example. It's very cliche to say that, but I think I really do that. What I mean by that is I work a lot of hours. My team works a lot of hours. Our people do. That's who I am. I want to lead by example. I think the most important thing is to be humble. What you do is what other people will see you doing it.

48:08They'll do it as well. So my leadership style has really been to roll your sleeves up, get involved. Some people here even want to say, I think to the negative, maybe too much in the weeds. Some of the people who work here probably would say, hey, you know, David, you don't have to get yourself into this side of the firm. But maybe occasionally it's okay. You're not going to do it all the time. but if occasionally you get in the weeds, it shows that you care, that you're focused on it, you're interested. And then it sets an example in that way. Yeah, I hope so. I mean, at the end of the day, my getting in the weeds is not to disturb or disrupt.

48:41It's really to help make it better and to help contribute. Culture is really important for me. I think it's paramount in our business to have the right culture. We have almost about a hundred employees here now. And I think that everybody feels that culture. I hope everybody feels that culture. We are a family, essentially. We're small enough still to be a family. And so we want to make sure we take care of everybody in the family. It's lead by example. It's being hands-on. It's really trying to have everybody have the similar rowing, the same direction in the boat. It's all those elements. How would you describe your North Star?

49:15What direction is the boat rowing? How do you define it for everybody? I would say very, very high on ethics. We always want to make sure we're doing the right thing for clients. Again, cliche, but I think it's hard for a lot of organizations that get bigger to do that. Every company that I've ever worked for, including our own company, their first tenant is always the client's interest comes first. But the reality is maybe not true everywhere. They say that, but it's a different thing to act that way. Yeah. And it's rare when you can find an organization that really does live that mantra. Client's interest comes first.

49:57I've been associated with a few, but I've also been associated with a few that didn't live that mantra. You learn and you course correct, hopefully in the right direction. Are there specific qualities you look for in partners and employees? All of those things we just discussed. I want my partners to be as passionate as I am about our business, as passionate as I am about our clients, to care about what's going into our portfolios and how we do it. The greatest compliment that a client can make to me is to say, hey, would you be the trustee of my kids' trust? Or when I pass, will you take over as trustee of my family's assets?

50:35Because you've gained that level of respect and trust. Yeah. That's the biggest compliment. And I've been fortunate in my life to have many people ask me that. And I've said to them, look, first of all, I can't do that for everybody. I want to be able to spend the time on it. And I will absolutely be there to help. I usually also tell them that your investment advisor should not be your trustee. So if you want me to do this, I will do it. But first thing I'll do is fire myself as the investment advisor. And we'll have to go find another firm to do that because you don't want to have your investment advisor as your trustee.

51:07That goes back to the conflict issue. Yeah, total conflict of interest. So I don't like to take that assignment on because obviously I'm in the business of advising families on their investments. So it's better if there's a trustee that's another confident trustee, a family member or a good solid institution who's very low confliction on handling those affairs. That's the biggest compliment a client can give us though. So let's close our discussion by covering just a couple investing topics. So we talked about active versus passive, and you believe in passive, generally speaking, because of the tax efficiency, low cost, and it's difficult to outperform over time.

51:47Would you talk to us about how you think about alternative investments? That's a big topic these days. And would you distinguish that from public markets? How do you think about that? let's define alternate investments, I guess, because the industry defines anything other than stocks and bonds as alternate investments, which could be gold as an example. I think of alternate investments as being more of the illiquid call down investment vehicles, the ones where you're locked up for multi-years. You could say private equity funds, but they might be private debt funds. They might be distressed debt funds or things like that.

52:22I look at it as the third leg of the stool where you have beta investments, where we talked about which is the very, very tax efficient indexing. You've got the active managers we talked about where they're hopefully protecting your downside years and hopefully give you a return that is comparable to the markets, but less volatility to get to the same place, not as tax efficiently. And then the third leg is the alternative side. And that to me is going to fall into categories of real estate, private real estate, private equity, private debt. And I think of it as another return stream that is somewhat uncorrelated to the other two.

53:01I say somewhat because everybody says, oh, it's totally uncorrelated. Well, it's not really totally uncorrelated. At the end of the day, you are subject to capital markets, you're subject to cap rates, you're subject to interest rates, you're subject to - The economy. The economy. All those things are still going to affect those private investments. But hopefully the managers have more leeway ability to manage around those issues. So you have a third leg of returns. And the more that we can find that are lower correlated to the public equity markets and the public debt markets, the better. So that's the way I think of those alternative investments.

53:35Now, that being said, it's not for everybody because giving up liquidity is precious. And so you don't want to go into alternatives without a lot of soul searching and thinking about them. Right now in our industry, everybody's A lot of groups are seeking out those alternative strategies. And I think a lot of people have put them into public vehicles. Some of them are probably going to work out, but some are going to probably not work out, in my opinion. I think that when you put inherently illiquid investment into a pseudo liquid format, there can be a higher degree of disappointment from your investors.

54:13There will be a higher degree of disappointment from your investors. So you have to really, really educate people. We want our clients to be very knowledgeable about what they own before they go into them. I personally have a very large percentage of my assets in those alternative investments. I feel that those are very, very attractive investments that have a place for the portfolio. Now, if you look in the last 10 or 15 years and you say that I'm comparing it to the stock market, even more so the U.S. stock market, even more so the S &P 500 or the Magnificent 7 to take it to a far extreme, then you're like, well, that was a terrible idea.

54:51But you can't really look at that comparison. You have to look at it over longer periods of time and in a more diversified manner. And I think that you'll find that those are very attractive ways to create returns over time. Is it fair to say that the reason you draw a distinction between prioritizing passive investing and public markets is it because that's a much more efficient space, information is widely available. Whereas when you move into the world of private investments, it's more fragmented. There's more opportunity to have an edge and it's potentially easier to underwrite from an advisor standpoint of who has that edge.

55:28Is that generally how you think about it? You say it always better than I do. Yes, absolutely. That's the information dissemination issue. It's also structurally different. If you're a real estate manager, there are structural elements, the debt and the way you structure the debt that you can take advantage of that perhaps in public markets, it's harder to do. There are other things in the private equity markets that people can do that are harder to do as a public company, as an example. When you're a private equity owner of a business, if you want to change some aspect of that company, you don't get the public blowback.

56:04There are advantages being private, there are advantages being public, and you just kind of have to find the managers that are really good in each of those spaces. David, the last question I'm going to ask you is related to alternative investments. I know you focus on middle markets as opposed to perhaps some of the large funds or even maybe the small funds. Why do you focus on that area? Several reasons. One, I think at the end of the day is we believe there's more opportunity in those middle markets than there are in the very large markets. Similar to the large cap companies are probably more covered than the small cap, mid cap companies that probably don't have a big following from research.

56:44So there is usually some kind of benefit from going to the markets that are less traversed. So middle market alternatives attract less interest from the very big pools of capital because it's hard to put the money to work and to do it if you're going to buy a, if you have a$10 billion fund, you're not going to go and spend time buying a$20 million,$10 million cashflow business. It's just not going to draw your attention. So by being in the middle markets is much more interesting, we think, from a return perspective. You also have an aspect of those middle market companies can be sold to the larger companies, to the larger, bigger firms as they grow.

57:21If they get bigger and bigger, you have an exit strategy. So there's a multitude of reasons why we spent our time there. I think also, if you think about the large pools of capital that are in the alternate markets, they're distributed pretty widely. So if you think about a very big XYZ firm, the 10, 15,$20 billion funds, you can probably buy them anywhere. You can probably go direct and access them. Well, that's how they got to be so big. Yeah. That's how they get to be. You can go direct. There's really no advantage for us to go and to leverage as many of those larger ones to provide them to our clients.

57:53We're trying to find those diamonds in the rough that are a little bit more unique. And I suppose similar to what we talked about in terms of the sweet spot for a wealth management business. You don't want to be too big because you have fewer opportunities and you don't want to be too small because you can't get all the resources that you need. So is that a fair comparison for middle markets, alternative investments? Yeah, I think it's a fair comparison. Again, we're all about that medium size opportunity market size of firm where there's still more opportunities in our opinion. Well, David, this has been great.

58:29I appreciate you sharing your insights. I've known you for 20 plus years and I feel like we covered a lot of what I've learned from you over that time. So thank you for sharing that with us. It was fun. Thanks so much for the opportunity. 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. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes. And don't forget to forward today's conversation to others you think would enjoy listening.

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