#77 - Charlie Ruffel: Asset Management Industry Evolution, Alternatives

0:05Welcome to the Insightful Investor podcast, a weekly series that seeks to share industry investment and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, a leading investment advisory firm. Learn more about our show at insightfulinvestor.org.

0:38Today's guest is Charlie Ruffell. Charlie is founder, chairman, and managing partner of Kudu Investment Management, which focuses on taking minority stakes in boutique, asset, and wealth management firms. Charlie has been a board director of Charles Schwab Corporation and a director of Charles Schwab Bank since 2018. I'm excited to welcome Charlie to the podcast and to hear his insights on the asset management industry in today's episode. Charlie, thank you so much for joining us. My pleasure, Alex. Thank you. Let's jump into your journey through the industry. Let's begin with your experience learning from the outside.

1:16You've approached the asset management industry from several angles. As a journalist, an information provider, an investment banker, and so on, let's start at the beginning. As a financial journalist, what did you learn about the industry and its leaders? I mean, it's a while back now, and the industry has obviously evolved. But now we're back in the 80s now. I think two things. One was actually a personal lesson. One thing as a financial journalist, you learn how to listen. And that really was my introduction to this, trying to understand the business, which was just listening, listening to people as opposed to talking over them.

1:54To answer your question more directly, what it taught me about the industry, which I think is still true today. it's a remarkably transparent and open industry. People then and now, I think, although there's a more nuanced and probably more negative view of journalism and talking to the press, but I still think the same sort of logic is in place that I found back then, which is people are very, very open to talking about what they're doing and how they're doing. It's a remarkably transparent industry. I would also argue, and it's been my own experience, that this is a business that has integrity at its very core.

2:32And people who generally don't behave with integrity get weeded out pretty quickly. Certainly that's what I took away then and still believe now that this is a very open and transparent industry with people who are very willing and able. And sometimes, obviously, it's in their own interest to talk about what they're doing and how they're doing it. And generally, I think it's an industry of great integrity. After journalism, you moved into publishing. and providing information and data to the investment world. Would you tell us about that experience and it helped deepen or even change your understanding of asset management?

3:08It was obviously a related but different world. That experience taught me how the asset management space, and I'm talking about that very broadly, covering everything from private investing to defined contribution investing. That experience really taught me how people spend money in the space. when they spend money, how they spend money, how they want to spend money. It taught me about budgets. It taught me the difference between trying to sell to an insurance company that has an asset management business to a small boutique. From my standpoint, that lesson was invaluable because it gave me a sense of the machinery of the business.

3:48I remember a long time ago. This is a world where defined benefit asset managers were king of the roost. And we're going a while back now. And they just didn't believe in marketing. They just, they believed in sales. So the journey of trying to understand how the asset management community evolved in terms of sales and marketing, I think that was the prime learning I took away from it. And then you transitioned to investment banking, where you gain insight into building, marketing, and running an asset management business? What were the biggest lessons from that phase? The biggest lesson to me personally was if you're going to work as an investment banker, you were always selling.

4:33I enjoyed it, but you're always selling and you've always got to try and find a person in power who's A, willing to hear your ideas and B, who your ideas suit. I think maybe the biggest takeaway from an industry standpoint is the sort of fuzziness around M &A in our space. There's obviously a lot of deal flow. There always has been. A lot of the deals haven't necessarily worked. I think that's probably true of M &A, regardless of sector. But it's not a business where it's really clear what really good deals are and what deals are not good. And if you're a banker, you've got to somehow convince people, even when history shows that so many of these deals certainly have underperformed, that your idea is a really good one.

5:21And just as important, you have to have somebody who thinks your idea is a really good one and is willing to back it. So it's a lot of selling. It's probably still true to say that a lot of M &A goes on in this space that is ill-considered. And do you think part of the reason the M &A hasn't worked out as well is because the business is just very difficult? It's just hard to add value over time? Or do you think it goes beyond that? I think it comes back to something that I think is a real core component of the asset management space, which is how much it is a function of individual talent within these organizations and individual drive.

6:03Sometimes it's really hard for that drive and that talent to sustain itself within much larger organizations. I think the business is a difficult one and nobody gets it right all the time. That's the nature of the beast. But I think probably if I was going to try and pin down one reason why a lot of deals don't work, I think it's because this thing we call culture, which we can define, which really comes down to either one individual or a handful of individuals imposing a particular vision on what they do and how they do it. That's a really hard thing to transplant. and it's fragile. And I think that's probably the reason that so many deals don't work out as expected.

6:49And there are always gains to be made from scale and from marketing clout. And those gains sometimes tend to make up for challenges that the individual executives face when they come into these new organizations or are bought. I think scale in particular probably covers a lot of wounds, so to speak, but it's hard. The dynamics of M &A in this space are hard. I feel like the point about culture is really important, particularly in this industry, because having met probably thousands of managers through the years, I've noticed there are so many different cultures within these organizations. It's unlike most industries that I've come across, where firm A has a very different culture from firm B, from firm C.

7:32Even if they're trying to do the same thing. There's so many different ways to approach asset management. And so you can see why when you have a wide disparity of cultures, trying to put two together, if the culture isn't a match, you could have some difficulty. I think that's right. It's tricky to do it. And yet, we live in an age where these large sort of multi-asset class firms, particularly the ones that have reinvented themselves out of the alternative space, almost feel of necessity that they need to grow inorganically. So regardless of the nuance of it, they're going to be buying businesses and trying to harness those businesses to their distribution or brand count.

8:14And it's very tricky. The other thing which I think is relatively unique to the asset management business is you sort of need the assets and the track record to make it, but you can't get those unless you have the assets and the track record. So it's like the chicken and egg problem that potentially M &A can help solve and get you off the ground. Yeah, and I think one of the challenges that the business does face is exactly a function of the dynamic you're describing, which is it's become increasingly difficult to start asset management businesses. The creativity that's always been part of this process where a really skillful portfolio manager in a particular asset class or a team want to go out on their own.

8:58I mean, it's always been difficult. Nobody should kid themselves about that. It was difficult, even when these boutiques that have exploded into these huge firms today were founded as recently as the 80s and 90s. It was always difficult. But now I think the bar on compliance is so high. The bar on that original sort of seeding number is so high. And I think also, I would say, asset owners, however you define them, whether they are foundations and endowments or pension funds or family offices. Probably family offices are less guilty of this, but they really don't want to be taking chances on managers that might simply not survive for a couple of years.

9:40And so you just simply don't get the flows into these new managers. I mean, there are exceptions, obviously, but you just don't get the flows into these new managers that they probably merit and their performance would merit. And the net result is they don't survive. And so the sort of creativity that I think has always been part of this business, I think is a little threatened now. And one function of that is that some of these big asset managers can find this talent and put them in business. It's not the same as their own business, but it's the next best thing. So across these roles that we talked about, journalist, information provider, and investor banker, how would you say your understanding of the asset management industry evolved through time?

10:22The only thing that I would say is that because I've had a couple of different lenses, it's sort of multidimensional. I think we live in a world in the asset management space where most people find themselves in silos. It's just the nature of that world. You really have to know your silo to excel. And the luxury I've had is different silos. Now, the danger there is that you're a jack of all trades and a master of none. But to have a sort of multidimensional lens on this business is a useful one. It certainly served me well. If we look back and reflect on this journey, are there any unexpected skills or insights that have proven to be most valuable as you move from outsider to investor?

11:04And then we're going to get into being a PE firm founder. I think the most important thing in this industry, if you step away for a moment from the very large institutions that tend to dominate asset management, because I think those businesses require a very different dynamic inside them. But I think the most important element to this business is personal relationships. If I've come to understand anything about this business in this journey, we've all had thousands of meetings. And if you have the ability to have some sort of institutional memory of those meetings, and you've been able to leave people with a view as to what you do and how you do it, and hopefully the belief that you do it with integrity, that's immensely valuable.

11:49To be able to call somebody up and discuss something with them because they had an intelligent discussion with you five years ago, that's a real asset. For all its institutional heft, it's still an incredible personal business, very dependent on relationships. That's the abiding lesson. If somebody asks you about an institution and by sheer luck over the years, your paths crossed with somebody at that institution, that's how you get things done. It's really hard, I think, to move towards a model that is impersonal. I mean, going forward, we might be in a position where decisions, allocation decisions, decisions about picking managers are entirely driven by a different set of parameters, but not now.

12:36That's not the world we're living in now. It's really interesting because you would think it's a data-heavy analysis where you can just look at the data and be completely objective and then decide who are the best managers. But what you described is a world where personal relationships matter. I don't know if it matters more, but it's certainly a significant part of the equation in terms of who you pick. Why do you think that is? And is that the right way that it should be? it can seem sometimes incestuous, this business. First of all, I would say that merit in terms of producing results and character, obviously, to put it mildly, are not mutually exclusive.

13:19And I think you cannot compete in this business regardless of the asset class here. This is a manager that you're competing in. I think you cannot compete without three things. First and foremost is performance, I think. Let's make that clear. And maybe that first element of this can be entirely data-driven. And I think a lot of the screening and stuff is very data-driven. But I think the second element is a narrative. You've got to be able to explain to people what you're doing and how you're doing and why you're doing it. And part of that narrative is why what you're doing has tailwinds. I think everyone understands how challenging it is to compete in a space where their head wins regardless of how much talent you have.

14:00And then I think the third thing is trust. This is a business, both I think institutional, maybe more institutional than retail, but certainly institutional, where all sorts of things come into play, capacity, fee levels. Trust is really important if you're going to give someone a lot of money and not just about performance. It's how they're going to treat you or communicate you in the asset class tanks, regardless of their own skill set? How open are they going to be to what you need as a capital investor? You have to feel that you're going to be treated well. There's so much that comes out of the blue in this space.

14:41It's the nature of what we do, that if you don't have that level of trust, whether you're having that in your wealth manager or you're having that with your asset managers, I just think you need all three of those things. It does start and should start with performance to the extent that that is going to be increasingly driven by the type of data that we now all have access to. I mean, I think we're probably getting there already, but there's got to be the narrative and there's got to be the trust. That's just simply the nature of the business. My sense is that performance is always backward looking, right?

15:18You can only see historical performance. You can't see forward returns until they happen. And that's probably part of the reason why trust and relationships and narrative and storyline and all that is so important because you only see the performance of the past. Even when you see the performance five years from now, it's past performance, right? And the decisions you make at that point are going to impact future returns. You kind of always need both sides of that. So that's, I think, one of the reasons it's not just pure data because you're looking into the future. Do you agree with that? Absolutely agree.

15:52with that. And I also think the rise of these sort of new types of intermediaries that take on some of the responsibilities that allocators used to have, the OCIO space in particular, that's all about trust. You're relying on somebody who understands you well to go in and essentially execute on all these things that maybe you used to do. It's a different level of relationship and it can't just be data-driven. The other aspect of it, which I think is interesting and somewhat unique to the industry is, particularly in public markets where there's more efficiency, arguably, than private markets and alternatives, there's less persistence of outperformance.

16:34So you could look backwards and see somebody who's outperformed and then you invest with them and then they go through a period of underperformance and then you have to decide, am I gonna sell low and buy an outperform that I should have hired? and hope that they continue to outperform. And that level of lack of persistence of outperformance, particularly in that space, introduces additional challenges. Yeah, I mean, I think that touches on bigger issues. I mean, they're always going to be really good stock pickers. And I think particularly in constrained asset classes like small cap, you can find them.

17:07But boy, the industry has just moved away from a belief that active can outperform in large cap US stocks, as an example. And the net result has been these huge trends we've seen. I mean, whether it's indexing or ETFs or just simply low cost beta, that's a headwind that you just simply couldn't get in the way of, regardless of the merits of it. And maybe some of the byproduct of that type of decision making, is very, very real in the marketplace. Are there any aspects of the asset management industry that you feel are particularly counterintuitive or underappreciated by outsiders? I'm pretty positive about some of these trends in the industry.

17:54I think what we've seen in the last decade with this sort of growing belief that you need equity market exposure, you don't need a stock picker and the resulted expense and maybe variability of performance to get it, I think is a tremendous thing. And if you look at the defined contribution business as an example, basically the bulk of assets in that space now are in essentially index proxy funds, target date funds, and the like. And you can make arguments as to why those aren't the most sophisticated vehicles, but they give low-cost exposure to millions of Americans to the equity market. I think in a way, maybe some of the fundamental problems that we faced in a time when stock picking, mutual funds, hoovered up most of the assets, I think that's a really good thing that that's behind us.

18:49One observation that I've had, and I'm curious if you've had a similar experience. When I look at the universe of money managers, you can put them on a spectrum. On one end, you have those who are truly in the business and focused on generating returns for their clients. And then on the other end of the spectrum, the other extreme are those that are really in the business of gathering assets. While everybody claims to prioritize returns, but their actions and the way they orient their businesses might differ. What are your observations? this is a profit-seeking business like any other and the larger you get regardless of your narrative and your narrative can be clients first or long-term greedy or however you want to define it regardless of your narrative you're in the business of being profitable and growth of assets has always been the fastest way to do that or the best way to do that i would say It's a very scalable industry.

19:47There is this belief amongst a lot of investors that they should find managers who understand what their own limitations are. And by the way, all these very large asset management firms, a lot of them have been sensible about restricting capacity within particular asset classes. They're just some asset classes that can't scale. I think that dynamic you've described is real. And every now and then, it becomes apparent when asset classes grow, or when particular managers grow in very different ways than they have historically, not incrementally. But actually, I think the industry, by and large, there are exceptions and bad exceptions.

20:31But by and large, does understand that ultimately, its job is to produce returns. And if they don't produce returns because they've taken on too much money, it'll catch up with them. I think by and large, I would say the industry understands the dynamic you're describing, whether they can resist the pressure to grow assets when there really shouldn't be a case for growing assets. That's a different story. In other words, most operate somewhere in the middle of that spectrum. And maybe they lean left or lean right, but they kind of have to fall somewhere in that middle, because if they don't, the market will force them that way.

21:07I think so. And you know, look, this is a business with immensely intelligent consumers. And if a PE firm goes from a billion dollar raise to 4 billion, well, they're going to be doing something different at 4 billion than they were at 1 billion. There's absolutely no guarantee they'll be good at it. Right. In my experience, meeting a lot of investors, and obviously you've met many, many great investors. My sense is most are highly intelligent, but only a few stand out as truly exceptional. I guess you could say same thing about any industry. Do you agree? And are there any qualities that you feel set those exceptional investors apart from the rest?

21:47I think I agree with that general take, which is this business attracts such talent. I mean, they're extraordinarily smart people in our business. Maybe you used to see them more in hedge funds, and now you see them more in the alternative space. Probably the most exceptional investor, this has come as a bit of a surprise, I suppose, I ever interacted with and got to understand, was actually a planned sponsor. It was a guy called Jay Vivian, who ran IBM's pension fund. And the effect that Jay Vivian had on people's lives, I mean, there are hundreds, tens of thousands of IBM employees who've retired with a much better retirement fund because of what Jay Vivian did, both on the defined benefit plan at IBM, but maybe more to the point on the defined contribution plan where he created the type of structures that way ahead of time that you see today, really early into target date funds, really early into taking the institutional relationships that IBM pension fund had on its defined benefit plan and putting them into those managers into defined contribution plans, changing the lineups, always keeping price really low.

23:01He was an extraordinary man who foresaw so much of what was going to happen in the next decade. I think he was a very cynical guy to get something past him. He was completely inscrutable and uncorruptible. There was no taking Tim to dinners. Just a remarkable, remarkable investor. And no one really talks about him, but I'm a big believer that some of that generation of, there were only a handful of them because most of them just went where the water carried them. But a handful of plan sponsors in that era actually shaped where we are today in the defined contribution space and did it because they were data-driven and they were intensely conscious of where returns were to be had and how you could pay if you had assets like IBM had, you could drive those prices down.

23:53And it sounds like he had immense impact, which also adds to its relevance. He did. That's exactly right. As I say, a lot of baby boomer IBMers retired with significantly more assets in their defined contribution plans as a function of what he did. So if we take a step back and you just look at the asset management industry, what is your sense of the direction that it's headed? And do you anticipate any major inflection points in its trajectory? Well, we're going through a major inflection point. In some ways, we're in a world now that these large multi-asset class alternative businesses that have grown out of either private equity or credit or just footprint is larger and larger.

24:40They represent, I think, a dynamic that became clear a while back, which is that if you have real distribution power, it's rocket fuel in this industry. People, obviously, groups like BlackRock have always understood that. But I think it's this new generation of players in the space, the Apollos and the Blackstones of the world, who've really understood what distribution power can do for you. and obviously what they bring to the table is the skill set they bring a narrative you know which is the alternative investment sort of narrative and they bring a skill set in that world that served them really well i mean that's been a really interesting change you know when these changes happen in the asset management business you bit like going bankrupt they happen really slowly and in really quickly.

25:28And that's happened. I mean, if you go back to the 80s in this business, the asset management business was still dominated by some of these big trust banks, most of which hardly don't exist today, let alone manage huge pools of money. And that happened slowly and then very quickly. Now, we're seeing the same thing happen in the asset management space today. I think it's accompanied by another, let's call it a characteristic rather than an inflection point, but you're also beginning to see a real understanding of the merits of specialization. Because as these monstrous firms grow bigger and bigger, I think the returns are going to speak for themselves.

26:08They're going to normalize. And the sense that you want real performance in particular asset classes, there's this whole new generation of boutiques that have managed to survive the challenges of starting businesses in the last 20 years, whether they're private equity, private credit, or private real estate in particular. And these groups now have a decade or more under their belts. They've all raised more than a billion dollars, the successful ones. They're real businesses. And I think you're going to see real flows into them too. The major inflection point that we're seeing as an industry now is how these relatively new players, they're not new as in they've been managing money for a little time, but they're new as in being essentially able to manage much more money than they used to across a whole set of different classes, are now real players in the industry.

27:01It's interesting when you take a step back and you look at the evolution of the industry, it seems that, generally speaking, you've gone from a period where there was less appreciation of the challenges of picking stocks and trying to outperform an index. And now here you are 15, 20 years later, and you can look back and say many managers didn't beat the index. So there's less value there. So the price that managers can charge has gone down. There's price and pressure there and the boom of ETFs and indexes and so on. And so the smart people are kind of gravitating towards other areas where they can add value.

27:36And so that introduces alternatives. And then you've had the democratization of alternatives and the distribution and building the relationships that you talked about. And so you could see how that evolution is gradually occurring. And I think it's all to the benefit of investors and clients because now there's more investment options available to them. Yeah, I think so too. And I actually think that, you know, that's why if you step back from this industry and try and understand the evolution it's taken, while part of it has been exactly the dynamic you described earlier about this quest for asset gathering, A large part has been to provide a better solution to investors across all types of investment.

28:17And what you're seeing now, I think, is a reflection of exactly that. There are obviously huge exceptions to this rule, but at the end of the day, the ability to deliver cheaply and effectively exposure to public markets, particularly public equity markets, and then through different vehicles to give you exposure to alternatives. That's a really positive development. It really is. Part of that development has already been mirrored in the way of most Americans save, which is in their defined contribution plans. But there's a lot of work to do in that space too, in terms of getting to exactly that place that you've just described, because it's still very much an equity-dominated investment outcome.