Episode 378: Learning from Market History

25:25And you just start realizing that most of the stuff is noise. The big changes don't happen often. And almost everything you read in the newspaper's noise is going to disappear and be forgotten very soon. And you just don't react to it. Most people are much too reactive to what amounts to noise. We think things are unique when they're not. That's such an important insight. I love that. What lessons from history, I'm asking you to speculate here, do you think that the US financial system is going to have to relearn or is going to end up relearning the hard way? The question is where. We relearn the same lessons constantly.

26:00What's happening in private markets is not unique. Unless there's something I'm missing, it's going to collapse in sort of a unique way, but not as unique as people think. A lot of people are going to get burned. Another thing that'll probably happen is some regulations will get created that are intended to solve the problem. And to some extent they might, but then they're going to cause a new problem. That happens a lot. We constantly relearn lessons. And it's such a tragedy because it's not necessary, but it just seems to be the way we operate. That's the pessimistic. We also have learned a lot.

26:32And that's something that often gets taken for granted. We're not doing complete wildcat banking and we're not missing a central bank. State banks issuing currency that depreciate as you get further from the bank is not happening anymore. So we have learned a lot, but it's kind of like two steps forward, one step back. We kind of are redoing all that stuff with the whole crypto ecosystem. That's like its own version of wildcat banking. That's worrisome. I would not invest in that. Regulations have gotten better. So people were like, well, let's just create a new thing that's not regulated. Well, especially the decentralized banking that has been tried before.

27:06If you look at the state charter banks in the 1800s that were effectively issuing their own currency. I do see similarities between decentralized banking now and the wildcat or free banking era in the early 1800s. So I don't see how that's stable. We already saw some of them blow up and I expect to see more. Got to keep relearning lessons the hard way, I guess. I want to talk more about alternative asset classes, the big alts that we're seeing today, how long have those asset classes been around? Longer than 45 years, but the trend really started 45 years ago in the 1970s. The age of computing was really getting going and the venture capital firms that were funding them that were having trouble raising capital.

27:55And one of the reasons was the trustees at pension funds and insurance companies, they were worried about the Department of Labor's interpretation of the prudent man rule, which essentially prevented them from investing anything that had a high likelihood of major loss. The National Venture Capital Association had a big lobbying effort to change that interpretation. It was successful in 1979. And then you saw a flood of capital going to venture capital and also buyout funds, which there was a unique opportunity for a variety of reasons, which I write about in the book, to do buyouts. And they had the window at their back.

28:32So it really took off in the 1980s. David Swenson joined the Yale University Endowment in 1985. They were early investors in both buyouts and venture capital. They did extremely well. Then in 2000, he wrote Pioneering Portfolio Management, which shared his strategy. It didn't say this, but people interpreted it as, well, oh, if we just allocate to alternatives, we're going to get yield-like returns. So then that really accelerated the flood into things like private equity or buyout funds, venture capital, now private credit, hedge funds. It has just increased a massive amount over the past 25 years.

29:15Now, the latest trend is bringing it to retail investors, even in 401ks, and it's really concerning. So why has so much been allocated to alternatives in recent history? I think the trigger was the people chasing Yale-like returns. But now you have a situation where you have consulting firms that can increase their fees, kind of entrench themselves with organizations by making portfolios more complex. Now, do they do this consciously? Some probably do, but a lot of it's just subconscious. You have staff at major pension funds and endowments and foundations whose entire career is built on running an alternatives portfolio.

29:58This is the danger of it. You have this perception that just allocating to alternatives is going to get you better returns and better diversification. And there's a lot of evidence, by the way, that that's not true. But even if it was true, the more funds you shove into the sector, the less likely is going to be true in the future, the incentives are not aligned with stopping this. It's maybe more skeptical of academia. You see these very complex studies that say how alternatives have increased risk-adjusted returns. They use different time periods and they get into minutiae and miss the big picture.

30:38And the big picture is when you have a massive amount of capital moving to a certain sector, I don't even care what the past returns look like at some point. The future returns are not going to look the same. You have all these studies evaluating minutiae in the past that is no longer applicable. I think that's a danger too. Totally. It's a simple equilibrium effect. If an asset class is that good, then people are going to invest in it up until the point until it's not that good anymore, other than the risk that you're taking. And all of the academic studies, my interpretation of them is that I don't even is they're giving the right message to begin with.

31:13But even if they were, it's not applicable anymore. Super interesting perspective. I tend to agree with you. Related to this, this drives me crazy because I've experienced it firsthand. Can you talk about how modern portfolio theory is abused in the promotion of alternative investments? I gave a talk at CFA Live in March or April. It was basically arguing that private credit, it's just the next one. it's flooded with too much capital and most people are going to be disappointed. I went over a bunch of red flags and one of them was there a standing room only in the room, which in and of itself is a red flag that everyone's looking at the same thing.

31:51But more importantly, so I looked at this company called Horizon Actual Aerial Services, does like an average of long-term assumptions for different asset classes they survey. I don't know what it is, 20 to 40 or something like that, consulting firms and advisory firms. What's interesting is the amount of money going into private credit is accelerating, yet the long-term expectations are also going up while over the past five years, the assumptions for the long-term return, like a 20-year return for private credit, have consistently gone up when the amount of capital is skyrocketing, which you should see the opposite effect.

32:30As the amount of capital goes in, you should see future expectations going down. So the two largest allocators to private credit, I don't know if it still is, but at the time of the speech, it was for the prior six months, were a company called Makita and RVK, where I used to work. Their assumptions consistently went up, especially Makita, over the past five years. Is it that they're doing something unique or is it that they're driving all these allocations simply because they've made a return assumption that is higher than everybody else? That's the way it's abused. These models are very imprecise.

33:07They're useful to visualize the risk return tradeoff, mainly between equity and fixed income. But beyond that, they're not precise. And the danger is that you can literally drive massive amounts of capital just by raising an input well within the margin of error and drive capital into areas that you shouldn't. In general, it is used well beyond its intended purpose. I would also throw in the expected return piece for sure, but then you've also got modeling low correlations with public assets, which just further exacerbates all these issues. It's little more than guesswork marketed as science. What do you think about the quote evergreen funds that many private equity managers are launching?

33:54I always marvel at how when there's a loophole, it's like watching a helicopter shove a huge load of$100 bills over Wall Street and just watching what happens. That is what is happening with these evergreen funds. So in 2009, there's this kind of obscure valuation guideline called ASCA 20 issued by FASB. And at the time, secondary transactions were very uncommon. So if you were an LP in a private equity or venture capital fund, you usually held it until the life was over. Selling those on the secondary market was very rare. There were about 10 billion secondary transactions in 2009. They were traded among different pension plans and foundations and endowments.

34:42It's called a practical expedient for reporting purposes. It was kind of hard if you bought one of these and you bought it 20 % below the latest reported NAV and the NAV keeps coming in different than how you bought it. It was kind of a pain for reporting purposes. So the FASB allowed you, it's called a practical expedient. If you bought an LP interest for 20 % below or any percent below, you could immediately market back up to NAV just to make reporting simple. But the problem with that is you had a one-day gain. But these things were kind of rare, and it didn't really move the needle that much.

35:14Fast forward 15 years, the number of secondary transactions has risen from 10 to about$160 billion last year, and it's expected to go up to$200 billion. But even more concerning is now, which was not true back then, you have these closed end funds that are called evergreen funds that are offering retail investors access to private markets. One of the ways they're making them attractive is they're starting the fund by buying LP interest on the secondary market, immediately marking them up to the NAV, sometimes by 20, 30, 40%, reporting enormous returns, but they're based on markups that assume that the NAV is correct.

35:54The analogy I use is if you saw on Zillow that a house was worth 1.3 million, you bought it for a million, probably because it's worth a million, and then immediately mark it up to 1.3 million and brag to all your friends that you just made 30%. That's essentially what's happening. What makes it a fundamental structural flaw is that the only way to continue generating these returns is to keep buying incrementally larger amounts of secondaries. That kind of formula, eventually you run into problems when the money runs out and the money will run out because you have to keep buying incrementally larger amounts of money.

36:27The question is when, I don't know. But if there's a way for this to end well, I don't see it, period. I just don't see it. I just want to walk through it to make sure it's clear for listeners and you tell me if this is right. So a private equity fund invests in some company and usually private equity funds sell companies within three to five years. Now they've created these evergreen funds that are buying on the secondary market. So a company that's already been purchased by another private equity fund, the evergreen fund is buying it from that private equity fund and they're buying it below the NAV, which in a transaction, you'd usually assume that is the price, but they're assuming that actually isn't the price.

37:03The NAV is the right price. And they're taking that difference between what they paid for it and the NAV they're marking it up to as an immediate return to the fund. And this is all kosher from the perspective of FASB, which is the accounting standards body in the US for GAAP accounting. Correct. Yeah, that's wild. So the big bet is that the NAV, which there's a lot of evidence that these are inflated. Just look at the long queue. Private equity fund exits are really strained right now, at least at the prices that they're marking these assets to with the NAP. So there's a lot of evidence that not only is the discount probably the real value, it might be inflated now because you have so many secondary funds that are bidding on these assets to generate those initial markups to attract more investors.

37:51There's actually an argument that the discount is above what they should be paying. This is just a loophole that's being exploited to the point of, at this point, absurdity. Obviously, this is going to boost the returns of the Evergreen Fund that's buying the secondaries. How big is this effect? If you go and look at these funds, what kind of returns are they showing from these? Oh, it's a huge effect, especially initially. It gets less, which is the challenge. As they get bigger, you have to get bigger and bigger chunks to make a difference. you already took the markup on the stuff that exists.

38:23I'd have to go into actual data, but there are some funds where almost all of the return within the first couple of years is from these secondary interests. When they buy an LP, they invest directly in a fund. It takes a long time to get a return if you get a good one at all. So all of the returns in the first couple of years are coming from secondaries. To make matters worse, and this is where it gets really ugly, A lot of these funds are paying themselves incentive fees on the performance based largely on the one-day gains. There's one case that was profiled by Tim McGlynn and Jason Zweig at the Wall Street Journal, the Hamilton Lane Private Assets Fund.

39:04And I don't know how in the world they convinced their investors to approve this, but somehow they did. They changed the way incentive fees were paid. they used to do it based on when the assets were sold, which makes sense. If you just mark it up based on the nav, I mean, you don't know if that's real or not. It made sense if you realize those gains, then you pay the incentive fees. But they changed the rules so you could pay the incentive fees out just based on the markup. Think about that. Imagine if you got your friends to invest with you, you spend a million dollars on a house that Zillow said was worth 1.3 million last week, You can market up to 1.3 million and then pay yourself an incentive fee for getting a monster return.

39:45That's what's happening. Yeah, that's crazy. So what do you see as the biggest red flags in private markets today? The biggest one is no one believes a bubble is possible. To be clear, I don't know if it's a bubble. To me, it's pretty obvious. The risk return is just so skewed. In crypto, at least there's a lot of skeptics out there. There aren't many skeptics in private markets. That alone is scary. You have the supply chain. you have the media, it's very difficult to convince the media that this is a problem, especially the trade media. When you think about the trade media is funded by a lot of these organizations with advertising.

40:21So there's very little skepticism. When you have very little skepticism with a massive capital inflow, that is very scary. And then just the stuff with the evergreen funds. The funny thing is, it's almost like they have a bank front problem, but they've solve that by pushing all the risk on the investors. So a lot of these funds can gate immediately. They don't have to honor redemptions at all. Even their guidance is if there's more than a 5 % outflow, we can lock the fund and you can't get your money out. There's going to be a run on some of these funds eventually, even if it's not their fault.

40:54There were bank runs back in the 1800s because there's a big line at the grocery store next door. It may not even be their fault. And when that happens, they're just going to gate it and you're stuck there. So it's like they solved the problem of the bank run by putting the risk on the depositors. It probably goes without asking based on everything you just said, but what do you think the outcome is going to be if retail investors, which they've been getting easier and easier access to it, and that's true both in the US and in Canada, what do you think the outcome is if retail starts really taking up private assets?

41:25I think people are going to be very disappointed with the returns and they're going to be stuck in these things longer than they can imagine. I wouldn't touch these things with a 10-foot pole and the fees on them. And I wrote about this actually in the book before I was aware of these things, because I ended the book in March 2023. And this was early days of the Evergreen Funds. And I remember reading about the fees that they charged for investment companies in the 1920s and 1930s. And I was just like, this is ridiculous. They would have a commission load essentially of 7%. The annual fees would be 1%, 1.5%.

42:00There are also some other fees. it amount to like 5 % a year for a lot of these funds. And I was thinking to myself, wow, I can't believe that happened. We'll never see those days again. Well, we have. You look at some of these evergreen funds and with their management fee, with their incentive fee, there's an added cost to have a custody. Then you have the underlying fees of two and 20. I mean, you're talking five or 6%. I don't know how you could possibly argue that they're going to generate enough value over five or 6 % a year to warrant investment. It's mind boggling. It's another case, I would say, of financial innovation benefiting the people creating the financial products more so than the people investing in them.

42:42That's usually the way it works. Yeah. You work at IFA with Mark Hebner, who's been on this podcast in the past. In your capacity there, you work with institutional clients. Yes. Also a lot of high net worth too. Okay. You work with high net worth too. Okay. Good to know. How often are you seeing institutions who have been sold alternatives? That's typical. That's the thing that always amazes me is there's so little skepticism about it. The simple answer is they're just surrounded by consultants, by advisors, by staff, by the trade media, all saying the same thing. it's hard to dissuade them of that.

43:26And the funny thing about it is trustees of institutions, they're very resistant to doing something very different than the norm and the standard. So if you go out on a limb and you get it wrong, there's a lot of reputational risk. The irony of that is if you're going to be like everybody else, then the only sensible way to go is to index everything. If you're going to outperform your peers, you have to be different. You most likely have to be early and you have to be right. If you're doing what everybody else is doing by allocating to heavily to alternatives in the same places, by definition, you're not early, definitely not different, and you're almost certainly wrong.

44:10It's a completely self-defeating strategy. It's not that hard to see if you open yourself up to that possibility. If you're going to be like everybody else. The only sensible thing to do is to index. It's hard to convince people. How's the uptake of index investing been in the institutional world? To be honest with you, it's easier with high net worth. And that's why I do have a sizable high net worth component now. My background is an institutional. I think it's desperately needed. It's just a harder sell and it takes longer too. High net worth can move relatively quickly. Harder sell, really?

44:46With institutions, yeah. Yeah, really. It's a very different mentality. On the smaller end, it's less hard. I highly doubt there'll be any uptake anytime soon with large public pensions that have billions of dollars. That is a really hard sell. On the smaller end, it's not as hard, but high net worth is easier to explain the rationale behind it. The peer effects in large institutions is just so strong because they look at their investment committee down the road who also have alternatives. And like, well, we can't get rid of alternatives if these guys still have them. It's not a sound strategy, but it's hard to convince people.

45:28Let me just tell you the premise first. You can tell me if you agree. I think the uptake of alternatives in general has been much stronger and happened much earlier with institutions, even smaller ones than it has with retail. Do you agree with that observation? I don't know. I don't have as much experience on the retail side, probably because they didn't have the vehicles available, but now they have the evergreen funds, which if I had to pick the worst possible vehicle to sell to a retail investor, that would be it. But probably that. I don't have as much familiarity with the history behind it though.

45:58On the topic of it being difficult to convince institutions, if you're sitting down with an investment committee telling them like, hey, index funds make a lot of sense. This alternative stuff is no good. What's the main pushback? What are the main challenges in talking to that type of group? This is where there's a disadvantage. So there's usually not that much pushback. But I know that there are plenty of academic studies that I would question and consultants or other advisors using their expectations to say, even if that is true, generally, we've solved that problem. And they probably convince them.

46:35You don't necessarily see the process going on. And to be clear, I have almost 100 million or around 100 million in institutional assets. So it's not impossible. It's just I have a lot more high net worth in terms of assets under management. One of the most educational things that I've done in the last few years is joined an investment committee as a volunteer and just seeing how that sausage is made and how decisions are made. And it's absolutely fascinating. A lot of it really is. Peer effects, like this is what everybody else is doing, existing biases, advice from consultants, and it's diverse opinions too.

47:07You can't just convince one person, well, that's what we should do. Even if you do convince one, there might be other people who don't agree. And you mentioned these decisions with institutions taking a very long time. It's a very slow moving process. The greatest risk that investment committees have is the instability of their own governance. They're going to get replaced, let's say on average, every five years. Every time there's turnover, there's risk that they're going to reverse things at an opportune time. And there's a lot of evidence that they do do this. by indexing, you're basically hedging governance instability.

47:40Because if you're constantly hiring active managers and firing active managers and there's turnover, there's a good chance that the new group is going to come in and be like, this manager is underperforming, this manager is underperforming, you're going to fire them at the wrong time. Then you're going to hire a manager that is outperforming and then repeat the cycle every five years. That's actually something that's more of a risk with institutions than it is with individuals. And people don't often see it because they only look at their tenure. They don't see what's coming next. That's a super important point.

48:07Indexing does kind of solve that, but also every time you get turnover, I've seen it where the new investment committee comes in and they don't want to do indexing anymore. I think the ones I've seen that are super successful over long periods of time have a person or a small group of people who are like major advocates and continuously convince everybody this is the right thing to be doing. But without that, it's tough. One thing that does help, if you look at Nevada PERS, they've been almost entirely indexed for 20 years now, the wind is at your back, especially over long periods of time. Short periods of time, there's randomness involved here.

48:40But over long periods of time, now Steve Edmondson, he's outperforming, it depends on the timeframe, but like 90, 95 % of his peers, that's before fees, and he has a huge fee advantage. It's hard to argue to abandon indexing when you have performance like that. Yeah, true. His story is so cool. So 60-40 isn't dead. Yes, but that's assuming everyone has a risk profile. You can have a 70-30, an 80-20, 50-50. You don't have to necessarily have a 60-40. It depends on your risk profile. Minimizing the cost through indexing and the risk of underperforming the market using active management is the more important point.

49:18Our final question for you, Mark, how do you define success in your life? Well, on a professional level, I always look to Alexander Hamilton. He had a great quote that came from August of 1782. It was a bad period of the Revolutionary War. And he was dispatched to New York to report on economic conditions. And he told the Continental Congress exactly how bad things were. and he ended the letter and he could see it online with a statement that I always thought it was my duty to exhibit things as they are, not as they ought to be. I believe that there is a market for truth, not that I know it perfectly, but if I strive to tell it to the best of my ability, I think I'm doing something good that I could feel good about.

50:04So that's what guides me on a professional level. On a personal level, I have my personal values, my family, just staying true to those. Your circumstances change, which there's a risk that that can change your values. And always trying to stay as grounded as possible and not to change those values is something I strive for personally. So those two things. It's a great answer and makes you a great fit for this podcast. Well, thanks. I thought that was a great conversation, Mark. Thanks a lot. Thank you both for having me. I appreciate it. I hope this is helpful to people. Great to see you. Thanks for coming on.

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