Episode 386: Is anyone doing dd? with Aravind Sithamparapillai

24:02So that means that when your forecasted return over 24 and 25 is basically the same, but You expect the whole thing by 25 to have flipped over into these new higher rate mortgages. Something is off there. It doesn't quite make sense. So my hand went up. And so I asked the question and I said, I don't, I said, this is the thing. I wasn't trying to catch them in a lie or - I just want to understand. Yeah, I just, I didn't get it. So I put my hand up and I said, I don't understand if the duration is under two years, but you just told me like the mortgages haven't turned over. I don't quite understand how this works or why we're not seeing those increases.

24:39And so what they admitted then on stage was that they had been extending the loan at the same terms. They hadn't been renewing any of the loans to current owners at higher rates. So I pinned them down afterwards, again, out of curiosity to say, I don't like, why would you not? And so what came out was the areas they were lending to, the geography and the buildings that were being purchased had fallen by more than 30 % at that point in time. And so they loan at a loan to value of 70%. So what that means is if a building was a million dollars, they would lend you 700 ,000, you put up 300 ,000 of capital.

25:19The building value falls more than 30%. That building is now worth less than 700 ,000, which means if the owner can't make the payments and they default and you seize that building, you still don't have enough value in the building to sell and get your entire loan back. So here's what gets interesting, Karen, because of that stability of the NAV piece. So what happens is everyone thinks that a default automatically is a triggerable event, so on and so forth. And that's true. But if there is no default, if you extend, so this is the term I learned in the industry, extend and pretend. If you extend the loan at the same rate and don't increase it because if you increase it, you know, this business owner, this person who's already kind of struggling will likely not be able to pay that higher interest rate.

26:11So if you just leave it at the same rate, you know, under the hood that the property has fallen more than 30%, but you just keep making the payments. It's a non-marketable event. Nothing has changed. So you don't have to re-strike the NAV. Now, on the other hand, if you increase the rate and then they default and you seize the building, you have a triggerable event, which then requires you to mark down your nav because the value of the building is not enough to pay back the loan. So by extending and quote unquote pretending, you can pretend that your nav is stable and everything is fine and let things go on as they will.

26:48So that blew my mind. I would say sort of like the first like, oh, wow, what is on stage and what is said is not necessarily always going to be the whole story. Also, to my original point about the formula, I now understand a framework for thinking about real estate and real estate lending, and then term risk and credit risk and how all those pieces come together. So what then happens is that's 23. 2024, almost a year later, a fund shows up at our office. And most of our office knows how I think about things. But in general, sometimes I'll sit in these meetings to kind of take a look or understand.

27:26And so it was a mortgage fund, specifically lending to real estate, lending to real estate owners and operators. And so what was interesting is I'm sitting there and in general, I'm kind of listening, but I'm not going to allocate. So why spend too, too much time? And then the fund salesperson says, oh, and And our loans are all ultra short duration. So that's one of the ways that we keep the fund stable and we keep it safe and we try to make sure. And so I hear that and my mind goes all the way back to the 2023 presentation where someone told me that the loans are ultra short duration. So then I pulled up the marketing literature.

28:05So now we're at 24, right? So now we've had enough time where if I look at the duration and I see the interest rates, in theory, I should see that these rates are climbing over time. The rates were not. And so I asked the question, why are the rates not going up commensurate with these interest rate increases? You know, a couple of people around the table were like, well, maybe they're trying to be conservative in their assessments or whatnot. And I was like, I just want to hear what he has to say. This is my thesis, though. And I said, here's what I saw from another fund. Can you corroborate?

28:31Can you say why the rate is not increased? And the fund salesperson kind of laughed awkwardly and said, you know, it makes a lot of sense when you say it like that. But the answer is, I don't actually know I can get back to you. And he never got back to me. So people around table are like, wow, that's great. This makes a lot of sense. We probably shouldn't do anything with this. And nothing happened to that fund for almost a whole year. And then this year, earlier this year, that fund gated. So you can still be right. Hold on, hold on. You got to tell the listeners what gated means. For anyone who understands mutual funds or ETFs, they're fairly liquid.

29:02In a mutual fund, you sell the fund back to the fund company essentially, and then you receive your cash. And there is a one or two day transaction period, and then you receive your money. In the case of alternatives or what are often called OM or offering memorandum products, where there's a whole bunch of extra legalese, disclaimers, things that they can do that don't sit inside of the typical landscape. One of them is they can arbitrarily decide to essentially lock or prevent you from redeeming your units for your cash. So that sounds nefarious on the surface. I think it's important that everyone remember that alts are often things like you're investing in private debt where you've secured a five-year loan or private real estate.

29:48So now you have a bunch of big buildings that you can't just fire sale. Private equity. If you have a business, a large private business that you now aren't selling for a few years because you're in the middle of a turnaround, in the olden days, you didn't get your money back as a pension fund or something like that. You gave it to them with the knowing that they were going to only give you that money after they sell it in five years. So now with a lot of the public or retail versions available where they say, hey, we offer monthly or quarterly redemptions, they still have provisions where if there are too many redemptions or some issues, they can essentially reserve the right to lock or gate the fund.

30:29And so in this case, that fund specifically then gated. Now, we don't know whether it's gating for good reasons. Maybe there are some things that they're doing that are appropriate or whatnot. But to me, that was a sign of two things. One, kind of dodged a bullet. Again, based on taking one lesson from credit and really a lesson that we learned from the basics of your CSC or the wealth management essentials, and now applying sort of the same factor framework, understanding credit risk, and applying it in the private world, but also that you could be right about something. and then still look wrong for a whole year because nothing happened to that fund.

31:07It's seven-ish, eight-ish percent rate of return still persists, which sounds great for a private debt fund relative to public bonds. So you could be right and then still have everyone think that you're crazy for a very long time before the fund gates or the crows come home to roost. Gates sounds so much nicer than locked, doesn't it? Yeah. Or just arbitrarily not handing you your money back. Okay, so Erivan, I want you to take us kind of give us a front row seat. Ben and I don't get a lot of pitches, if any, in the offices, but I know many firms have kind of a parade of people pitching alts. You can talk about the different ways that they market their funds.

31:47So I think the first and maybe like the most like, hey, there's no data integrity, but it's still a chart crime is you'll see a lot of illiquid alts often pick a start date right before some public equity crisis. So you'll see like a lot of funds and they'll start in like 08 or 07. So then you have equities take a sharp dip and then you have the illiquid alt kind of cruising along at a steady pace. So it looks like it's outperforming over a certain period of time. The data is all correct. They're posting whatever their stated returns are, but they've picked a start date such that you kind of hit the worst.

32:28You start with a 50 % drawdown. So you're basically giving the fund a head start in some sense. And so that doesn't necessarily give you a clear picture of the risk and reward of equities versus an alt. I can talk about a few others, but any questions about that or anything to clarify for the listeners? Nope. Makes sense. What else is there? IRR, I think, is a standard one. So you all have talked about this on the podcast before. After hearing, I think, Ben talk about how early returns and IRRs can skew later performance, I actually went and played with what happens if I had an amazing IRR in the first couple of years from a fund distributing and then sort of playing it down the line and realizing it.

33:07I had to know. It blew my mind. I did the same thing when I read about that, obviously. This is why we get along. But what's crazy is knowing that, and then you see a lot of fund marketing, and they'll sort of advertise since inception IRRs. And so I realized then you start to read some of the fine print related to those IRRs, and you realize a couple of different things are stacking up in those IRRs. First is sometimes they're aggregating IRRs across vintages. So it's not even necessarily the same fund. It's like, hey, you know, based on these three vintages. And so I showed a case study where, or not a case study, like I created like a fake example of you could have three vintages where you had one IRR that was insane, like 30 something percent.

33:49And then they use that as marketing for the next vintage. And even though the vintages subsequently have worse and worse returns, your since inception IRR after three vintages were the last one, I think, delivered an IRR of 5%. Your since inception return was still 16. So you can now take a since inception return going back 10, 15 years of 16 % with the fine print saying, you know, spread across three or four vintages. And now you can market that and say like, look, we have these awesome returns and we know that past performance doesn't necessarily indicate future, but you have to know that under the hood.

34:26And I think Ben has already talked on the podcast about the academic literature around anchoring in the fact that IRRs still kind of create an anchor bias for advisors and investors. So that's IRR. The other one that I find fascinating, but has happened a few times, is using benchmarks of alternative asset classes to say, hey, look, they're equivalent or better than other public market returns without baking in what the actual fees and net of fee return would be. So I saw a large firm put up a private credit benchmark against the S &P 500. And it was just gross returns. It was in a webinar, I couldn't, it was one of those pre recorded webinars.

35:08I was watching it because this large firm is available to the retail public. And so I had a couple of my clients who were active on social media, so on and so forth, and kind of just asked me about this, which is why I watched the webinar. So we have private credit and S &P 500 average returns over the last 15, 20 years of like nine-ish percent without going the extra step and saying, well, you can buy the S &P 500 for single digit basis points. The fund that this company went on to then pitch has a 1.5 % fee and a 15 % performance fee above a hurdle of 5%. For anyone who doesn't know a hurdle, basically to say, hey, the first 5%, we won't take a performance fee on.

35:47But after that 5%, if we outperform, we're going to take 15 % on that. And this is at tail end of 22, beginning of 23, where you could buy T-bills for basically 5%. So again, when you think about the whole idea of credit risk, and we're just going to lend to people who can't borrow already at 5%, you're not really earning performance fees. You're just getting a fee on the additional risk that you're taking to some degree, but none of that is disclosed. So again, to the average person comparing benchmark to benchmark, it kind of looks great. And it looks like you're getting this correlation benefit or non-correlation benefit because some years the S &P 500 is going to do well.

36:27Some years private credit is going to do well. But once you take out those fees, all of a sudden your nine and nine don't look so similar anymore. It's crazy, man. And it's not as easy as like, there's so much data for public funds now that everyone kind of gets it that most funds have underperformed. And you can go and find a really easy to understand report showing that to be true or an academic paper. It's just the information's out there. But for private funds, it's not the same. There's a few papers looking at it. We had Mamdu Medhat from Dimensional on recently. He's got a paper looking at private fund returns.

36:58And he basically shows that if you benchmark against a risk-appropriate public asset, the public market equivalents, like the outperformance relative to that public benchmark, they tend to be really small if they exist at all net of fees. But that information is not out there for everybody to see. So everything you're saying, I agree with it, but I think it's really hard for the average advisor or retail investor to go and find information to say, what are the base rates for this asset class? Should I expect this thing to outperform on average? I mean, I think usually the answer is no, but anyway, we can talk more about that.

37:31Anything else to say on this one? The only thing I would say is it's work to even understand the benchmarks. That's the other piece. Even in understanding that piece and when I wrote, because Ben, I think I had sent this to you because you would ask me for this report because someone else had asked your team for it. And to then say, okay, so this is private credit, but what element of private credit? Because even private credit as an asset class, there's so much happening there. There's maybe people who need a mortgage, but can't get it from the bank. Then there's mezzanine debt, which is like, hey, you don't have asset-backed debt.

38:01You don't have any real estate to secure. So this is going to be even worse from a risk perspective because we can't seize anything. And then what's the actual credit rating of the borrower? So as you look at private credit, there's just so much in that space. So what are you actually benchmarking to? And then you have to look at the firm that's doing the benchmarking because none of this information is so readily easily available that it's proprietary data to some degree. I remember speaking to that benchmarking firm because they were at FutureProof and telling them that I saw their benchmark being used in this webinar.

38:36and it was great that they released it for people like me to read and study. And they're like, yeah, that firm actually never licensed that benchmark from us. So like we have to have like a conversation with them about it. They'd already known about it by this point because, you know, public webinar and everything like that. To that point, it's so difficult to know what you're getting into. And I would say like, it's probably not worth most advisors time unless you're kind of crazy like me and you do it out of curiosity. But to get to the same thing at the end of the day, which is like markets generally work.

39:05Do we really want to incur taxable events or pay higher fees for an uncertain future return? In most cases, most clients don't want that level of detail that I've done. What do you think about the low correlation argument for private assets? A couple of things. Let's start with the assumption that low correlation is a benefit and it does actually exist. Even if it did, you have to manage it somehow. You can't just hold the asset. You can't just hold two different equities and non-correlated private debt in their individual constituents and then just let them grow. Part of the non-correlation benefit comes from rebalancing, selling whatever is done well and is a larger share of your portfolio and then buying into the thing that's relatively lower.

39:46So can you do that with a lot of the restrictions or if a fund happens to be gated or if you're trying to do it on a very quick timing basis when they have maybe a six month, a quarterly or an annual redemption process? So like COVID is a great example. 2022 is a great example. So public markets are down. And we have an opportunity to rebalance, to quote unquote, take advantage of this, you know, non-correlation benefit, which in 2022, I saw so many posts on LinkedIn and online about, oh, you know, this is why you should hold non-correlated assets, so on and so forth. So then the question becomes, cool, were you able to sell?

40:23Could you sell in a timely manner to get the cash to then rebalance back into volatile markets? That incurs two problems. That's the timing. And then there's behavior. Because at the end of the day, you're now making an active decision. and you're telling your clients, hey, we're gonna sell this thing that's done really well to buy into falling markets, which everybody hates. And it's so tough to pull the trigger on. And so you're doing that. And that's at the retail level where it's sort of liquid in, quasi liquid out. And one of the arguments that will then get posed is, yeah, but if you're doing it at an institutional level.

40:55So if you're managing it sort of like on a per deal basis or direct with those larger tickets so you can strip out some of the fees, well, then you're dealing with what are called capital calls. So for anyone who doesn't know what a capital call is, they don't take all your money at once. Like when they say it's a minimum a million or a minimum 10 million to invest in the fund, what they're saying is we're going to do 10 deals at a million dollars each. We're not taking all 10 million from you at once. When we find a good deal, then we're going to get that million from you. So now you have another element of project management around how do I keep this cash?

41:28What do I do with it in the meantime? You know, if they're going to take it over six months or over a year, how do I invest it appropriately? When they call it, where am I pulling it from? So on and so forth. So even if the non-correlation benefit is there, and then you make a commitment to then allocate to some of these funds, how are you managing the timing of your portfolio such that you can actually take advantage of this diversification benefit? And so that's if the non-correlation benefit is there. I would also say, and you talked about this literally on the last podcast episode, around the fact that a lot of it is some type of stale dated pricing, or really once you take out the smoothing of returns, the underlying assets or the underlying industry, sector, geography, whatever the case is, there's a lot more correlation there than you expect.

42:16So before investing in alts, Erevin, how important is it to come up with some sort of expected return? I think it's paramount because you have to understand, like, what is it adding to your portfolio? So if you believe there's a non-correlation benefit, I mean, that's great. But non-correlation at the cost of or at the price of what? Because as an example, we talk about cash and bonds as, you know, somewhat being like a diversifier or a non-correlation benefit to equities. But we also accept that to some degree, we're reducing the long-term expected return and we're pricing that in for projections.

42:50So in order to say that there is a benefit, the benefit to me has to be, well, commensurate with these risks, illiquidity or whatever the case is, I'm getting a better return or maybe similar return, but non-correlation benefit or lower risk or whatever the case is. But again, if you can't actually derive an expected return for this asset class that you're investing in, then you have really no way to actually gauge or assess whether it's adding anything of value to your portfolio, or if it's adding another benefit net of return, what is the cost to your overall expected return of your portfolio?

43:32And from a financial planner perspective, I raised this point at the conference too, because from a financial planning perspective, forward-looking projections and assumptions, like Ben having sat on FB Canada for I don't know how many years now helping them make those, you know, asset class assumption guidelines. We use those because we're trying to do two things. One, we're trying not to under or we're trying not to overestimate returns and then leave clients in a position where they don't have enough money to achieve all of their goals. But in line with finding and funding a good life is, you know, you've talked about many times on the podcast, if you're understating returns.

44:07So if you're using standard FB Canada assumptions, and then you're saying, hey, but I'm going to allocate to these other illiquid asset classes because they're going to provide a higher return or they're going to provide a non-correlation benefit, which then from a rebalancing volatility perspective, you'll have a better long-term return. If you're understating your returns, then are you depriving your clients of the ability to truly spend more during years where it might benefit them? And so that applies to active management that applies to alts, et cetera, if there is a portfolio benefit that meaningfully improves returns, well, then shouldn't that be part of your expected return assumption that you're baking into your financial plans for your clients?

44:47When you've looked at these things in the past, how have you approached estimating the expected returns of them? It's tough. And I will say that you have to think about every asset class individually based on what is the asset, how does it grow, so on and so forth. So the way I kind of broke it down, and I don't know if this is like in a textbook anywhere, but trying to come up with a formula that I could use. You know, what I said is we can start with the gross return of the asset class, because in general, you can either derive it, figure out a discounted cash flow. The fund company might have some models around that.

45:19So start with the gross return of the asset class, add in the impact of leverage. So both scaling up whatever that extra return would be based on, you know, maybe borrowing and buying at a two to one ratio, deduct the cost of interest, and then deduct other fees and performance fees. And then you can add in an adjustment if you feel it's in your skillset for sort of manager efficiency, operations, alpha, whatever the case is. And to me, that way, if we break these pieces out, even if we don't necessarily know like the manager alpha or whatever, like we don't have that longstanding relationship.

45:55And when you figure out these pieces, which everyone can generally kind of agree, helps us paint a picture of the asset class and what we're going to get out of this fund. You know, then we can kind of look at it and say, okay, well, if manager performance doesn't add anything, or potentially detracts or whatever the case is, what are we starting with here that justifies investing in this? So that's kind of the framework that I've now started to approach a lot of these with is how do I just strip it out piece by piece and starting with that gross asset class and then adding in all of these pieces actually helps turn it from this big chaotic mess into something where you can isolate and look at each piece and sort of test out the assumptions a little bit more rigorously.

46:36I can walk through Ben if you want. I have that case study that I shared at IFP of like looking at private real estate as that example based on a fund that I had sort of reviewed at the time. No, I think the way you explain it is good. I think going through numerical examples, probably too much for all of our audio listeners. Touche. But I'm curious, you've looked at some, how did the private fund expected returns, net of fees compared to public markets? I mean, they ended up at roughly the same spot. So one private real estate fund basically borrows at two to one. So for every dollar you put in, they're going to borrow a dollar, take$2 and invest in real estate.

47:14When you net out the expected return of real estate right now, you can use any sort of like public benchmarks or real estate broker firms or whatnot to talk about where you see apartment buildings, et cetera, and scale it up, account for interest, and then account for management fee and performance fees. You kind of end up in that like eight-ish percent range. So now I'm looking at a private real estate fund and saying the The expected return maybe is 8%. You know, you got to be somewhat conservative because we know we're not precise with these assumptions. What don't I know? Because have I studied this enough to really know that every single fee I've accounted for?

47:51Because there are many, and I know there's a question later, there's many different levels of fees that you can incur. And have I got this right? That 8%, which relative to a full equity portfolio right now is six and a half, seven-ish maybe. So all of a sudden, this 1 % premium, but 1 % doesn't really feel like a very big premium for all of the uncertainty. And then the extra illiquidity, the risk of gating, all of those pieces. You know, in my mind, we're basically kind of back to a public equity style public markets portfolio in terms of expected rate of return for the risk, not just in up and down volatility, but all of the other operational pieces that we haven't thought about.

48:30Can you talk about the one example where the private fund had outperformed a public REIT index, but when you looked at the component of the public fund that was actually comparable to the private fund, the performance was similar? Yeah. Someone had posted in a financial planner forum, and one of our mutual friends had tagged me in the forum because he knew that I had actually studied this private REIT specifically. And so it was a Midwestern residential REIT. Specifying Midwestern residential private REIT is important because the person who had asked the question said, hey, they're comparing this private REIT to one of the standard low cost.

49:07It might've been Vanguard. I can't remember for sure, but they had been comparing it to one of the standard low cost REIT ETFs. If we start and we look, well, the REIT ETFs have a variety of geographies and sectors. So we're talking industrial, office, residential, storage, et cetera, et cetera, et cetera, and across the country, whereas this single private REIT is just Midwestern. So we're talking like Alberta, that kind of thing. It's not really fair to take that and then compare it to this broad, diversified behemoth. Now inside of that REIT though, there weren't many, but there was a single public REIT that had similar exposure, mostly Midwestern, all residential.

49:50They had some other geographies too. And so when you actually compare it, so the reason that this planner had brought this question up is in general, that REIT ETF had declined over the last couple of years, whereas this Midwestern REIT had been going up. And so the question was, is it really good? Is there something shady here? What's the question? When you peel it back and you looked at that single Midwestern residential REIT inside the ETF, it had also been positive over that period of time. And so when you compare those two, you realize all of a sudden, oh, REITs as a whole, sure, gone down, but this Midwestern residential area seems to be very geography specific.

50:25It's doing all right. Now, that private REIT, I think it outperformed by a couple percentage points per year. But when you look at that general trend, all of a sudden you're back to, this is actually performing like very much in line with a public equivalent. So now I'd have to get really deep into the granular details of how are they pricing? What do they buy it at? What's the strategy to understand some of the nuances to say, is one actually legitimately better than the other? This has come up for us recently too, where a lot of those private funds are comparable to one REIT inside of a REIT index, like the example that you just gave.

51:01But then it becomes, it's like taking a stock in the S &P 500 that has outperformed the index and being like, oh, well, this is a good company, but it's one company. You're adding a whole bunch of idiosyncratic risk. One individual REIT has a ton of single company risk, just like a stock would, even if it has a bunch of properties underlying it. And it's just hard to look at a diversified benchmark and compare it to a single holding. And you can find ones that have done well for sure, But like you just explained, do you go and pick it apart and figure out, did it do well because it's a well-managed private REIT or because it happens to be in this area, this sector, whatever, that has done well recently?

51:37Exactly. Now, do you want me to dive into the sort of like, this was the context of where I said, hey, if this outperforms, maybe if this outperforms, do we want to actually allocate to it? Because I think it's appropriate time to take this and carry the story further. So, you know, to that point, I kind of look at it as, okay, fine. And looking at a private read like that is to me no different than saying, okay, I'm going to roll up my sleeves and do a DCF and a deep dive on a single company in the S &P 500 or Canadian stock market, whatever the case is, for the purposes of stock picking. You now have to actually know what you're doing to assess this as a single individual business.

52:12In this case, there's a modest outperformance. So let's assume that we want to replace this public version of the Midwestern residential rate with the private version. The question becomes, what percentage are you allocating? If you generally kind of believe in efficient markets or you generally kind of believe that market cap weighting to some degree across industries, et cetera, works, then REITs, specifically Canadian REITs, I think accounts for like 2 % of the world. I think it's like some small percent of Canada. I think REITs in like most portfolios account for like 2 % or 3 % of the world.

52:48Correct. And so Canada has a 30 % weight in the portfolio means that if you want your Canada weighting to be somewhat similar, you're not going 30 % times two or 0.6. But the Midwestern piece, that tiny little sliver, depending on the benchmark you use is as low as like 0.15 % of the portfolio or 0.29, again, depending on the two benchmarks that I reviewed in Canada. So I'm going to go through all this work, maybe have like a 1%, 2 % outperformance relative to the appropriate public version. And I'm going to put a quarter of a percent in my portfolio. And then I'm going to rinse and repeat this over and over and over again across a whole series of privates.

53:31To me, like the juice isn't necessarily worth the squeeze then, at least not at a small individual level. And that's assuming that I got all of this analysis right in the first place, and then accounted for illiquidity, taxation impact, like with CGRM and mutual funds, you're now deciding, hey, like some of the tax benefits that we get from keeping everything sort of all together, I'm choosing to unwind that and make a more expensive process, a bigger, more involved thought process. So the outperformance like really better be worth all of that extra work that we're going to put into allocating to the portfolio.

54:07I would give an inverse perspective on that too. I agree with everything that you just said. But the other way to think about that is that if you're putting enough in your portfolio for it to be worth it, like you're giving a 10 % allocation to this one REIT, you're dramatically over-weighting, in this case, Midwestern Canadian real estate in your portfolio. Why? Exactly. That's the piece. If you say, because I've seen people who've held this and they're talking about having like 5 % allocations. So what exactly is the thesis? Is it Canada? Is it real estate? Residential? Midwestern residential?

54:38Where was your overweight perspective across all of those allocation decisions to get down to the point that you decided that this was what you were going to add 5 % or 10 % to? When you ask that question, most people's faces just kind of look at you like, I have no idea how to answer that question. And all of those subcategories you just went through, each one of those has its own significant amount of idiosyncratic risk. Exactly. On fees, how well do you think people understand the total all-in fees that funds are charging in this space? The reality is I don't know if anyone outside of the fund providers really, truly understands it.

55:12Like I've read them. And sometimes I'm still like, wait, I think I missed one as I go through the list. You know, I would say most advisors, to be honest, I don't think they are. Because if they were, then this whole expected return, net of fee return discussion wouldn't be so groundbreaking. Like even as I presented it at IAFP, I had people coming up to me and saying, that's like an amazing framework. Like the way you thought about that is amazing, which is great. But if you think about the fact that if you knew fees and you knew your expected asset class return, it would be pretty easy to derive an expected return.

55:42So my guess would be the most or not. I might be getting into trouble by saying that, but that would be my initial assumption or my initial hypothesis. It is interesting, though, right? Like you did what to you is the basic level of due diligence to understand the equation of the formula, as you described it earlier. How does this thing work? And then you present that to a group of your peers and everyone's like, wow, this is groundbreaking work. But you're like, isn't everyone doing this? In fairness to IFP, like from a planning perspective, this probably isn't. And even for your firm, right?

56:12I would say like your advisors who are working with clients at sort of the ground level, you have an investment committee. You've got Ben, the CIO, who's reading academic papers left, right and center. So the reality is there has been a bit of a choice to sort of segment out the duties and responsibilities. So it may very well be that the investment committee has a framework or a process for this and it hasn't necessarily made its way all the way down to the planner level. But the point that I would sort of push back on planners is unless you're like explicitly advice only with no sort of referrals to other firms or whatever the case is, you're just kind of there sort of like reviewing, maybe generally talking about asset classes, getting paid a fee and then walking off into the sunset.

56:55Even if you're outsourcing to a third party or you have like a referral arrangement to a firm, you're kind of implicitly endorsing what's happening. And if you're managing an ongoing relationship, you kind of bear that client relationship when things work or when things don't work. If you're creating asset class assumptions, or you're saying, hey, based on a projected rate of X percent, you can or cannot hit your goals, you have to save more, or you can save less. All of that to me means that as planners, even if we're not directly managing the investments, if we're kind of adjacently touching it, then we have a responsibility to understand some of these pieces, which is also why I can't let it go to some degree.

57:35Which should be, and it is, people should be following the regulation. Know your product. You should know your product. There's a difference between what you're doing and I think what often gets done or what would pass as know your product due diligence. So what boxes need to be checked as part of that due diligence process for advisors that do want to use these kinds of products? You know, at a base level, do you understand the asset class and can you derive an expected to return? Do you understand some of the operational mechanics that are going to go into dealing with all of this? That just touches upon its application in the portfolio.

58:08But I had attended a due diligence session at a conference in the US. They had two CIOs of like large multi-billion dollar firms that are almost exclusively private asset firms or allocate very heavily. And they were talking about not just how you have to look at the asset class returns and like sort of the pure financial piece. But when you're making allocation decisions to managers, again, just like investing in a business, there are all of the other operational pieces. So they talked about things like, does the firm have like a good AML process or anti-money laundering? Do they have operational controls?

58:44Do they have cash controls? Do they have directors, E &O insurance? Are they following all of the required rules around reporting on a regular basis? And what kind of tech stack do they have for communicating with their investors, communicating with the constituent funds, so on and so forth? And that made me realize as easy or as service level as it sounds, it made me realize like I've never thought in any of this, my default has been open up a financial statement, read numbers. So I've never really thought about all of the other applications. But that's usually where to some degree, that is where like things blow up.

59:20Cash controls, fraud, et cetera. It all happens there. It doesn't necessarily happen in the financial statements. Additionally, they talked about background checks and this one blew my mind. So these are firms that are, again, multi-billion, they get tons of pitches. And they said that they, for the people that make it to that shortlist, so somewhere between 10 and 30 a year, they'll do a background check on the fund managers. So, you know, hire an investigator, so on and so forth. And they said that pretty consistently, there's something in like one to three fund managers passed, whether it's a bankruptcy, whether it's another fund that blew up, whether it's allegations of even like harassment, sexual assault, things like that.

59:56So their sort of ending point on that was when someone tells you like, oh, like all of our checks have never turned up anything, or they're not necessarily forthcoming about who they're hiring, who they're firing or not hiring and why it's there. You have to look for it. So that was also really eyeopening. I mentioned this earlier, but that all sounds hard. There are some firms that specialize in either creating funds or outsourcing due diligence on alternatives. Do you think that is enough for an advisor or a financial planner to just say, well, no, they did the work. I don't have to understand this.

1:00:29This is a tough one because it's also really arrogant for any of us to say, hey, I refuse to trust the watchers. It is in some sense, I would say arrogant for me to say, well, I'm doing a good enough job saying it's in the too hard pile. And therefore, I'm not going to trust a firm who says this is our specialty. This is our expertise. But I think there's two pieces. Actually, I would say there's three probably right now at this point in where the trend has gone that people should be aware of. The first is that we've seen funds with issues. We've seen private investments blow up at all levels of third party firms.

1:01:04We had FTX, which was owned by pensions, as an example. And the legal structures and all of those pieces, the fact that they were trading and was it working, was it not? It wasn't assessed properly, and we only found that out after the fact. So from the top down, we can see that there are firms who their job is to do that, and they haven't necessarily done that. And the second is in Canada, specifically, the regulation between Canada and US is so different. I think the OMS for a lot of funds that I've seen in Canada, so the offering memorandum, which is the financial statement plus all the legal disclosures.

1:01:36So maybe 60 to 100 pages. But there was one fund that I stumbled across once, and they're cross listed. So you could buy in the US or Canada. And so to save on fees, time, whatever, they basically just added like the Canadian addendum to the US piece. So they could just distribute like one document. And what's crazy is like that it's like 400 pages, because the US version and all of the regulations in the disclosures are like, hey, when we charge a fee, this is how the fee gets paid. If the fund does this, if it goes up, this is how the fee gets stocked. The fund goes down, this is how the fee gets stocked.

1:02:10So that also made me realize that the level of detail and disclosure is so different. So what level are we assessing at? And then third, and finally, I think a lot of firms are inundated. The demand is there, like Cameron, you said in Toronto. So now imagine that you have more and more dollars chasing a hypothetically exclusive asset class. And so if you want to grow, you want to collect those fees, you want to shove those dollars somewhere, you either have to loosen the restrictions on who you're allocating to or the deals you're partaking in, or turn away dollars. And that's a really tough place to be.

1:02:47How much comfort do you think audited financial statements should give investors in these private funds? We've seen the big four. We've seen auditing firms get sued for private funds that have blown up. And that's not to say that, no, you can't trust auditors. But I think you have to take the statements for what they are, like a starting point. You know, not only have they been sued for maybe not catching controls or maybe the reporting hasn't been tight. But for anyone who's looked at sort of the underlying assets of a lot of these illiquid funds, there's like a, in terms of what they call like the fair market value assessments, there's a level criteria, level one, two, three.

1:03:25So a level one is when they say, hey, this is like a publicly traded equity. There's like a current daily value for it. So this would be like when you review Berkshire's investment statements and you see Apple on there or whatever the case is. There's a public price. You can directly link the public price. So you can kind of get a fair value for it. Level two and level three are basically decreasing levels of transparency or further remove links from a true public market proxy. So level two of members serves correctly is, you know, there's recent reportable transactions or something like that.

1:03:59So you can get a rough gauge, kind of like how we would look at real estate. And, you know, if your realtor says, hey, you know this, you have a three bedroom house, a three bedroom house down the street sold for X. So we can roughly ascertain that. And level three is that there are one or more inputs that can't actually be fully directly verified from the accounting firm. So then you're relying on like a discounted cashflow or a valuation assumption or something like that to draw what that value is. So in that respect, you also have to understand that there are assumptions being drawn into the financial statements.

1:04:33And those are all now backwards looking. The question is not just about, can we trust the financial statements? It's what do the financial statements actually tell us in terms of today's price relative to the future? So you then still have to go back to, if I believe what I see in the financial statements, and if the fees line up to what I see being docked, okay, I still have to determine whether this is the right price, whether the expected return is appropriate, so on and so forth. That's all the questions we had. I think that was a great discussion. As we've been talking about, it's a space that's hard to understand.

1:05:02It's hard to look at. And a lot of people just aren't looking at it. But the problem is they aren't looking at it, and they're still allocating it. I think that's the challenge. I do want to be clear about one thing. There are likely, there are probably very good firms doing very good due diligence. And there are likely good alternative funds out there. I know you guys have talked about it, like the fund that's doing well doesn't want your money, the fund that wants your money, you probably should be wary of. But it's like, can you do the work? Can you do the due diligence? Can you look at performance fees?

1:05:32I think the one quick example from a number standpoint is I looked at three hypothetical case studies, where the average return of the 10 deals would be 10 % on a 20 % performance fee. But then I started spacing out the variance or the spread in return. So everybody achieved 10%. A bunch achieved 20, like five achieved 20 and five achieved 10. Five achieved 100 % or whatever the number would be. And then five went to zero. And so what people don't realize is performance fees are one interesting example where they take the fee on the winners, they don't rebate the fee on the losers. And so as you spread that variance out, those big, big winners, you can actually take so much of a fee from those big winners that you end up as the investor net negative because you've lost money here.

1:06:19And then you gave away so much in performance fees. And I know that on the podcast episode you just had, they talked about venture cap being one of those where there's a lot of those where you see this big variance with a lot of the funds actually being net losses. And so to me, that made so much sense when you thinking about, oh, well, venture cap is, you know, one becomes the unicorn that becomes XYZ tech company, the rest go to zero. Oh, great. If the rest go to zero and I get to take a 20 % or 30 % performance fee on that, I can now start to see how investors lose. And so how do you ask those questions?

1:06:50How do you determine how the fees are being paid? I think most people can't. I think some can, but it's really finding the funds and what is your due diligence process for doing it? And I think for most people, that's going to be far too difficult to do properly. Yeah, the performance fee thing. We talked to Zahi Ben David about that when he was on a while ago. He has a paper looking at hedge fund fees for that. And I don't remember the exact numbers, but directionally, it was like it goes from a little bit less than two and 20 as the contractual fee to something like a little less than two and 50 as the actual fee that most people are paying because of what you described, because you don't get credit for losses, but you pay the full performance fee when you have big winners.

1:07:31I think it might have been Cliff Asens. I heard him on a podcast. And he said, there's no investment that has such a great return that it can beat a high enough fee or something like that. Basically, there's a fee high enough that it can turn an amazing investment into a terrible investment. Right. Well, it's like that we also talked to Ludovic Falapu about this, about how basically private equity managers have added a ton of value before fees, but the managers have mopped up all the value for themselves. And there's been very little, if any, left for investors. You know what? I think Ben, you and I were talking about this, right?

1:08:04You got to assume to some degree that you don't necessarily know all the pieces in the equation. And so that's, that's what I come back to is I'm just here on sort of like a mission to ask the questions and try to figure it out. But I would say where I've defaulted to is more and more, the more I study it, the more I'm like, so far, there doesn't seem to be an efficient way to allocate in a transparent method that gives me reassurance that I'm not blowing up my client's money by doing this. And so to that degree, I care. I invest my client's money the way I invest my own. And so if I can't necessarily look that fund and say, I think I'm going to incrementally gain something by adding it to the portfolio, net of all the work fees and risk, it doesn't make sense to me.

1:08:42And to your point earlier, it's worth reiterating. It doesn't mean that there aren't good private funds out there, that there are bots, there are smart people running them. It's just a matter of doing the work to identifying them and having a degree of confidence in what you're allocating to, understanding what you're allocating to, that's the disconnect we're talking about. It doesn't mean that there aren't, there isn't good stuff out there. It's just, can you find it? Is it worth trying to find it? How much of a difference is it actually going to make when you adjust for the risk that you're taking, all that kind of stuff?

1:09:08I would add one piece too, and this comes back to Cameron's point at the beginning, as planning focused people, what you have to ask is the papers that you've done on dynamic corporate compensation, that to some degree has been groundbreaking in terms of giving a framework for thinking about corporate compensation. So for everyone who says, oh, we're awesome at due diligence, allocating to alts, doing all that stuff. And don't worry, we got the planning on lock too. Well, if that was the case, then they would have produced a paper on dynamic corporate compensation. Or as we're talking about with MoneyScope, studying pensions and studying who?

1:09:40So as much as I want to say like, yeah, everybody can do everything. Like I see it in practice. So as the client or as the end investor, what matters to you? Potential? Theoretical? Half a percent or one percent outperformance? And what is it coming at the cost of? Taxes? Planning? Man, it comes back to something we've said so many times in the podcast. You've got to focus on the things that you can control. Adding value through optimal corporate compensation, or we've been doing some work recently with corporations on asset location. And those are things that like they'll much more reliably add value than picking the best private fund.

1:10:17But for so many practices, financial planning is a throwaway, right? True. It's a cost center either to generate sales or to close business in so many cases. Sell insurance policies. But we talk about this, Cameron. We do planning so hard, for lack of a better way to describe it, that it's probably detrimental to us as a business. We could be a much more profitable business if we didn't plan so hard. But like Erevan said earlier, we can't help ourselves. But it's the right thing to do, right? People are relying on you and the stuff matters. 100%. And in so many places that in the industry, you talk to the different people and there's no planners on the team or it goes into central planning.

1:10:55Some person at some desk that just goes into a pipe and kind of comes out the other side. That's not a real plan. You don't really know the person. Or you're just getting a financial planning projection and that's the end of the so-called planning. I think a lot of financial planning, you could kind of double up retirement projection in place of financial plan, because a lot of what I do see is that. I'm not saying that's necessarily a bad thing, if that's what you as the client or you as the investor want. But most of the time, they're showing up and saying, tell me I can spend X in retirement, or tell me I'm going to have this amount of money when I retire.

1:11:27And that's super important. But then once you start talking about inflation, taxation, the types of clients that we all work with who aren't just focused on, will I have enough to retire? But how do I set my kids or my grandkids up? Or if I have a business, if I have a corporation, am I managing this corporation properly? Or am I paying far too much in taxes? That is far more all-encompassing when you start thinking about the legal implications, the tax implications. So to Cameron's point, sending it away to a central place to input some numbers and some projections doesn't necessarily help hit on all of those other personal emotional goals they may have.

1:12:06I think the industry is changing. I think people are waking up to it. But to that point, those people that are starting to realize what they want are so far removed from where we are today that finding out how to bridge that gap is something that I still remain obsessed with. Getting the end client to know this is what is right, as opposed to the shiny thing that promises a 20 % IRR, even though that means nothing, that is hard to communicate. It's really interesting to think about the point that you're making, I think, which is that really good planning is hard. It's objectively hard. Due diligence on alternative investments is objectively hard.

1:12:37But the place where we can much more reliably add value is the really good planning. And if you have limited resources and limited time, you probably can't do both really well. So where should we focus our time? And that's basically why we end up where we are. Kitsis said recently, or not recently, he was at this conference in the summer I went to, and he was speaking to NextGen advisors. And one of the questions was like, how do I find the right firm? So on and so forth. How do I find a fit if I care about planning? And you said something that I think is really interesting that really hits home on what we're wrapping to here, which is, is like, I kind of see a bifurcation in the market.

1:13:09Eventually you'll have a small sleeve of firms who are, they'll come up with like a niche idea for investing or some very specific investment solution, you know, pursuing our performance, so on and so forth. And then you'll have sort of the broad majority in some type of vanilla index or index like diversified, et cetera. And they're going to focus on really good planning and however they can execute or add value or differentiation there. Now, he was saying that as advice for next-gen advisors, like think about where you want to end up. If you care about planning, then you should be asking questions that help you ascertain both sides of what they're doing there to figure out where they're allocating those resources.

1:13:48Because if you're at a firm that is spending a lot of time on the investment side, they're probably not spending a lot of time on the planning side from interviewing back as opposed to just blindly finding a job. That was his advice. But it also made me realize, and Cameron, I know you've been talking about this for the last year or two, like the landscape is changing, being at the forefront of planning, explaining that markets work. As people wake up to that, being at the forefront of that curve, I think is a really cool place to be as people wake up to what they're not getting. All right, man.

1:14:17This has been a great discussion. We appreciate you coming on. It's great to hang out and chat. It's an honor. Thank you. Great to see you, Ervin.

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