July 2017 IssueLong scroll reading

Summer Musings

By Edward A. Studzinski

“Change is the law of life. And those who look only to the past or the present, are certain to miss the future.”

      John Fitzgerald Kennedy. Speech, Frankfurt, 25 June 1963.

The first six months of 2017 are gone, and most global markets have surged during that period. So those like me who thought valuations were starting to look extreme at the beginning of the year, once again cried “wolf” too soon. For those six months, Vanguard’s S&P 500 Admiral Fund achieved a total return of 9.3%, with an expense ratio of four basis points. Many actively managed funds, alas, did not perform quite as well for their investors, although their managers continued to do quite well, purchasing apartments in Paris or London, or jetting to their Georgia coastal estates.

Jason Zweig had an interesting column in The Wall Street Journal a week ago, pointing out that over the last twenty years, the number of publicly-traded stocks in the U.S. has been cut in half. This has happened as a result of takeovers, being taken private, etc., etc. My friend Michael Mauboussin, a strategist at Credit Suisse earlier this year highlighted the trend in a report titled “The Incredible Shrinking Universe of Stocks” that also pointed out that it made for a much more competitive environment for active managers. Mauboussin’s point was that active managers had a smaller number of issues to select from if they deviated from the index, notwithstanding that that was where the best opportunities, resulting from inefficiencies, might lie. Let us leave aside the issue that many so-called, or perhaps more aptly, so-marketed, active managers are really closet indexers.

This week, Mr. Zweig, in response to a number of letters from individuals at various asset-gatherers, backed off somewhat from the import of the shrinking number of stocks as pertains to small cap stocks. After all, that is a tiny part of the overall market. The action is all in the large caps and mega-cap securities. I think that raises a different issue. The increase in the shift from active managers to passive managers is resulting in a far larger part of the capitalization of issues being effectively “locked away” from the market unless the index funds start having negative flows. It also explains why valuations continue to rise. More money is chasing a smaller set of outstanding shares. Effectively, the universe of active managers has become the hamsters turning the wheel, having to run ever faster to mirror, let alone catch, the relevant benchmark index.

I had lunch this past week with my friend who is a very senior executive at a large, Chicago-based, financial services firm. Both of us see the demise of the mutual fund as preferred vehicle for investment somewhere out on the horizon (in fairness, one of us sees it on the horizon, and the other just over the horizon). Part of the issue is the impact of fees and fund flows on performance. Both factors in tandem destroy performance and serve to place funds at a competitive disadvantage to index products. One solution is the commingled equity trusts, which have come into vogue for 401(K) and other retirement accounts, slicing out a heavy layer of fees. Another solution is the return of separate account management, which will make use of individually-managed stock portfolios or ETF’s. The graveyard humor here is that many investment counseling firms were already ideally positioned for the new world. Unfortunately, their senior executives got greedy and focused on where the money and profit margins were, which was in the mutual fund business. They pushed out the portfolio managers and counselors with experience and brains, and replaced them with client-servicing personnel. Both of us see the demise of the “star” manager. Indeed, some firms face the problem of insurance firms with commission-driven sales forces in a world of internet purchasing and activity. They would love to go from point A to point C, but don’t know how to get there having sold the mystique of the star. Some cope of course by announcing teams of co-managers to present the image of a collegial decision-making process with sustainability and consistency as there are personnel changes. Sadly that assumes that the brand of yesteryear is the same as the brand today. If you buy a package of a Kraft product today, is it made by Kraft or distributed by Kraft, with the ingredients a function of a manufacturing contract to provide the greatest margins at lowest cost. In the investment world, I am thinking of an energy analyst in New England who retired some years ago, with a lifetime of contacts in the energy industry and a valuation methodology tied to valuing reserves in the ground in relation to the current futures strip. If the replacement does none of those things, merely trying to guestimate earnings based on an estimated production number, the brand is not the same.

Everybody Can’t Be David Swensen

As we have mentioned in the past, David Swensen of Yale University is justifiably famous for his multi-asset approach to running Yale’s endowment, which has allowed it to outperform most college endowments. Other endowments, egged on by their rather expensive consultants (there primarily to provide cover – the consultant made me do it), have tried to emulate that approach, slicing and dicing their investment portfolios into a multiple of asset classes, adding real estate, private equity, and venture capital to the traditional mix of global stocks and bonds.

Here I must point out that Mr. Swensen, having written a book on personal investing for the individual, basically said his approach could not be replicated easily, as he had access to a range of managers at prices others would not be able to obtain. And, although he was writing for individuals I think his advice was meant as well to apply to smaller endowments. He said that individuals (and the smaller endowments) would be better served by investing in a mix of passive, low-cost funds.

In recent years, from my own experience, I had noticed an uptick in the percentage of assets recommended and committed to private equity investments. The recommendations emanated from the consultants as well as the members of private equity and venture capital firms serving on endowment investment committees. They argued that the higher returns available from private equity (versus equities) justified a greater commitment of funds to that area. Let us ignore the multiple apparent conflicts of interest that exist in the scenario I have just presented. What’s the attraction to private equity?

Well, in the last two weeks I have twice had that question answered. Allegedly when private equity funds, which have limited-lives of usually five to seven years, are liquidating, some sixty per cent of the companies invested in are sold to new private equity funds being raised by competitors. Tulip mania? Let’s call this what it is – “greater fool investing.” But why still the attraction to illiquid investments? Answer – they don’t have to be marked to market, so the reported returns appear to be smoother. As we all know, today the enemy is “volatility.” Even though volatility is usually an opportunity for value investors, for rating agencies, donors, trustees – volatility is a curse.

Technology Strikes Again

The May/June 2017 issue of MIT Technology Review has a fascinating article on page 22 entitled, “Goldman Sachs Embraces Automation, Leaving Many Behind.” The article points out that in 2000, Goldman had six hundred equity traders at headquarters, buying and selling stocks for clients. Today there are just two equity traders left. Automated trading programs have taken over the work, with the support of some two hundred computer engineers.

This is another area where what you don’t see, may result in what you don’t get. Technology, especially in trading platforms, is an area that has been ripe for underspending by asset gathering firms. I still remember some ten years ago when the CEO of such a firm told me that automated trading and algorithms would never amount to more than ten per cent of trading volume. That mentality allowed the deferral of hundreds of thousands of dollars on equipment, software, and technically-literate personnel. Of course, having individual traders as opposed to programs allowed for some degree of control. Now, best execution may now actually turn out to be best execution. And compliance may now be subject to automated audit programs to confirm the elimination of “friction” on trading costs.


On a sadder note, we note the closing and liquidation of the Oakseed Opportunity Fund as of 30 June 2017. It points out the difficulty of a fund getting traction without a major start-up marketing effort to garner assets. It is also reflects the difficulty good managers have in overcoming sub-par performance. For in today’s world long-term really isn’t, even when you have what is a differentiated product in terms of security selection and portfolio composition. And most value investors have been forced to become value-oriented investors, whatever that term may mean. I wish my former colleague Greg Jackson, and his partner John Park, well in the future.

UK Governance

This week the financial regulator in the UK announced an effort to eliminate conflicts of interest while restoring investors trust in the UK’s approximately 7 trillion pounds sterling investment market. Fee structures are to be overhauled and made more transparent. Governance standards are to be toughened. Fund boards are to now have two independent directors (in response to those who say trustees here are independent, I say you are joking, when asset managers hand-pick trustees who are thought to be willing to be “flexible” in return for being allowed to set their own compensation). The Financial Competition Authority also turned its guns on the hedge funds and private equity funds for lack of transparency over fees and expenses. Fees received by the managers when investors buy and sell funds are to be curtailed. The FCA has also taken the position that the government should allow it to regulate the investment consultants who determine the allocation of pension and endowment funds in the UK.

It will be interesting to watch the fallout from the above. The rest of Europe is watching, given that similar issues exist in many EU jurisdictions. In this country of course, notwithstanding the effort to derail the implementation of the fiduciary requirement, it has gone into effect. While there will be a review of that rule, I expect, like the banning of restrictions on pre-existing conditions for health insurance as a result of the Affordable Care Act, the fiduciary standard is out of the box for good.

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.