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Look at this beauty I found.
The abstract:
CIOs [Chief Investment Officers] and consultant-advisors oversee about $10 trillion of institutional assets in the US. They have underperformed passive management by one to two percentage points a year since the Global Financial Crisis of 2008 (GFC). They rely heavily on expensive alternative investments; and the more they have in alternatives, the worse they do. Large institutions use scores of managers, making them high-cost closet indexers. Inefficiency abounds.
The red color above is mine. Long-time readers of this newsletter know I don't use highlighter much, but I couldn't help myself.
So institutional firms that have large budgets for investment advice as a group did not outperform passive management. The key takeaway is that more money does not lead to a performance edge.
Also, good luck when someday they have to close out those alternative positions and mark them to market in the process. Some of our clients have discovered, as those positions get closed out, that the bids come in lower than recorded on the statements.
In credit to the institutional managers, their arguments are etymological showcases. Words like "alternatives," "color," "tail risk," and everyone's favorite: "synergy."1
What is going on here? All this high-powered talent and they can't outperform? All those years studying through school, getting the B- on the organic chemistry final and pulling the panic ripcord, switching to a finance track from pre-med but ending up at Chase instead of Goldman, eventually realizing that's ok but brushing up on the vocabulary (see above, I'm working on it) to get an in-house institutional position because it's going to be less pressure and also easier on kindergarten drop-off days? But then you become an institutional manager, and you can't beat the plain-vanilla index? What?
The problem they are trying to solve is exceedingly difficult. At its core, you can be correct in your investment thesis, but perhaps not correct enough. There are so many variables swimming around that you have to weigh them all accurately, an impossible task. The human mind likes stories and theses, and it attaches to storylines in securities analyses that sound reasonable. But it is all of the other storylines that you may not have weighed correctly that can overwhelm the choice you made.
There is another difficulty I have noticed over the years. A lot of securities analysts have been doing that job their whole lives. Many of them haven't been in operating businesses. And that's a disadvantage. For example, in high school I worked at CVS as a floor stocker. I would have to go through hundreds of little tubes of lipstick and repack the ones that didn't sell by a certain date. This was eye-opening to me one because I didn't know you could theoretically come up with that many variants of red, and two because I couldn't believe how many problems resulted just from this repack operation.
I could see the cost related to that complexity. When something like Trader Joe's shows up, with their simplified model versus Kroger, I intuitively know all the steps on the floor that no one has to do. In theory you can see this on paper, but sometimes doing the job itself, or experience in an industry, gives you insights that you believe more strongly.
Before signing off, I'll note that I'm not sure that an analyst with industry experience would matter anyway. The markets are so efficient that the benefit in today's world might be instantly competed away, and the passive indexes would still outperform you.
Dan Cunningham
1. I love the term "synergy." In 2001 Smucker's bought Jif Peanut Butter from Proctor & Gamble. The investment bankers were crowing about "the synergy between the peanut butter and the jelly." I thought "this is a job I can always do as a backup if needed."
Leo Tolstoy once wrote that "everyone thinks of changing the world, but no one thinks of changing himself.” I'm not sure that's true, as New Year's resolutions generally fall into the bucket of changing yourself. You have to focus on yourself here, making New Year's resolutions for others just isn't polite!
Resolutions tend to sort into things we are going to add, and things we plan to remove. Both buckets can feel difficult to implement. But in finance One Day In July generally prefers removal.
As a young sprite growing up and interested in art, I would draw large scenes using a form of realism. And I would really try to fill the scene - white space meant I hadn't done something; the art wasn't complete. My works would get busy, ending up like a cross between a Richard Scarry children's book and Bruegel the Elder's The Fight Between Carnival and Lent.
Later, my art teachers told me, begged me, to breathe a bit, and give the subject space. The lack of activity on the page also had meaning. I could remove things, and the art would get better.
Your investing works the same way. A la Tolstoy, the first thing most non-indexers should do is consider changing something. They are often stuck at firms or in investments that are sub-optimal, and they need to reach the activation energy level to make a change. This is why New Year's resolutions are great: they help people get through that hurdle.
But the next step is realizing that the positive change could be a complexity subtraction. Most of the time this is the case for new clients at One Day In July. More complexity and activity do not necessarily equal better returns. Not to throw Bruegel the Elder under the bus1, but complexity results in something that can be difficult to understand. Sometimes you need a little less Carnival and a little more Lent.
This approach works as an investor because finance is a broad and complex field. Your investments react to the economy and the news cycle in myriad ways. By simplifying the problem set to fewer items, we understand them well, and the understanding leads to confidence. We want clients to share that confidence with us, because the benefit shows up in periods of deep fear in markets. If you don't understand what you own, your confidence will crack under stress, and if that happens you will struggle to do well as an investor.
Dan Cunningham
1. Ok, ok. He painted this on boards of an oak tree. Just for that I need to cut him some slack.
At least in the Dutch Tulip Mania, when it all came crashing down, you had a pretty flower. Granted, the bulb was no longer worth the price of a fashionable Amsterdam mansion (including carriage house and garden), but your spring would have been a little more beautiful.
The same cannot be said of the crypto bubble.
As this odd financial behavior plays out, let's review some keys points.
Keep in mind that one of the underlying premises, or fears, driving this bubble is well-founded. The United States government is trying to deal with an increasingly high debt load, and the way it has and likely will try to mitigate that liability is by inflating at least some of it away by debasing the dollar. But there are better ways to protect yourself as an investor (mainly by owning businesses) than resorting to coin-land.
One of the beautiful things about investing is that you do not need to swing at every pitch. This is not baseball. You can let pitches sail right through the strike zone, and there is no harm done. People make money all kinds of ways. In 2024, Bitcoin is up a lot. That's fine, and that's wonderful for Bitcoin holders, assuming their coin wasn't lost or stolen.1 But it does not mean you have to get on board.
So let's step through a few reasons why, when your nephew pontificates on the wonders of crypto at your holiday get-together, you are going to just let it roll.
1. Notice the currency used when everyone quotes coin prices. Do they quote it in Bitcoin? No. Do they quote it in Ethereum? No. They quote it in U.S. dollars, because U.S. dollars are the universal standard that everyone, well most people, trusts. Universality and trust are key elements of a currency. There is so much irony in the fact that they use dollars to quote their coins.
2. Don't be fooled by the tech nature of this bubble. What is happening here is the crypto promoters are acting as if the technology is some useful thing that sheds value onto the coin as an investment. Venture capitalists are actually decreasing their investments in blockchain and crypto, as after 15 years, use cases are just not showing up.2 The VCs had a period of time years ago where they couldn't find the next tech wave, and they blew oxygen onto the crypto fire, but now that they have found useful artificial intelligence, they are moving on. (To be fair, crypto does have some "use" in facilitating illicit transactions.)
3. So if you don't need the fancy veneer of software to market the underlying coin-which-has-almost-no-function, why are we using roughly 2% of the nation's energy to mine these things? If we are going to trade something around that is of fixed quantity (not all cryptocurrency is of fixed quantity), why not just, say, put 10,000 unique glass spheres in a box, start the trade at X value, and say "have at it folks, convince other people to pay you more for your unique glass sphere. The dollar might depreciate but we are not going to inflate away the 10,000 spheres."
I suspect over time a few of these coins will stay around, roughly serving a function similar to gold. The majority likely will fade away to zero. I could be wrong. I don't really care if I'm right or wrong though, because I believe there are better, more understandable opportunities in indexing.
Dan Cunningham
p.s. Get those financial New Year's resolutions ready! Unloading expensive financial products and managers is a great way for you to fight inflation.
1. NBC News 9/10/24: Crypto scams stole $5.6 billion from Americans last year.
2. Galaxy Research 10/15/24: Crypto & Blockchain Venture Capital Q3 2024
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