Key Decisions
Ask a CIO: Week 5
It’s a big week for Supreme Court decisions, and I’m sure you’re all eagerly awaiting the first presidential debate this evening. I suspect we’ll have plenty to discuss when it comes to politics intersecting with markets later this year. But for today, I’ll keep it brief and let everyone get back to focusing on the major non-investment related happenings.
A Follow-Up Question on People
Although teams are important, the buck stops with the key person. How do you evaluate the key person’s experience and risk management abilities? How do you measure the intangibles (competitiveness, humility, prior training, etc.)?
For now, let’s take your assumption as true, that it’s all about the key person. With an established manager, there’s a lot of information that can be extracted from the manager’s historical data: deal/position level attribution, historical exposures, factor analysis, etc. This is all standard stuff for evaluating experience, skill, and risk and portfolio management ability. In terms of the intangibles, I would argue that the one that matters most (beyond being ethical and high integrity, obviously) is whether the manager is motivated to deliver performance as well into the future as they have in the past.1
For a newer manager, LPs are trying to evaluate how well the individual can transition from investor on an established team to portfolio manager and leader of an independent firm. It’s one thing to produce and execute great individual investment ideas, it’s another to manage a portfolio. If the portfolio manager had similar responsibilities at the prior firm, then there’s an opportunity to reference check and validate. If the individual didn’t, the new firm might be in for some growing pains.
Without as much of a quantitative track record, the qualitative stuff matters far more, but not entirely in the way you might think. Competitiveness, humility, prior training all matter in terms of the ability to generate great investment ideas, which is table stakes. But building a firm that can sustain and produce great returns for years to come – that’s about having the ability to recruit other talented investors, build infrastructure and processes, raise capital, and critically, recreate the network effects that enabled success at the individual’s prior firm.2
But back to your first assumption – it’s all about the key person. Is that actually true?
In my experience, it actually depends a lot on the asset class. For public markets strategies (long-only and hedge funds), it’s not uncommon for firms to revolve around a single key person. As these firms mature, additional key persons are typically added (because LPs care a lot about key person risk, succession planning, and firm continuity). However, the perception of a single key person doesn’t tend to shift, and for any number of reasons, public markets firms appear to have a harder time transitioning through successions.3
In private markets, where LPs are expected to commit capital for 10+ years, it’s more common to see firms launch with at least 2 co-founders.4 And for any number of reasons, of which I suspect this is one, there are far more examples of private markets firms successfully executing succession plans over time. We probably went way further into this question than you bargained for, but there you go!
Tax Considerations
How important is tax loss harvesting?
For a taxable investor, tax loss harvesting has simple, intuitive benefits: sell a position valued below cost, book a loss, and reduce tax liabilities. Fewer dollars paid in taxes means more dollars to invest, compounding over time into higher total returns.
It should go without saying, but tax losses are useful to offset taxable gains. In a vacuum, there is no other purpose. Which is to say that tax loss harvesting is not in itself an end goal – it is a portfolio management tool.
Tax loss harvesting is now often incorporated into passive equity investing and is one of the potential benefits to direct indexing versus buying an equity index fund or ETF. The main consideration here is the tradeoff between maximizing tax losses and minimizing tracking error. In other words, you can trade to minimize taxable gains, but each trade creates the possibility of tracking error.5 It would be counterproductive to produce 2% of tax benefit only to underperform the index by 3%.
You can also think of the tradeoff between tracking error and tax alpha as an optimization exercise where, rather than a risk/return efficient frontier, it’s a loss harvesting frontier. Run the optimizer, vary the tracking error, and look to maximize losses. Of course, the actual experience of any individual investor will be path dependent when considering the timing of portfolio inflows and outflows. And finally, a market with greater dispersion across company performance will allow for more potential loss harvesting for any given level of tracking error.
In summary, tax loss harvesting is a genuinely useful tool, but the quantum of tax alpha produced for any given portfolio is path dependent and market dependent.6
Lessons Learned
What are some of the important lessons you’ve learned as an institutional investor, and how can individuals use that information?
It sounds obvious, but investment decisions are just choices to trade risk for return. It’s asking yourself: do you have an understanding of the various risks you’re taking, and are you being appropriately compensated for those risks? With that in mind, and recognizing that this is almost certainly an incomplete list, here are some of my most important learnings:
Alignment of incentives is key
Markets are unpredictable, and even the most apparently infallible investments can go wrong. As institutional investors, we always want to be sure that we and our investment partners share the same definition of success, especially in difficult moments.
This is probably the most important lesson for individual investors. There are so many suboptimal investment choices available to individuals, and they exist because the sales incentives are strong. In the bluntest terms, parsing alignment of incentives can be as clear as – how do the other parties in this transaction make money versus how do you make money?
Avoid uncompensated risks
Don’t take unnecessary risks that don’t offer excess returns. These risks can take many shapes, such as headline risk, geopolitical risk, currency risk, etc.7
Sometimes it can be hard to identify the hidden risks – the unknown unknowns. For individual investors, a good rule of thumb is the old adage, if it seems too good to be true, it probably is. In this case, if an investment seems too good to be true, it’s likely that the risks are just hidden.
There are no points for complexity
Keep it simple where possible. Certain great investment opportunities exist because they are complex to execute, but an investment that is complex to execute is not necessarily great. I think this lesson applies equally and identically to both institutional and individual investors.8
There’s always another train leaving the station
Institutional investors generally see countless opportunities in every asset class, and it’s very rare that a manager has an entire market or opportunity set to themselves. In my experience, even limited time opportunity investments generally come back around. Removing superficial urgency promotes better, more thoughtful decision making.
For individual investors, the takeaway here is don’t be distracted by FOMO. I can appreciate that the investment opportunities any individual investor sees might be limited. If you see a real estate opportunity, or hear about a private debt investment - how many of those do you see a year? And if you only see a few a year, how do you know if it’s good? Do you feel rushed to do it because you don’t know when you’ll see another? How you answer these questions is up to you, but I think they’re worth asking.
Some of these lessons have been ingrained in me by mentors over the years, and some are hard-earned. Investing over cycles is a humbling experience, and there is a lot outside of any investor’s control. A disciplined investment approach helps manage the risks that are manageable and provides a path forward when the unexpected inevitably occurs.
Thanks to everyone that has joined the newsletter over the past month! I appreciate your interest and as always, I welcome your questions: askacio@ivyinvest.co.
Until next week,
Wendy
This is where institutional investors get into a GP’s business – how much of the fund is comprised of internal capital? How are economics shared across the firm? Is there an outside owner of the business, and what are the terms of that transaction? You get the idea.
A great mentor and I talk often about the value of a seat, and differentiating between the value of the person and the role that person occupies at a particular organization. It’s unclear why, though I have my suspicions, but certain highly regarded firms consistently produce successful spinouts, and certain just as highly regarded firms have only produced duds. At some firms, it would appear that value accrues to the seat; at other firms, it accrues to the person.
We could have a much longer discussion around decision making processes within firms and what leads to optimal investment decision making. For now, I would posit that the prevalence of star investors and single PMs at public markets firms make it difficult to transition away from the star PM.
The single GP risk is often just too high to back in a private market setting. LPs don’t want to be stuck with a portfolio and nobody to manage it in the worst case key person scenario. Even for solo GP VCs, which are not uncommon, firms tend to add additional partners over the years as they institutionalize their investor base.
In the current market environment where market concentration is pronounced, and the S&P 500 is driven by a handful of companies, the risk of tracking error is higher.
Northfield Information Services has produced some great analysis on the reliability of tax alpha, and their research suggests that tax alpha of up to 1% annually is reasonable and achievable.
Yes, we can debate the degree to which some of these risks are compensated or not. Sure, you might say that relevant international markets are discounted to reflect their known geopolitical risks. But as recent events have shown, it can be difficult to quantify the risks, and that difficulty is compounded by the extraordinarily high potential consequences of miscalculation.
It always raises a red flag for me when a manager hypes up the complexity of their strategy. Some strategies, like biotech, are inherently complex and highly technical. A great manager will spend time with investors to get them up to speed (and sometimes, it can take a lot of time and meetings to get up to speed). A less great manager will jargon talk their way through meetings and fail to provide any useful answers to questions, because Dr. John Smith is brilliant, and can’t you see how great our brand-new crossover biotech strategy is?