The transcript from this week’s, MiB: Andrew Beer, Dynamic Beta investments, is below.
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VOICEOVER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
RITHOLTZ: This week on the podcast, I have a special guest. His name is Andrew Beer, has really a fascinating background and career in finance. He is a managing member at Dynamic Beta Investments which is one of the oldest firms doing liquid alternatives, really quite fascinating. Their goal is to roll out things that look like hedge funds but with full transparency, liquidity, and none of the high fees.
It’s really a fascinating space, sort of bringing the philosophy of Jack Bogle to the hedge fund space.
If you’re at all interested in liquid alts or manage futures or want to learn how these things work, I think you’ll find this to be a fascinating and wonky conversation. So with no further ado, my conversation with Dynamic Beta’s Andrew Beer.
VOICEOVER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
RITHOLTZ: My special guest this week is Andrew Beer, he is a managing member at Dynamic Beta Investments, one of the older farms in the liquid alt space. Their goal is to deliver hedge fund like returns but with reasonable fees and daily liquidity.
Their long short hedge fund ETF was up 25 percent for the year in 2020 while their managed futures fund was flat. Andrew Beer, welcome to Bloomberg.
ANDREW BEER, MANAGING MEMBER, DYNAMIC BETA INVESTMENTS: Thank you, Barry. It’s a pleasure to be on the call today.
RITHOLTZ: So let’s start with your background, how did you find your way to the investment management industry?
BEER: So I — it wasn’t clear I guess, I started as an M&A banker in the early 1990s and back then, if you were an energetic young M&A banker, you wanted to go into the LBO business, that is where all the kind of fame and glory was.
And so I went back to business school, and my second year of business school I got a job at one of the LBO firms, a very well-respected firm in Boston run by a guy named Tom Lee. And in my – so I was kind of in my second year of business school and thinking about where I was going to go in that industry and I heard about the secretive investment firm Baupost, that have been started by some Harvard Business School professors and was hiring.
So I applied and I don’t think I knew what a hedge fund was, but I really like the idea of focusing on these weird niche investment opportunities. So instead of going into the LBO business or possibly doing a Ph.D, I became a hedge fund guy and you know, 26 years later, I’m stuck in that role.
RITHOLTZ: So let’s stay with Baupost for a minute. It’s run by Seth Klarman, a legendary investor, his book “Margin of Safety” was published years ago, and anyone who had a print, copies go for some crazy $2000 a copy on Amazon, what was it like working with a legend like Seth Klarman?
BEER: So it was, I mean Seth is extraordinary, I mean he is absolutely brilliant and I think the interesting thing about Seth which is all that stuff was a value investor probably from the day that he was born. It wasn’t something that — it wasn’t a study that he read about, it wasn’t for an academic paper that resonated with him. He just thought of things in terms of value.
And – but I think it’s really important to note that this was in the early stages of the industry, the hedge fund industry was really a cottage industry back then, just to put it in perspective, Baupost had 2 percent of the assets then that I has today and it was still considered one of the ten largest hedge funds.
RITHOLTZ: That is amazing.
BEER: So what you can do what 600 million versus 1.8 million is very, very different and then a lot of these markets that people invest in today were also in their infancy. So it really was, it was an extraordinary learning experience and I think there are probably three big things that I learned from Seth, and I think the first was you should try to get the area right. In other words, it is much better to find a dirt cheap area and spend your time — than spend your time trying to find the best idea than an expensive one.
And then I think the second is that things should be cheap for a reason and there is a certain humility in that, I think Seth never thought that he could look out some big large-cap stock that everybody else is looking at and think he had a meaningful advantage.
But if you could see banks unloading real estate assets or because they had a certain regulatory requirement where they had to get rid of them, well, that gave you a reason why something might be selling at a discount.
And I think the third point is that risk isn’t statistic. That there are a lot of qualitative and other judgments that go into thinking about the riskiness of an asset. So the whole idea of margin of safety is really embedded in those kind of complex multidimensional thinking.
And in part, it was that – I think in more recent years as I have thought about those years, I think it’s one of the reasons that concluded that the value — the value factor per se was really missing something, but that’s part of a much larger discussion, I think.
RITHOLTZ: Well, we’re definitely going to get to the value factor a little later.
You know, your comment about Baupost having 2 percent of the assets in the hedge fund space reminds me of a comment that Jim Chanos famously made. He said 30 years ago when he was launching his funds, there were 100 hedge funds they all created alpha, today there is over 10,000 hedge funds but it seems like it’s still those 100 hedge funds that are creating alpha. Is that an overstatement or is there some truth to that?
BEER: So I think the hardest thing about hedge funds, is we are always looking at who is doing well today and people have a natural bias to assume that is going to continue. And so if you go back in time, it’s a little bit like the mutual fund industry. I remember back when I was at Baupost, I was talking to a guy at Fidelity, and he said, you know, we start 12 new mutual funds every year, and we kill six of them by June, and by the end of the year, we got three great performers.
BEER: The hedge fund industry isn’t quite like that but when you do look at hedge fund today, people tend to focus on those hundreds that have done well. What was interesting about 2020 was that as much as you read press about guys having historically good years, there are plenty of guys who had middling years and plenty of guys who had awful years.
And so the hedge fund industry as a whole, I think had a difficult 2010, but not nearly as bad as it was portrayed in the press.
RITHOLTZ: So let’s talk about that because the reputation especially since the great financial crisis was the performance has been lacking, that the joke is come for the high fees, stay for the underperformance, do you think that’s too harsh or is that fair for certainly the bottom half of the hedge fund community if not more?
BEER: So here is an interesting statistic that if you could pick the top quartile of hedge fund in advance, you’d be up 30 percent a year with no down years. No one would care about fees, right?
BEER: It’s a little bit is a little bit like saying the hedge fund industry – even probably more so than the mutual fund industry today is replete with this idea about we’re going to find the guy who is going to go up. In reality, people find the guy who went up.
And so – but that issue aside, the disappointment about hedge funds in the 2010s comes from three areas. The first at 2008 was quite bad. And it wasn’t just that hedge funds went down more than expected but that Madoff blew up large parts of the business and there was widespread suspension of capital for investors who wanted to get out.
So this was about as bad as it could have been from a PR perspective for hedge funds.
And it was also in stark contrast to the previous bear market where hedge funds are actually made money during the bear market, something quite extraordinary.
But the second issue in the 2010s, is that the easy thing did better, in the 2010s, sorry in the 2000s, we have essentially a lost decade for US equities, you know, the S&P was down over the decade, NASDAQ was down something like 40 percent.
And in the 2010s, just by owning large-cap U.S. and tech, I mean that pretty much destroyed everything else. And then the last is that fees are too high and this is something I’ve written a lot about but basically, when somebody is earning three percent or four percent and they are taking half of every dollar that they make all, people get more frustrated with that over time.
And so it’s sort of a combination of factors and there are a lot of psychological reasons why but I think actually the most interesting thing is that the 2020s look a lot better.
RITHOLTZ: That discussion of fees kind of leads me to a different place which is there have been some fairly innovative new concepts in fees not just fee compression, but things like pivot fees where there is a participation to the upside only if the fund is beating its benchmark and there’s even a giveback if the fund is underperforming its benchmark.
What do you think that looks like in the future? Are we going to see some innovation around traditionally higher hedge fund fees?
BEER: So, I think it’s going to be mixed.
I think a lot of the industry, you know, one of the reasons — there are a couple of reasons that hedge fund fees have remained so high. The stark reality is that most people who allocate to hedge funds, it’s not their money so they really don’t care at the end of the day.
BEER: So they are investing in a hedge fund because, I mean if you read the Financial Times or Bloomberg has some very good articles recently on hedge funds that have gone up 100 percent, people will be lining up at the door and completely indifferent to fees.
BEER: Because it is much easier for people to say, you know, I don’t care about fees as long as my net returns are high.
The problem is when you’ve got 20 guys and you’re paying away six out of every $10 that they make in fees and you look back over three or five years, and hedge funds have — the hedge fund managers have made billions of dollars and clients really haven’t.
And there was one article recently that a firm called Brevan Howard which is by all accounts run by Alan Howard who is one of the greats of the hedge fund industry, and those articles are talking about the fact that his funds had a historically good year in 2020.
What they don’t mention is that when he had $30 billion in assets, they went through a five-year period of time whereby my estimate management made $2 billion to $3 billion while clients lost money.
BEER: So fees are a real perpetual issue, in terms of fulcrum fees and things like that, I doubt most hedge funds will do it, I think you’ll have a bifurcation of products where some will be expensive and some will be worth it, a lot won’t be worth it, and then you have a suite of lower-cost options for allocators to pick from.
RITHOLTZ: Quite fascinating. So let’s talk about this area, it’s quite fascinating. When did liquid alternatives begin to take off, what does the pace look like today?
BEER: So it’s a great question and I think a backdrop of liquid alts, you know, why do people care about liquid alts in the first place? It basically comes down to two things. The first is that the whole wealth management industry has evolved towards trying to push clients into model portfolios.
And model portfolios by definition have diversification between stocks, bonds, and hopefully other things. And so, you know, when you’re building a model portfolio and you could include a lot of different asset classes, in general, your risk goes down and get a smoother return profile if you add in things that have diversification benefits.
And the analog for this or the precedent for this is in the institutional space where a corporate pension plan four years ago may have had one or two asset classes in it and today it might have 30 or 40.
So what liquid alts are really designed to do or to bring hedge fund like strategies that have proven diversification benefits but make them available to investors who can’t be behind minimums, don’t have the ability — aren’t accredited investors, can’t bear the illiquidity of investing in these products.
The real — the liquid alts market really took off in my mind, around 2012 and that was when Fidelity gave money to a hedge fund firm called the Arden (ph) to create a multi-manager mutual fund. And a lot of people thought this was going to be the resurgence of the funded hedge fund industry which have gotten battered during the great financial crisis and it launched this whole wave of alternative multimanager funds that were designed to give you index plus like exposure to the hedge fund space. So that have, you know, a couple of equity long-short guys, a couple of credit guys, a couple of macro guys, et cetera.
And what it really did is it turned the attention of asset managers to this area when they looked across the world and they said look at all these target date funds out there. You know, look at all these ETF based model portfolios? These things are in our minds, under diversified because they don’t have exposure to the same type of strategies that a big pension plan might have.
And so it really kicked off this arms race among fund management companies and there were 40 or 50 respond that were launched within the next couple of years and they were and then since then, there has really been this wave of — wave after wave of new products that have been launched.
And so now there are hundreds of products out there but you know, one of the things we have written about is that we think actually 80 percent to 90 percent of the products are shouldn’t be — shouldn’t have investors, something like 80 percent or 90 percent of the products should be shut down because they don’t do what they were originally designed to do.
RITHOLTZ: So let’s talk a little bit about both of those things what are these products designed to do? Is it simply we are going to capture a premia that your stocks and bonds aren’t and give you daily liquidity, is that the concept behind hedge fund replication ETFs?
BEER: So hedge fund replication, so I think one change that people generally don’t think of hedge funds as a single mass of strategies. And just to go back to the definition of hedge funds, I mean, hedge funds, there are dozens and dozens of different kinds of sub strategies of hedge funds.
The common theme in hedge funds which, I think is very important but can be lost in some of this is that in general, hedge funds are a lot more flexible than mutual funds or ETFs or their equivalent.
So a guy who was a you are invested primarily in tech stocks at the end 2019 might be heavily invested in emerging market stocks today and he doesn’t have the allocators, you know, wondering why he burst out of his strategy bucket.
RITHOLTZ: No style box.
BEER: And the other thing about hedge funds — no style boxes, I mean the institutions have tried to put style boxes on it but which has actually been negative for the industry but it’s nothing like what you see in the mutual fund space.
And the other is that these guys generally have their own money on the line so I don’t know of many mutual funds where you’ve got the mutual fund manager has $1 billion of his own capital sitting alongside you. And that enforces a particular intellectual honesty in it that if they think — if they’ve just made a killing on you know, having owned Apple and Amazon over the past five years and they are taking profits, it doesn’t mean that they have to turn around and go into Moderna or Tesla, because I think those stocks are overpriced.
They can go to different areas and find cheaper opportunities.
And so, you know, I think when people are looking at these strategies and thinking about it from a portfolio perspective on the wealth management space, you start with the idea that there are specific strategies. Equity long-short, managed futures, certain other strategies that could be building blocks in a portfolio.
And you can look at the very, very long-term returns of these strategies, put them into your asset allocation model and make a determination as to how much diversification benefit that they provide and where they should be in your portfolios.
And so I think when the liquid alternative space, they’re moving away from some of these broad strategies that cover the whole universe to strategy specific building blocks and that’s where we’ve really focused our time.
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RITHOLTZ: So who were the owners of these liquid alts? Who were the allocators? Is it foundations, institutional investors, RIAs, who are the buyers of these?
BEER: It’s a good question. I have to say, I don’t know granular data, I suspect most of it is RIAs and wealth management firms, that institutions who particularly those who don’t have liquidity constraints tend to like actual hedge funds more than they like liquid alternatives. I would say five years ago, I saw some consulting firms building liquid alts efforts and that seems to have somewhat died out.
I guess there are two big problems of liquid alts, the first is that a lot of hedge fund strategies when you take a guy who’s been earning eight percent per annum in his hedge fund and you ask him to do the same thing in a mutual fund, you often end up with three, four, or five. So you lose a lot of performance on the top just based on the constraints and that was the problem with Fidelity original investments and this is something I think we were one of the few people who realized it pretty early on is that they were losing 400 to 500 basis points of appreciate returns just by asking these guys to do what they were doing within a mutual fund constraint.
So broadly across the industry, liquid alts and Wilshire has the data on this but broadly across the industry, Wilshire, liquid alts have underperformed by 200 basis points and that doesn’t mean hedge funds were doing 10 and these guys were doing eight and these hedge funds were doing five and these guys were doing three.
And the other issue is single manager risk, and 90 percent of the products are simply single manager funds that have been ported into a mutual fund. And the problem with that from a diversification perspective is that hedge fund strategies, like equity long short as a strategy can provide or managers as a strategy can provide valuable diversification benefits, but XYZ manager within that space generally does not.
And the analog that we use is that if you if you like many people today are saying US market has gotten very expensive relative to say emerging markets, we want to move to emerging we want to add exposure to emerging markets, you don’t pick a stock in emerging markets and call it a day, but that whole idea of saying we like equity long short and we’re going to give it to Bob is a terrible, terrible idea, because Bob like every other guy in this space no matter what kind of tier he has been on, he is going to blow up on you in the next couple of years.
RITHOLTZ: Mean reversion is a cruel mistress to say the least.
You mentioned managed futures as a form of liquid alt, I have to confess I have never seen the attraction to this, it feels like the and I tend to think of this as the commodity traders even though that’s not fair, the rockstar commodity traders tend to trade their own portfolios and everybody else tries to raise outside capital.
Convince me I’m completely wrong about that.
BEER: Sure, so you are not — I would say you’re not at all completely wrong. The — there are two great benefits of managed futures in the context of a larger portfolio.
And let’s take a step back and talk about what managed futures is. All right?
So managed futures, it is called futures because these guys go long and short futures contracts and it’s managed because they’re not doing it in a passive way.
So really what it means if you walk onto, you know, walk into the office of a managed futures hedge fund, you got a bunch of guys with computers who are trying to identify in general, trying to identify trends and momentum among different markets.
So if gold has been going up, is it likely to continue going up?
If 10 year treasury yields have been rising should they be shorting on the 10 year treasury?
And then you know, in the art and the science of it is figuring out which markets do you want to be long and short, when do you rebalance, et cetera? So that’s where you get into the whole managed side of it.
Historically managed futures have had two very, very powerful benefits relative to — for a diversified portfolio particularly in stocks and bonds.
The first is they tend to have zero correlation to both overtime and although I will tell you that because they are long and short different things at different times, the correlations will go up and down overtime. So it’s not something like you’re buying, I don’t know like a private debt instrument that you don’t mark to market, it does go up and down.
And the second is that they tended to do very well in the worst equity markets, so they were up 15 percent to 20 percent in 2000, and then continue to do well in — during that bear market and then they were up you know, to 15 percent to 20 percent in 2008 and then did well in 2014.
So the — and that’s great, right? Because even if have a small 2 percent allocation to manage futures and you are standing with a client in the beginning of 2009 and you have this small beacon of green in the sea of red, you look like a hero.
The two issues with managed futures. Which are very, very real is that first, managed futures fees and expenses are still ridiculously high. And by that, I mean even in a big hedge fund product but the time a dollar gets back to clients, it’s been after something like 500 basis points in fees and expenses.
RITHOLTZ: Wow, that’s a lot.
BEER: And in the 1980s and the early 1990s, when these strategies were completely esoteric and nobody knew how to do these things, this was one of the most expensive areas in the hedge fund space. I mean Bloomberg had an article that showed that one fund was charging about 10 percent per annum so fees have come down a lot but not nearly as much as they should have.
And so as returns have come down, as markets have become more efficient, it means they basically but for the past five years every dollar that these guys have made has gone to them and their counterparties and not to clients.
And then the second is single manager risk, right? So now you have an area that’s attractive, but that on average has been earning zero and you want to add to its space because you believe in the long-term diversification benefits, what do you do, you find the one guy who killed it over the past two years.
BEER: And the problem with managed futures, is the second problem is what we call single manager risk, when a guy outperforms everybody else by 10 or 15 percent a year for two or three years, it’s luck, not skill, if they happen to be overweight treasuries in March and they happen to be long gold at the time the gold took off. And so what happens again and again in this space is that people say I want managed futures, I give it to this guy, and then he blows up on me.
And you know the poster child for this is AQR which did something phenomenally positive for the managed futures mutual fund space in 2010 when they launched already at that point a remarkably low cost product of 121 basis points, but they went through a good period and they became the default allocation in everybody’s portfolio.
So you have guys who would have a diversified portfolio then 5 percent with AQR for their managed futures sleeve, and that fund went to 14.6 billion in assets and then like every managed futures fund that’s been on a hot streak, it underperformed by 20 percent over the next year or two and now it’s lost 90 percent of its assets. So our approach to it was really we’ve got to solve, if we want the two first benefits, you’ve got to solve those two issues.
And the best way that we found to solve it is you replicate, so you basically an imitation is the greatest form of flattery, you replicate 20 of the largest managed futures hedge funds but you replicate what they’re doing before fees.
So if they are long gold by 15 percent, we will go long gold by 15 percent and but we don’t have hundred and 200 basis points of trading costs, we don’t have 300 basis points in fees, so we get you back to what the strategies can do before fees end and then pass those diversification benefits back to clients.
RITHOLTZ: Last question on this space, when you reference these sort of esoteric areas, the academics would have us believe they are really outperforming, part of it as you mentioned was luck, part of it is just inefficiencies in these lesser thinner markets, lesser traded thinner markets that when everybody eventually piles into, those inefficiencies eventually get arbitraged away. But what are your thoughts on some of the academic criticisms of this?
BEER: So I think that there is a huge problem with academic finance in general, the first problem that most academics finance guys are also practitioners, so this whole notion that academic finances some objective assessment of these markets is often clouded by the fact that these guys have another paper where they are trying to sell you something.
But this notion that markets get more efficient over time is absolutely true. And I think, you know, my criticism of the value factor is that you know what pharma (ph) identified in 1962 to 1990 was that these cheap beaten up stocks were cheap and they were built to stay that way.
Think about what it was like for Warren Buffett in the 1960s to find a stock like Berkshire Hathaway, he had to pick up the phone, probably a rotary phone at that point, call information wherever this company was located, have them mail annual reports to him, he gets them two months later, he is calculating by hand the market cap, you know, he may – I mean just the level of information of just trying to get information on these companies was incredibly difficult and there was no glory in that. You know, this wasn’t an M&A banker being you know kind of showing up on the cover of Forbes. These guys were toiling in basements, in his case, in an attic.
And so, now, today, you can pull up carefully curated financial information on every publicly traded stock, you can screen them, you can run analytics on it, it is — the world has changed and the world has become more efficient and there are – you know, I think one of the things that I’ve been asked to do is write a book on this and just to use examples of the kind of things that people are doing 30 years ago that if you could go back 30 years ago, you would say buy everything. It’s like forget about whether you’re paying 80 cents and Theralon (ph) you know is paying 78 and some other guy in Soros is know is willing to pay 82, just buy everything because the world has become much more difficult for active managers.
RITHOLTZ: Venture capitalist Mark Andreasen said something very similar, go back and look at that all the original investments they made in these pre-public companies, wouldn’t have mattered if they paid twice as much for Facebook, although admittedly there’s a touch of a survivorship bias in that.
Let’s talk a little bit about the approach dynamic beta takes. What is unique about it? How do you guys go about replicating all of those single manager firms?
So what we do is think of hedge fund replication and replication is a terrible term because it — I think a lot of people here they think of mediocrity but let me frame it in a slightly different way.
If the only way that you today could invest in the 500 stocks in the S&P was by investing with active managers who charge 300 basis points and someone came along and said we can directly access 400 to 500 of those stocks and we will charge you 100 basis points for it, it would be a pretty clear decision that the latter is not only likely to give you the benefits of investing in the S&P 500, but is probably going to do lot better than those active managers.
And so what hedge fund replication basically is it is using models to try to understand how hedge funds are positioned today across equities, rates, currencies, commodities and then copy their asset allocation in a low-cost form.
And so on our site, we really pioneered this idea and by the way, the whole concept of hedge fund replication has been around since the mid-2000s and it’s really the only area of the liquid alt space that has worked consistently and reliably, and it’s not just us, I mean the way you would analyze this is you would look at what we’ve done but also look at other firms who had been on the space.
And it’s — but what is sort of remarkable about the about this whole concept is that you don’t just do as well as hedge funds, you tend to do better. And the reason you do better it entirely from cutting out fees. Before the crisis in this space, people generally thought if we can create something that does just as well as this leading hedge fund index, but offers daily liquidity and low fees, we’re going to be heros, right? This is going to be – we are going to be the John Bogles of the alternative investment industry.
RITHOLTZ: Right, right.
BEER: And we did it, and we did it.
And so but after the crisis, we said maybe we can even do better because when we’re seeing this portfolio of hedge funds delivering six percent per annum, maybe they’re really doing 10 before fees. And if we can replicate eight or nine or even ten of the ten and charge less, it won’t just be like an index product, it will be an index plus product and so I think we’re now known as the only firm, at least that I’m aware of that has been able to consistently outperform portfolio of hedge funds similar to what you would think a fund of funds would do but with better drawdown characteristics, low fees, and daily liquidity.
And so in 2018, a fast-growing French institutional investor called iM global partner was doing this multiyear analysis of liquid alt space and said no we think these guys have the best mousetrap but they don’t have any products that are available to a broader range of investors and that’s when they partnered up with us and then launched these two ETFs around existing strategies in 2019.
RITHOLTZ: Is the plan to eventually become the Vanguard of the alternative space? Are you guys going to roll out more products or are you going to stay focused on just a handful of products?
BEER: We have been very, very focused on what we do and I expect us to continue to be narrowly focused. There are only certain strategies for which this works incredibly well, in the managed futures space, we’ve basically found a way to outperform large hedge funds by 400 basis points per annum with less risk.
So if you’re deciding how do you want to get exposure to managed futures, this should be the obvious choice. We run into all sorts of agency and behavioral issues and that’s for the same reason that the allocators fought passive investing for years but that’s s changing and will continue to change.
But in your markets, I think, actually and going back to think about stuff. One of the best things you can do with asset management is to decide what not to do and so when you ask the questions about the history of the liquid alts space, every time there was a new wave of products, we try to look at it with an open mind and say hey maybe this does something better than what we’re doing. Maybe we should do this instead.
And every time we concluded that these were products that were being, you know, that look great on paper, that wouldn’t work in practice. And I think we have been right six out of six times on that.
So it’s possible that we would introduce new products but I don’t expect to it broadly. Our goal right now is that for anybody who is managing a diversified portfolio who thinks that and we can help to make the argument, who thinks that hedge fund-type strategies and industry, I mean specifically equity long short and managed futures, has a role in their portfolios.
The argument that we would make is that the way that we do it is more predictable, more reliable, and has — tends to outperform over time and therefore if you’re thinking in five or 10 year increments in terms of how your clients, you know, are going to end up doing its portfolio and how you are going to do this portfolio, we should become the default allocation.
RITHOLTZ: So let’s talk about one of the ETFs in the space that you guys manage, the long short hedge strategy ticker DBEH had a great year in 2020, was up 25 percent, tell us how that sort of ETF is constructed, what goes into that and who do you think that’s appropriate for?
BEER: So that is a strategy that we — it is based on a strategy we originally developed in 2012 which is the we look at 40 of the largest equity long short hedge funds and diversified across a lot of different strategies, fundamental value, fundamental growth, emerging market sectors specialist et cetera, and we analyze how those guys have been making money before fees.
And our goal and what our research has basically shown is that the way these guys primarily generate alpha over time is by getting — it is through better asset allocation and this goes all the way back to you know, what I mentioned about Seth Klarman and this whole idea of get the area right.
If you look at, you know, for instance, over the past 20 years in the equity long short space, the preserved capital and big money in 2000 to 2002, not because they picked a particular stock and short of a particular stock, but they were very long small-cap value stocks and very short large-cap growth stocks at the time the markets fell apart.
But then, by the mid-2000 they had pivoted into emerging markets and they rode the BRIC wave that was on the long side entirely. And interestingly, in the 2010s, they did get the markets right, they were — went into US quality stocks in 2012 before the stocks took off and then ultimately embrace tech stocks before the end of the decade.
The problem with the letter two was that they don’t have that much of an edge in terms of picking which tech stock is going to take off, so when you compare them to the NASDAQ or particularly to the S&P 500, they don’t look as good.
So what we try to do is basically figure out you know if you — if you could look through each of these guys’ portfolios today and see exactly how much they were long and short every single stock, how much can we group into the S&P 500, how much can be grouped into small-cap stocks, mid-cap stocks, emerging markets, non-US developed into those major buckets? And if we get that right, then that ends up explaining 80 percent to 100 percent of their appreciated returns. So…
RITHOLTZ: So how do you track that information, how can you tell what these private and not very transparent funds are doing in order to replicate what the broad industry is doing?
BEER: So the way that you can do it most reliably is actually by analyzing recent performance, so looking at 13F filings doesn’t give you much valuable information believe it or not, even reading my brokerage reports isn’t terribly helpful. The way to do it most reliably is you simply run a what is called a multifactor regression against recent performance, and to be very clear this does not work with a particular hedge fund, it doesn’t work terribly well with a particular hedge fund because they will change what they do faster than the models can pick up.
But in the case of a pool of 40 of these guys, it’s a little bit like, if you ever read on Jim Surowiecki’s “The Wisdom of Crowds.”
BEER: So it’s basically that idea, it’s that — it’s that you know whether one guy is long or short a particular stock of particular area is much less important than these guys — their collective wisdom.
RITHOLTZ: You are looking more or less at quarterly returns for the group and reverse engineering what they’re doing based on how broader asset classes are performing, what would’ve gotten them to their quarterly numbers, is that ballpark?
BEER: Exactly with the one correction that it is monthly and not quarterly. So you look at the past 14 months of data is the way that we do it, and so if you take a year like last year, the equity long short space overall was up 17-1/2 let’s say, so really a remarkably good year for hedge funds and that equity long short guys were up as much as the S&P but with half of the risk.
But pre-fee, they were up 23 or 24.
BEER: So our goal is can we get all 23 or 24, only charge 85 basis points at an ETF and get all that — so hedge funds overall maybe get 500 basis points of alpha, we get closer to 1,000.
RITHOLTZ: That is quite fascinating.
You have previously written that we are on the cusp of the new golden age for hedge funds, explain.
BEER: So the first thing that I would say is that just in terms of my credibility in terms of writing that article, I have been a very well known critique of hedge funds in many circumstances, so this is not somebody who is dogmatically pitching a party line. In fact, my friends used to say if my car broke down and in Greenwich or Mayfair, I should lock the doors and call assets (ph) rescue.
BEER: So — but we saw something really interesting last year in that about midyear in our portfolios, we started to see what ultimately became the value and E.M. pivot, and hedge fund got a lot of things right last year, so the first to make it right, so and by the way, to understand positioning, they went with the tech bias into 2020 overall. Some firms were long airline stocks and got run over but overall the industry had a — had somewhat of a tech bias and it kind of blows up the academic notion that hedge funds are always long value because in fact, what we see is that what hedge funds do is much more dynamic, it changes over time.
But then they didn’t cut risk in the drawdown and as we started coming back in the second quarter, they bought into the recovery, they bought into the availability of the vaccine at some point and the depth and — of the fiscal and monetary stimulus, so they were adding risk as the market came back and then really interestingly, we started to see it pivot where tech stocks were as they increased risk, they weren’t adding more to tech stocks, they were taking it and adding it to emerging markets and small-cap stocks and non-US developed.
And so a lot of quant value investors have been waiting for this rotation into value to happen for years and we think it happened in a slightly different way which is that if you’re a hedge fund, you know, as I mentioned that had a tech stock that’s tripled over the past three years and it’s just gone up, you know, 80 percent in the second quarter, a prudent investor will take profits on it and then where do you put it? You don’t have to go back into tech stocks so they started to look for cheaper areas.
And so because of that, I think what you see is that hedge fund and this whole idea of asset allocation, the opportunity set for them in the 2020s looks great because back in 2016 or 2017, people were starting to say the US looks expensive relative to emerging markets and then the US took off and emerging markets didn’t, and then it was — small-cap stocks might look cheap and then you had more years of US large-cap dominating.
And so there is a valuation rubber band has been stretching and stretching and we’ve seen hedge funds pivoting into it. And so when — if you’re, the reason this is really important is if you have a portfolio today like most wealth management portfolio that is heavily biased toward US large-cap stocks and fixed income instruments, you have a really big problem. I mean US large-cap stocks are historically expensive and Fixed income instruments, the expected returns are close to zero.
So, you know, how can you add something that does better and I think what we are seeing is the opportunity set for hedge funds now because these valuation disparities are so wide and they have the flexibility to really take advantage of it, they have a clear role in investor’s portfolios over the next 10 years.
RITHOLTZ: So that’s a really interesting observation, the US has certainly been much pricier than overseas and emerging markets for way over a decade and you could say the same is true for growth over value and large-cap over small-cap, what sort of persistency might hedge funds have in these spaces, do you find generally they’re willing to ride out that rotation for a long period of time or does it — you mentioned a decade, the reputation is a little bit of the flavor of the month sort of thing and whatever next shiny object comes along is going to draw their attention.
Again, I always have to say is that an exaggeration or doesn’t that apply to everybody is an overstatement or is there some truth to that?
BEER: So the core of what hedge funds do is to get these multi-year trends right, the — attention often goes to short-term shifts. So for instance hedge funds have been short the US dollar, the general view among hedge funds is that other parts of the world are recovering faster than the US, the fed is likely to let the economy run hot which could be more inflationary for the US and other parts of the world.
But you know, what we have seed over the past five years is that you — and that view leads them to want to own more emerging markets over time.
If something materially broke down that view, if the Fed announced tomorrow that they were going to hike rates, then you would see a shift and a change, and that’s what you want hedge funds to do.
But you know, again, I think always the issue with looking at hedge funds is it’s the difference between the individual data points, the anecdote that’s being circulated versus what’s happening more broadly in the industry.
And so I wouldn’t expect that hedge funds are long emerging markets are buying emerging markets today, I wouldn’t guarantee you that they would be long in five years but these tend to be pretty stable and persistent.
But I think the other thing that is –you know, so when you think about that, that grates with how a lot of people think about hedge funds and that they want to share something special about this stock or that stock or some particular trade that nobody has thought about.
But the competitive advantage of hedge funds is that when they like the market and they see an opportunity, they can go big.
And so back to that example that I used in the mid-2000s, it’s when I first started looking at the space and whether this idea would work, it showed that hedge funds on average had about a 35 percent long position in emerging markets that you would never see, you would never walk into a wealth manager in the US who likes — or you get a pension fund who is very optimistic about emerging markets and see a 35 percent emerging markets position, you might see they — if they love it, they go from 4 to 6. And so that flexibility is very, very powerful over time because you know, over the period that I described in the mid-2000s, emerging markets outperformed the S&P by 30 percent a year.
So asset allocation was giving hedge funds 1,000 basis points of alpha a year, it didn’t matter what you owned in emerging markets, it’s that you can pick the right area, and so I think we have over the next decade again is you know is the easy money in the S&P has been made, the easy money in the NASDAQ has been made and could it go on for two years? Of course, it could.
But looking back 10 years from now, it’s hard to see — I think it’s statistically impossible to see the S&P putting up another decade with 30 percent annual returns.
RITHOLTZ: Makes a lot of sense, historically, you should start to see some mean reversion. You have referenced the second holy grail of hedge funds. I was thinking of the first holy grail is alpha, what’s the second holy grail.
BEER: So, let me first start with the term alpha.
So people use alpha in a lot of different ways. The interesting thing about going back to the 1990s nobody talked in terms of alpha, and alpha was a concept that was applied to hedge funds by institutional allocators who were trying to justify an allocation.
And it is statistically problematic because it all depends on what you’re comparing one returns into another. But the basic idea of the first holy grail of hedge funds back in the mid 2000s was what I described, could you find Seth Klarman in 1982 when he was just hired to build and run Baupost. Could you find define George Soros and Julian Robertson in the 1970s, can you find, I don’t know, even today Chris Shumway when he launched Tiger Global.
But — and that’s what the business with a brief thought that if you try to identify a guy today, he’s going to continue to put up or he could continue to put up spectacular numbers or he is so smart and so capable that that’s exactly what he is going to do over the next 10 years.
The reality is that is nearly impossible.
And if you could do it, you should give all your money to three guys go home and come back in ten years.
So the second holy grail was we like the diversification benefits of the industry broadly but had — it’s frustrating to pay these high fees. You know, it’s difficult to invest in something that is illiquid or sometimes we don’t get our money back at exactly the wrong time.
These things blow up with frustrating frequency. So if you could deliver the performance of hedge funds broadly but with low fees, daily liquidity, better downside characteristics, transparency, that this should have a role in every single hedge fund portfolio, that you don’t necessarily have to just pick 10 or 15 different illiquid hedge funds, you could have 20 percent of your assets in this liquid low-cost vehicle and then pick and choose how you invest.
So it makes it makes all hedge fund investing not just more efficient but also it tends to — it actually can improve returns and improve performance over time.
And so you know, if this had been embraced by institutional investors back in 2000s, in this, sorry– or in 2010, they would have saved hundreds of million dollars in fees over the next decade, but the whole concept of it runs into the same issues that the active versus passive debate has been dealing and in the rest of the asset management industry for 30 years.
RITHOLTZ: So you touch upon two things that I have to ask before we get to my favorite questions. One is that active passive debate again going back to the academics, you would think that as more people become passive, that should create inefficiencies that make it easier for the stock pickers, to make it easier for the active players.
Do you think that is accurate and why have we seen so many active managers fail to adjust to the money flows into passive?
It’s a great question, does passive make active more difficult and I would — I honesty do not know the answer to it. In theory, you are correct, right? I mean hedge funds should be out there saying here’s the stock, it’s 20 percent undervalued because it’s not included in this index, and all we have to do is buy it today and wait and there is this big dumb elephant of an investor is going to come up and buy 20 percent of the assets in one day or 20 percent of the flows in one day.
I think there are a lot of — there are a lot of myths about hedge funds that have been perpetuated for a long time because there I would say their convenientness, one that I’ve heard repeatedly that I’ve been asked about is hedge funds aren’t making money today because the markets aren’t volatile enough.
I haven’t seen any good data that actually supports the contention that a normally more volatile market is necessarily good for hedge funds. What I do think though, you can say is that when hedge — when markets trend aggressively over some period of time that hedge funds can be very good on at jumping and capitalizing on those funds whether it is manage futures or other areas.
So, you know, so I think passive is — has been a little bit of a bogeyman that people have put up there, but again, you know, I will admit that I don’t have a strong conclusion on this and maybe tomorrow, somebody will show me something that is dispositive but I haven’t seen it.
RITHOLTZ: And early in your career you were pretty heavily involved in the commodity space and the greater China region, do you still track China closely and do you have anything in particular to say about what’s been going on over there lately?
BEER: I don’t and I would say – so my experience with China was that around 2000, I had these two macro themes, one was the commodities would become much more important than they had been in years and the other was that the greater China region, really specifically China was going to become an important area of asset management.
And so, you know, within a couple of years I started to hedge funds in completely different businesses with guys to capitalize on both of those.
I would say the experience that we had with China was that capitalism in China is done — or at least back then was done with a different set of rules and that the idea of porting standards of conduct as it relates to Chinese business activities often meant that the guy who had those standards was somehow the guy who walked out of the room with no money.
BEER: And clearly, there’s a lot more government intervention in the economy. I met a guy at one of the private equity firms who had investment in China basically saying that he was talking about how the government will let them have one out of three or two out of three investors would make money and if the third one is making money, they would have to somehow give it back.
So I’ve spoken with some people recently about China who continue to do business there and those concerns are still out there but at a granular level and not close to today.
RITHOLTZ: Quite interesting.
I know I only have you for a limited amount of time so let’s jump to our favorite questions that we ask all of our guests.
Tell us what you’re streaming these days, what is keeping you entertained during the lockdown either Netflix, Amazon Prime, podcast, what are you keeping busy with?
BEER: So this is going to be the most depressingly boring answer for you I’m sure (inaudible) but my dad is 86 years old and he is a lifelong opera fan and he lives in New York and last year this time he was going to the opera three times a week and I would try to join him there, he obviously can’t go to the opera this year.
So I have been streaming operas on Amazon Prime to either watch with him or talk to him about — I do get in other things as well but it’s not — it hasn’t been a priority for me.
RITHOLTZ: That is not boring, opera is kind of interesting, even if you are not an opera buff, it’s still, you know, not run of the mill television.
BEER: The poor guy used to take me when I was young and I would fall asleep, I’d have a big lunch and then fall asleep every time so I think in my 50s, I’m – I have a sort of renewed interest in it and it’s wonderful to be able to share it with him.
RITHOLTZ: Tell us about your early mentors, who helped to shape your career?
BEER: So I think the earliest one is my late uncle Amo Houghton, H-O-U-G-H-T-O-N, he was this really extraordinary guy who unfortunately passed away earlier this year at age 93, but he had run a company called Corning Glass which was the business that his/my family started back in the 1850s.
But then he went to Washington and my first job was working for him as he was a young Congressman and I hope people listening to this will go read his obituary because it if there was ever an example of somebody that we need in Washington today, it’s him.
He went to Washington, he served as a congressman he tried to be bipartisan he was friends with people across the aisle, he really I think set the standard and he, I think just taught me the ultimately just a level of decency in business, you know, ultimately you are responsible for conduct and it’s not always about just making money.
And I think, you know, I think another guy is Jim Wolfensohn who was what I — who gave me my first job as an M&A investment banker and then he later went on to run the World Bank. But he was an extraordinary guy and in his you know what I knew him back then, he just have this energy in terms of wanting to learn– he picked up the cello when he was 40 or something and was performing with Yo-Yo Ma within 10 years. Just extraordinary and I think there’s something about — he had that almost a Warren Buffet like enthusiasm for things, I had the pleasure or actually visiting with buffet in 2016 on election day, believe it or not, and we’re talking about value investing and staffing and all these things and you know — and the guy a whatever age he was just still bouncing off the chair with enthusiasm talking about things.
And I think there is something really inspiring about that.
And then I think, you know, I think the one who’s not an early mentor but I think one of the people I do admire most of the industry today or over the past couple decades was John Bogle because he was right, you know, he was right and he stuck to his guns in the face of withering criticism and gailforce head winds and I think I was — as I was thinking about this, I wanted to see if I could — there are two quote that I thought I’d — is it okay with you if I share two quotes that I think…
BEER: That I think are just sort of fascinating…
So John Bogle, part of what he was influenced by what was Nobel laureate Paul Samuelson, the whole idea of index funds and investing in the market and what Paul Samuelson said about John Bogle in the first index fund was quote ” This Bogle invention along with the invention of the wheel, the alphabet, Gutenberg printing. And so it was basically look how extraordinary this index fund is and I remember in the because I think it’s the late 1990s or early 2000s, one of the luminaries of the LBO history was have this great quote which said “After the wheel, God’s greatest intention was the carry.”
BEER: And that to me – those two quotes summarized to me the whole active and passive debate is the role of asset managers to put their clients first and try to get as much money as they can reasonably get back to their investors or is it to maximize the profits of an asset management industry and the you know I’ve – that is 40 years I’ve cast my luck with Bogle.
RITHOLTZ: That’s funny. You know you reference The Financial Times earlier, they were the first ones who had the quote out that “A hedge fund is a system by which a savvy manager transfers wealth from naïve investors to himself” and I certainly think Bogle understood that as did the person who was talking about the carry.
Let’s go to everybody’s favorite question, tell us about what you’re reading these days what are some of your favorite books?
BEER: So my favorite books keep changing, I go through phases where I get kind of obsessed with a particular topic and then move on, the — one book that I keep going back to and it has a lot to do with the hedge fund industry although it has nothing to do with the hedge fund industry which is a book that believe it or not was written in 1962 by a guy named Thomas Kuhn and it is called “The Structure of Scientific Revolutions” and what he basically identified was that progress, in his day, scientific progress doesn’t just happen in a set of gradual way that most people who have been the existing paradigm and most people who had been brought up in that paradigm, they’ve been trained in it, they want to believe in the paradigm, they self-selected into the paradigm.
And they will not abandon the paradigm until there was something new that is established that they can safely hop over to. And that is where the hedge fund industry is today.
So I go back and I keep reading it because every year that you know I still face these headwinds in the industry, but we see them abating and we see more and more people buying into it but I keep going back and reading it because I want to make sure that I’m not you know, completely insane.
And then the other thing I did – and also, and I would encourage to go back and read books they read 20 years ago, particularly about business because you see what a different world it was.
BEER: And I recently reread so I do have a copy of Seth’s “Margin of Safety” that he gave me when I joined and…
BEER: And you when you hear what he was waiting about and the kind of thing the kind of opportunities that use as examples, it is so clear that no hedge funds with any meaningful assets could do any of those things today.
And if an opportunity like that came about, you know it would be 70 sophisticated hedge funds competing for each trade opportunity — investment opportunity.
So I do think that you know there’s another quote that I love, my great-grandfather’s very good friends with this guy named George Santayana who famously said “Those who forget history are doomed to repeat it” and I think in the case of people who are in the asset management industry, five years ago is not history, three years ago is not history, if you want to understand why quant-based investment strategies are disappointing you today you’ve got to go back and look at the 1990s and even better yet, look at what they were saying the 1990s about the 1970s.
And there’s not enough about the industry.
RITHOLTZ: Ray Dalio has been a big — his new book is all about that, unprecedented doesn’t mean it’s never occurred, it’s just never occurred in your lifetime and if you go back through history most of the things that seem to surprise us have happened time and time again after everybody forgets about the previous time.
BEER: Absolutely. I mean you know, like as Mark Twain said, history doesn’t even repeat itself but it rhymes, I think you can often find examples but sometimes there are alarming examples if you look at the political situation today, you can point to very alarming disserving examples where you had — not established democracies but democracies that were under threat in some way and you can see the same kind of politicized debate around that and you know I think it would do us all a lot of good to focus on historical precedents and think about what they mean today.
RITHOLTZ: Let’s talk about the sort of advice you might give to a recent college grad who was interested in either hedge funds or liquid alts, what sort of career advice would you give them?
BEER: So I think the – I guess I would start with the statement that you want to find an area broadly that is likely to grow over the next 20 years, and that probably has something to do with technology. So I mean one of the things I think that is so incredibly sad about the coronavirus crisis is that you have people whose lives were built around retail businesses, that were built around movie theater chains, that were built around things that are probably never coming back in the same way that they were 20 or 30 years ago when they made that decision.
So maybe this is kind of the shadow of — Seth’s original thing is to find the right area so if you’re going to have the managed industry have conversations with people about what do they expect to be big and new and maybe that’s crypto, I don’t – I’m not a — I don’t know an awful lot about crypto but I think you can point to it and say crypto in 20 years or 10 years is going to be bigger in some way shape or form.
Interestingly, the only way that you’re going to be able to figured that out is by doing it day-to-day.
One of the most interesting pieces of business advice I got was ironically from Mark Cuban in 20 — sorry, 2001 or 2002, when I met with him and we’re talking about the future of – I said, you know, how are you investing your money today and he said that he was willing to spend $100 million of his money to invest in high definition television and asked him what that meant and he said I have no idea. He said it could be producing, it could be better pipes into the homes, it could be all these different things, but what I could tell you with certainty is that 10 years from now, people are going to want much better quality than the grainy TV that they have today and the only way that I’m going to know where the real opportunities are is by doing it every day, it is not an academic exercise.
And so I think when people are going into it, they should have that view of trying to think about what is going on around them and how it is changing because if they are entrepreneurial, that’s where they are going to see the opportunity if not by writing a business plan by pulling on Wikipedia.
And I think that you know, alongside that, I would say flexible, you know it’s not, it’s not clear that age 25 or 27 or however old you are, it is not clear where the opportunities are going to be, we know that things will look very different in five or 10 years and so you know, keep financial flexibility, keep yourself on the balls of your feet so you can pivot as necessary.
RITHOLTZ: Quite interesting and our final question. What you know about the world of investing today you wish you knew 25 years or so ago when you were first starting out?
BEER: So I wish that I had understood how institutionalization of the alternatives business would play out. So you know, we started this by talking about whether I was going to go into the LBO business or go into the hedge fund business. And my in one of in a shockingly bad conclusion, I thought the LBO business had probably seen its best days.
Because the things that had made LBOs these profit generating machine was a function of the 1980s, it was the junk bond market, you could buy things with your 5 percent equity down and you would go buy a reasonable company with it because of distortions in the junk bond market. You had terribly-run companies with inactive boards that you could take over and clean up and double their cash flow and you have — you know, companies going through conglomeration phases in the 70s and 80s and were selling off subsidiaries because XYZ hedge fund, because the — an LBO baron had dinner with the CEO and convinced him to sell it at six times cash flow.
And it was — all of these things were that made LBOs in the 1980s is really — these great investments, huge excess returns. What I didn’t see and by the way when I was looking at this, you know, KKR had bought RJR and Nabisco and that had turned into a kind of a fiasco and people thought no one is ever going to be able to raise a $5 billion fund again today.
What I didn’t understand was that institutions and consultants around institutions, once that they had their own reasons for having these new asset class categories, so once they labeled LBO slash private equity and asset allocation, it was the first movers into that ended up getting new clients because they could say we have special access, we know how to invest in this area and their business will grow.
And then somebody else will look at them and say oh my God look at them, they just won that new client and it seems to be in part because they know how to get invested in LBOs and we don’t have that capability so let us hire some people to do it.
And this whole process builds on itself and so now you have you know and so you know now this is why you have $30 billion hedge funds which people would have said was preposterous 25 years ago or people routinely raising $10 billion or $20 billion private equity funds.
And so — so I think if I have known, if I understood that, I think that there would’ve been different ways that I would’ve managed some of my businesses, but you know, next life.
Thank you, Andrew, for being so generous with your time. We have been speaking with Andrew Beer, managing member at Dynamic Beta Investments.
If you enjoy this conversation, well, be sure and check out any of our previous, I don’t know, 389 such prior conversations, you can find those at iTunes, Spotify wherever you feed your podcast fix.
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I’m Barry Ritholtz, you’ve been listening to Masters in Business on Bloomberg Radio.