"The Emeril Lagrasse Theory" - Practical knowledge and culture is not often transferable

After hundreds of discussions with hedge fund managers, I am still surprised that there is a fear of revealing investment processes under the assumption that someone will steal their ideas and intellectual capital. There are few investment styles that are truly unique and special. What is special is still strategy execution - the practical process of delivering returns. Skill is with the decision-making execution of information and strategy.  

I often use the analogy of the cookbook written by a famous chef. Walk down the cooking aisle of any bookstore and you will see all of these books that explain in great detail the "secrets" of famous chefs. These cookbooks will tell you all of the ingredients. They will walk you through every step in the process. They will provide color pictures of what the dish should look like and will also provide pictures of intermediate steps. Why would these chefs give up their secrets? 

They provide transparency because they know that their practical knowledge cannot be replicated. The reader's attempt to replicate the meal often fail. Once readers see the complexity of the cooking process, they will often just go to the restaurant and enjoy their meal at a high price. Transparency creates value. We discussed this in our previous post -"Technical and practical knowledge - You need both for asset management"

Mike Lombardi in his book Gridiron Genius discusses "The Emeril Lagrasse Theory" as applied to coaching which is also applicable for money management. There are many who have studied and worked for a truly great coach like Bill Belichick or Bill Walsh, but they are often not able to replicate the success of the coaching mastermind. There are many who have studied with Emeril but have not replicated the quality of his cooking. They cannot replicate their mentor's practical knowledge, drive, or culture. These are Emiril's true skills.

We see the same thing with hedge fund start-ups where a junior manager decides to start his own firm. Some are successful, but many are not able to match the success of their mentors. There is intangible practical knowledge and culture that is not easily transferable to others. Investment skills such as culture and drive, whether associated with quantitative or discretionary managers, are not always transferable. Investment managers do not have to hide their investment strategy. The strategy does not make them unique. Implementation skills make them unique. For investors, once strategy is understood, due diligence has to focus on a manager's practical knowledge. Investor should allocate to strategies but back managers with practical skills.

Inflation - Where do we go from here?

Don't worry about inflation - the Fed isn't. Or, the Fed believes there is no value is trying to get ahead of any inflation increase given the relatively tight range for inflation.  The market penalized any fixed income investor that acted on inflation fears.  Any Fed objective function has a higher weight on growth.

The Cleveland Fed has been producing the median inflation rate for years. It provides a different perspective on inflation. It is moving higher, yet that is not a focus by the market.  The fact that the compounded effect of inflation in the 21st century has been substantial for those who do not have indexed wages seems to be missed by our central bankers. While there is talk of inequality by the Fed, the cost of low rates and inflation hurt the poor more than the rich. 

The current bias is that Fed will under-react to any inflation increase. The PCE showing an extended period above 2% lasting for months and CPI close to 3% seems to be necessary conditions. All verbal signals say that the cost of inflation is low relative to any slowdown in growth or decline in financial assets. This may seem obvious for many investors, but an implication is that any Fed behavior different from this current consensus will be disruptive. Any surprise in 2019 will be associated with tightening.

Mike Lombardi, football coaching and investing

I am not a football fanatic, but I picked up this book on a recommendation and was amazed by Lombardi's insights on leadership and management. Mike Lombardi is long-time football executive and media analyst. The book focuses on Bill Belichick and the New England Patriots, but his conclusions could apply to any money management firm. A good money management firm is successful because it acts like a well-disciplined organization with a common purpose. That is no different than a competitively run sports organization. Lombardi finishes his book with five key recommendations for firm success that are worth presenting in bold.

• CULTURE COMES FIRST
• PRESS EVERY EDGE ALL THE TIME, BECAUSE ANY EDGE MAY MATTER ANYTIME 
• SYSTEMS OVER STARS 
• LEADERSHIP IS A LONG-TERM PROPOSITION
• YOUR'RE NEVER DONE GETTING BETTER

I would employ these five recommendations to any hedge fund or money management firm. The idea that culture beats strategy has been a key insight from Peter Drucker. Always use any edge you have because you will never know when it will be useful. A good money management firm that wants to generate alpha always has to think about their edge. The system should always be dominant over a star. A star system can never be sustainable and never effectively uses the entire organization. If the smartest person in the room is always the same person, the firm better switch its hiring practices. There is no such thing as short-term leadership. Leadership is hard work that takes time.  Leaders do not think about the short-run but are always playing a long game. Finally, always try to get better. This is a variation on the Japanese management principle of kaizan, incremental improvement. 

I have often focused on management and decision-making with some of my posts for the simple reason that process is more important than any single market viewpoint or recommendation.

Endowments need help - Performance not strong versus balanced fund

Endowments are supposed to be the smart money, yet if you review the recent exhaustive paper on return performance, you will get a different impression. Large endowments do better than small endowments but when you compare with a simple 60/40 stock bond balanced fund there is not a lot of alpha generated. See "Investment Returns and Distribution Policies of Non-Profit Endowment Funds" from ECGI.

I was shocked by the results given that endowments can be patient money with broad mandates. They have often been at the forefront of hedge funds, alternative investing, and private equity. Now, this could a result of the way the authors partitioned the data. A $100 mm large fund cut-off is fairly low. 

An analysis of the endowments using a four-factor model shows that all alphas are negative but the smaller endowments are slightly less negative. The fraction of endowments with negative alpha is just under 60 percent. The odds of creating positive alpha are less than a flip of a coin.

However, the deeper dive into alpha using a four-factor model suggests the top 20 universities at best generating no alpha. This is better than the other partitions, but this does not mean that the large endowments should be patting themselves on the back.

The take-away from this study should not be surprising. Markets are competitive and it is hard to produce added return versus a benchmark or a simple factor analysis. There may be successful firms but it is not easy to consistently add value.  Endowments do not seem to have any special investment skill.

The current approaches to investment management by endowments are not effective at generating excess return. The processes in place for strategic and tactical asset allocation are not working. Endowments need to improve their investment behavior and do have a choice. They can move to a strategy of low cost passive investing, or change the current active return-generating model. 

By passive investing, we mean a structured approach to holding strategic asset class allocation or risk factors. A low cost passive approach finds low cost benchmark replicators and forms a well-diversified portfolio that is rebalanced through a set of rules. Be diversified at low cost. 

Changing the current return model may include moving away from a classic approach of adjusting asset class allocations and looking for successful active managers, and moving to a factor risk approach that allocates to a diversified pool of risk premia. The risk premia diversification will be adjusted based business cycle risks. There is a change in focus from security and asset class selection to factor management.

The choice of which approach will be based on whether an investment committee believes it has an information edge in the market. A candid review will likely conclude that a low cost passive approach may be a safe and effective investment approach. Yet, a factor-based approach can be coupled with low fees to create a viable alternative.