I was watching a presentation (anyone can watch here too) given by Howard Marks, of Oaktree Capital, to the board of CalPERS by invite of CalPERS’ newly minted CIO, Ben Meng on the uncertainty of producing returns. An appropriate subject considering the negative returns produced by CalPERS over 2018, and a decline of multi-year returns, on the whole, spelling out the urgent need for new and higher-order methods of control.
I have had a few one-on-one interactions with board members of CalPERS and a previous CIO, and have attended a strategy session for emerging managers some eight years back in Sacramento to learn and investigate the lay of the land in asset management.
The Man and the Machine
Howard strikes me as a remarkable, no-nonsense individual with a golden reputation of eking out investment returns when capital markets were somewhat underdeveloped and under-populated. There were lots of opportunities to grab in a developing financial marketplace when he started.
Do not take that to mean, however, that I reduce Howard’s current expertise as outdated, for he continues to demonstrate in the many videos I have watched to have an excellent grasp of the fundamentals that has allowed him to benefit from the changing financial landscape and marketplace opportunities since.
I always enjoy listening to people who, in their line of work, establish a higher normalization of truth than the herd. And thereby eradicate the many false positives with an ounce of prevention that delivers a pound of cure. Specifically, on a subject I bantered back-and-forth with Tim Draper years before he left DFJ when I explained how some of Tim’s venture investments were simply idiotic and naive. He too should have heeded Howard’s warning:
“If we avoid the losers, the winners will take care of themselves.” — Howard Marks
But as Howard admits, the complexity of financial instruments and the number of players have increased dramatically, causing the fragmentation of aberrations to increase while decreasing meaningful alpha. A financial industry eleven times the size of production in the U.S., according to an advisor to the President, will do that to money-making opportunities.
And yet, the complexity of our financial systems should not distract from the fact many financiers are, with all respect, glorified bean counters, not business savvy entrepreneurs with the foresight to break the norm. Indeed, beans must be counted, but from beans, as a consequence, one can not infer the causal reason for the long-term success of a company.
Financiers are generally trained as certified financial accountants without any understanding of what makes an asset tick before it reaches mass adoption and its success shows up in the rearview mirror. Not dissimilar to how I, as a one-time judge at VCIC, caught student VCs red-handed, knowing nothing about the nature of the asset after having priced it. This is the norm in finance, not the exception.
They use the performance of financial instruments from the past, guided by derivative valuations comps, to extrapolate towards a pretense of unprecedented financial foresight. Regardless, I must reiterate, of the intrinsic value of the asset in question. Compounded by values simply not living up to valuations, the trust in the financial system is subsequently eroded with unabashed pump-and-dump schemes towards an IPO or secondary exits.
With a limited set of financial instruments, plus overwhelming herd mentality in investment uniformity, and a lot of money managers vying for me-too success, it is not hard to comprehend how all financial instruments are destined to run out of steam. Mutual funds, hedge funds, index funds, real estate, fixed income, and other asset classes produce returns below the greenfield of growth available to the assets to which those instruments are applied — their artificial pooling resulting in even more deflation than their gating mismatch incurs. Even Oaktree Capital, Howard’s firm, yesterday reportedly admitting to experimenting with the escape-hatch provided by secondaries.
The point I am making is that even a supreme normalization of truth constrained to finance, as deployed by an investment guru like Howard, is not good enough to trace and support the capacity for upside of the investible asset. For a financial instrument is merely a derivative of the performance of the asset, and in its overwhelmingly commoditized distribution can quickly become the cause of a subpriming of the assets to which finance is applied.
For the theory, of investment arbitrage, determines what can be discovered, in the words of Albert Einstein.
So, the opportunity of producing repeatable investment returns cannot be attached to regurgitation and sub-optimization of past performance, but must instead follow and tailor to the needs of the individual asset to determine what distribution of risk and funds best meets its growth trajectory. The role of risk and distribution reversed. Meaning, asset risk (not investment risk) must determine distribution, not the other way around.
Improving the systemic performance of finance requires us to break the ceiling of finance.
If the above does not light your bulb just yet, realize that finance is a mere consequence of production (in the broadest sense) as its cause. Letting finance, as a consequence, determine the viability of production is a confounding of consequence and cause leading to grave depravity of reason, in the words of Nietzsche.
With production leading the charge of the opportunity for finance means the standard deviation of merit of purveyors will widen (rather than narrow in the inverse) and thus more opportunities to invest in the ever-expanding and widening fractal of human ingenuity will present itself. And as a result, the bell-curve of renewable investment opportunities will expand commensurately.
Up, Up, Up
Ergo, the role of an asset and money manager must change. Away from a mere pooling of distribution of funds, towards the assessment of asset risk vis-a-vis asset greenfield, supported by an intelligent evaluation of the ability of the company to execute mapped to the total addressable opportunity.
Asset and money managers must learn new skills and move out of the box of financial habit towards evolutionary truth, to make their assets produce the returns they expect to see. And then apply or create a financial instrument that best serves that purpose. Cause leading to consequence, in that order.
Predictability improves with a higher normalization of evolutionary truth.
Simply put, asset management strategies must be correlated to the risk of the asset, not to the risk of the financial instrument.
The savior of the financial system, in general, is that repeatable alpha is an unstoppable force of nature and derived from the natural renewal of all assets in our universe. All that financiers must learn is how to tune their financial instruments to reap the rewards of that natural phenomenon. I have created a 3-day masterclass explicitly designed to assist in the matter.
Welcome to a brave new world of finance.