head in agreement. One by one they all took their turn asking similar questions.
“How can we justify the use of inferior funds?”
“Don't you understand that you get what you pay for?”
“How do we prove our value-add when selecting these types of funds?”
“How could we ever sell the fact that we're not buying the best of breed funds at the highest cost? We might as well admit we don't know what we're doing!”
At first, this reaction by my fellow, more experienced investors, made absolutely no sense to me. Why wouldn't they be thrilled about the fact that certain strategies would now be much more accessible at a lower cost in a more shareholder-friendly investment vehicle? Wasn't the investment industry becoming flatter and more cost-effective a good thing for advisors, consultants, and investors alike?
Then I started to realize my naiveté. I was still a rookie in the field of finance. Not everything works in black and white when it comes to products and investment choices in the financial services industry. All of the pros in the room were thinking about the same thing – signaling. If they were using inferior products at a lower cost, they would be signaling to their clients that they weren't doing their job to uncover the best investment products available in the marketplace. These investors and allocators of capital were worried about becoming marginalized. If they couldn't offer access to only the best funds, then how would that look to current and potential clients? If you have your name on the list at the best nightclub in the city, you're in exclusive company. But if that velvet rope is open to everyone that wants to get in, suddenly the shine comes off just a bit and you don't feel so special anymore. Also, you get what you pay for is an expensive theory, but one that all too many still believe in. It's more or less a sales tactic, but one with a narrative that's difficult to shake for many both inside and outside the industry.
It was far too counterintuitive for these investors to accept the fact that they could earn above average returns at a lower cost while giving up the opportunity for extraordinary performance at a much higher cost. The extraordinary performance was much harder to get and there was no way that all of them were going to be able to succeed in finding it, but how could they admit this fact and not even try? These are very competitive people. They all went to top colleges and universities. Most attended the top business schools, obtained the prestigious CFA designation, or both. Everyone in the room was intelligent and extremely qualified. Investing can be a cutthroat business. Everyone wants to be the best investor by making the most money possible in the shortest amount of time. Unfortunately, it's just not possible for every single professional investor to be in the top echelon of the performance rankings. This can be a difficult realization to come to.
The look on the speaker's face was priceless after he finished answering the final round of angry questions from the audience. He had a smirk on his face. It was almost like he knew what was coming for many of these investors based on their reactions. He knew it was only a matter of time before market participants came around to his line of thinking. But breaking established viewpoints on the markets can be difficult for intelligent people. It's not easy to admit that there might be another way of doing things, a simpler approach.
Luckily, individual investors don't have to worry about entrenched positions from the investment industry. You don't have to try to impress anyone. You don't have to invest in the Rolls Royce of portfolios to reach your goals. A more economical, fuel-efficient model will do the trick as long as you're not worried about impressing anyone else (which you should not be). It's about getting from point A to point B, not how you get there. There are no style points when investing. There's no bonus for degree of difficulty. You don't have to signal that you invest only in the best, most exclusive strategies. No one is there to judge you or your portfolio and you don't have to compete against your peers. The most important thing is that you increase your probability for success. That's all.
Coming to this realization can be a huge weight lifted off your shoulders because, as you'll see in the next section, being in the upper echelon of investors is nearly impossible for even the professionals that do this for a living.
Institutional versus Individual Investors
Professional investors now control the markets, but it wasn't always like this. Fifty years ago, the little guy controlled the stock market, as individuals made up more than 90 percent of trading volume on the New York Stock Exchange. Today those roles are reversed, as institutions handle more than 95 percent of all trades in listed stocks while trading almost 100 percent of all other investable securities. Institutional investors such as pension funds, endowments, foundations, sovereign wealth funds, and wealthy family offices have trillions of dollars at their disposal to invest.12
Warren Buffett is probably the most well-known investor to the average guy or gal on the street. Not as many individual investors know who David Swensen is. Swensen is Warren Buffett in the world of institutional money management. He's one of the greatest institutional investors of all time. Swensen literally wrote the book on the institutional investment model, called Pioneering Portfolio Management. They even call his style of portfolio management, which has been imitated by hundreds and hundreds of investment funds around the globe, the Yale Model, because he is the chief investment officer for the Yale University endowment fund. Swensen has earned Yale nearly 14 percent per year in gains since the mid-1990s, an unbelievable run of performance over two decades.
Yale's portfolio is currently valued at over $20 billion. For those wishing to replicate Swensen's success, it's worth noting the structure of Yale's endowment fund. The school brings in hundreds of millions of dollars a year in charitable donations and grants. Ivy leaguers love giving back to their alma maters. Yale has a staff of 26 fulltime investment professionals who specialize in particular areas of expertise for the portfolio. Plus, Yale is a tax-exempt organization, meaning they don't have to worry about tax implications when it comes to their portfolio decisions. They also have a time horizon of forever, more or less, as the endowment is a perpetuity to the school. Large institutions, such as Yale, have access to certain funds that most average investors can't invest in because the minimums are far too large. There are deals that the largest players in the industry are involved in that would never become available to individual investors. Large pools of capital get a foot in the door simply for having such so much money at their disposal. The scale of these funds allows them to pay less in fees as a percentage of assets through negotiations because the absolute amounts can be so large.
While it's important to distinguish between individual and institutional investors, Swensen is quick to point out that even within the rank of professional investors there is a hierarchy. In the Yale Investment Office's 2013 annual report, Swensen offered the following advice to both institutional and individual investors alike (emphasis mine):
The most important distinction in the investment world does not separate individuals and institutions; the most important distinction divides those investors that have the ability to make high-quality active management decisions from those investors without active management expertise. Few institutions and even fewer individuals exhibit the ability and commit the resources to produce risk-adjusted excess returns.
The correct strategies for investors with active management expertise fall on the opposite end of the spectrum from the appropriate approaches for investors without active management abilities. Aside from the obvious fact that skilled active managers face the opportunity to generate market-beating returns in traditional asset classes of domestic and foreign equity, skilled active managers enjoy the more important opportunity to create lower-risk, higher returning portfolios with the alternative asset classes, and private equity. Only those investors with active management ability sensibly pursue market-beating strategies in traditional asset classes and portfolio allocation to nontraditional asset classes.
No middle ground exists. Low-cost passive strategies
Charles D. Ellis, “The Rise and Fall of Performance Investing,”
