[i3] Podcast Transcription: Brian Singer

MarketFox columnist Daniel Grioli speaks with Global Macro investor Brian Singer about his time working for Gary Brinson, his views on mean reversion, the essence of dynamic asset allocation and the attributes of a good investor. This is the transcription of the interview. To listen to the podcast, please click here.

Daniel: Welcome to another edition of the [i3] investment podcast. This is Daniel Grioli, MarketFox columnist for [i3]. With us today we have a very special guest, Brian Singer. He is head of the dynamic allocation strategies team at William Blair, a global investment boutique manager that is headquartered in Chicago. A very interesting guest. He’ll tell us more about his background shortly. Brian, welcome to the podcast.

Brian: Thank you, Daniel. I appreciate it. Good to be here.

Daniel: Thank you. Thanks for joining us. We usually start off asking our guests a little bit about their background and how they got into finance. What’s your story, Brian?

Brian: It’s an interesting story, as things go. Fate often plays an important role. I went to university in Illinois, Northwestern University. It turns out my economics adviser was an individual I got very close to and over time, she introduced me to her husband as a summer intern, and that happened to be in the commodities space, believe it or not, in futures here in Chicago, before there weren’t really any financial derivatives except for bonds. There was no S&P derivative futures contract or anything like that. But I worked there for a number of years and ultimately discovered that macro was the way that I really thought and what I really enjoyed, and migrated over to ultimately multi-asset portfolios and I’ve been doing that since 1990.

Daniel: Okay, that’s a long time. What was your first job on the macro side of things?

Brian: Believe it or not, my first job was writing a book. It involved going through a quantitative analysis of the seasonality of commodity futures contracts and exploring what seasonality was there, what may be driving that seasonality, and what one may be able to do with it if it’s identifiable in any form or fashion. Originally, quantitative; originally doing a lot of programming and focusing actually on agricultural commodities, not on financials.

Daniel: Okay, that’s interesting. How has the macro landscape changed over that time or how have the ways in which investors use macro economic information changed?

Brian: It’s amazing how much it has changed. I’ve observed this over my career. If I can look even prior to that, you observe the same type of thing. Since 1990, I would say that the big change that has occurred in the macro space is thinking about things in terms of asset classes and multi-asset portfolios, to where we are today, thinking about risk categories and risk management or risk allocation, as opposed to asset allocation. It’s a transition that is still going on, but I believe that we are clearly in that risk arena now, much more so than we are in the asset class arena.

Daniel: I would agree. You see that even in legislation here in Australia. Institutional investors, pension funds are now required by law to look at the underlying risks of their portfolios. Although the legislators in their infinite wisdom don’t give much guidance on what that actually means.

Brian: It’s interesting because it’s hard actually for anybody to pin it down. I do know that looking at the world today and then back in the ‘90s, a client or prospect would ask me about diversification and say that they wanted diversification. What that meant then was that they wanted exposure to something they weren’t exposed to, such as high-yield bonds or emerging market equities or something like that, which would be new to the portfolio. Now, clients ask about diversification and what we realize is that no one wants diversification when the market is going up. They only want diversification when the market is going down.

Today, it means basically downside risk. Protection against downside risk. More diversification is the same thing as saying I want downside risk management. That’s quite a change in the way people actually use the word diversification from then to now. It is reflective of that shift from asset classes over to risk factors or risk categories in portfolios.

Daniel: I think that’s an important observation because we throw words around like “diversification,” and we almost assume implicitly that we’re all talking about the same thing. Your comment there brings out the point that what we’re talking about may be different and may also change over time.

Brian: I think you’re absolutely right. We are, in some sense, in a period of transition. We’re in the early stages of thinking about the world from a dynamic risk capital allocation perspective. In that transition, the jargon isn’t fixed. Words are used in many different ways. It really is difficult in the industry, even for veterans who’ve been in it for a long time, to understand exactly what’s being communicated without asking a lot of questions.

Daniel: Okay. Coming back to your background, how did you end up from the world of commodities to William Blair? What were some of the things that happened in between on that journey?

Brian: It was an interesting time in the ‘90s. There was a lot of consolidation of the industry and many of the firms that I worked for were simply bought out by other firms. Ultimately, I found myself at a primary bond dealer, primary dealer, and that was Continental Bank here. When I was at Continental Bank, I was much more focused on the trading of bonds and bond derivatives, in particular, options at the time.

Then it was really pretty basic. It was caps and floors and collars. Basically, capping an interest rate or putting a bottom floor on an interest rate, or creating some type of boundary above and below, as a collar would be. That was really my first major introduction to financial derivatives. It kind of went from there.

Daniel: Who were your early mentors starting out?

Brian: I’d have to point to early mentors as I got into the industry of thinking about it from a macro investment perspective. When going through and doing research, even when I was an undergraduate, I was actually researching into Harry Markowitz and understanding this concept of an optimal portfolio. When I got out of undergraduate and actually began working and then studying at graduate school, I became much more focused in on individuals like in terms of derivatives, Black Shoals, and Sharpe in terms of capital asset pricing model which, in my mind, is a much more kind of macro concept back then.

Ultimately, when I got into the industry from a practitioner perspective, in 1990 was when I joined a firm called Brinson Partners here in Chicago. It was ultimately acquired by Swiss Bank and then UBS. But Gary Brinson, the founder of Brinson Partners, was very much a mentor for me, as was the primary individual there focused on asset allocation, a man named Denis Karnosky. Those two individuals, Gary Brinson and Denis Karnosky, who are really the mentors that I would observe, practitioner mentors that I would really observe in my career, in my path.

Daniel: That’s interesting. So, we all know of Gary Brinson from that famous paper. What was it like working with Gary and his team at the early stages when they were pulling together what has since become some of the most cited and famous research in finance?

Brian: It was fantastic. Literally, it was a wonderful opportunity, not just with that paper, but that paper was indicative of a broader relationship, where we would often find ourselves in the office on weekends arguing about various aspects of finance. It was just a wonderful experience to be able to have that back-and-forth dialogue and learn along the way. This was simply an example of that, where realistically it was Gary Brinson and Gil Beebower and Randy Hood who kind of formulated that approach to doing performance analysis.

Then we went a second step later, with another article and wrote that to apply it in a much broader fashion. It was something new to me. Thinking about the performance of a portfolio and slicing it and dicing it up into the decisions that you actually make or the decisions that you can make in a portfolio was exciting. I understood from that point forward that anything that was pretty much new, I was quite excited about, especially if it had any credibility to it, academic credibility to it, and theory behind it. That was really kind of the first big thing as a macro investor that I got involved it. It was fantastic. It was as fun as it could be.

Daniel: We’re definitely going to talk more about that research in a moment. But first, I just want to circle back to a choice of words that you made that I’m curious about. You used the words “We’d get there on weekends and we’d argue.” Do you think it’s important to have proper collegiate argument in an investment team and how do you do it?

Brian: Sure. I think it’s critical, in fact. It’s very difficult for that to become a standard aspect of a team. Some would say discuss. Some would say argue. In the end, the key is to be able to express dissenting views without ramification. Other than just purely the logic or the correctness or lack of correctness of that argument. But that becomes difficult. Often there is a desire to say yes to the boss, to agree with the boss.

Ultimately saying no to the boss, I disagree with you in this aspect of analyzing performance, being able to say that is something that ultimately I, as a leader, need to reward and encourage so that I do get dissent along the way and I don’t end up having a lot of people just agreeing with me. That’s kind of why I use the term “argue,” as opposed to “discuss.” I really want the disagreement aspect to come out. As one of my colleagues said once recently, “What we want is not constructive criticism, we want destructive criticism.” In some sense, that’s actually true. I don’t want anybody to hold back.

That’s the important aspect of it and that’s kind of why I often use the word “argue,” as opposed to just “discuss.” I’ve been very lucky. We’ve been together on average about 18 years. Those are behaviors that we now have as part of our culture. As we bring new people in, they quickly see that as part of the culture. It takes them a little bit to get comfortable with it, but it’s do deeply embedded in who we are as a team now, that it makes it easier when we bring new people in. There’s nothing to change. It’s just become a part of it.

Daniel: That’s very good. I think that word, “argue” has taken on a purely negative connotation recently, but it did have that meaning of passionate debate, which is I guess what you’re referring to.

Brian: Absolutely. If someone’s disagreeing, they’d better disagree because they really believe it and can support what they really believe. That’s where it becomes impassioned in terms of they really hold it as the correct thing addition they’re willing to stand up for that.

Daniel: Very good. Coming back to the Brinson-Beebower-Hood paper, it’s probably one of the most quoted and misquoted papers in all of finance. This is a pet peeve of mine. As you knew the authors and were there at the time that this was being worked on, what does it really mean?

Brian: You’re absolutely right. It is kind of funny when I think about how frequently it is misquoted. The way it’s typically misquoted is when people say something along the lines of “More than 90% of a portfolio return is due to its asset allocation.” The problem with it is, it never studied return. It studied the variation of return. The point of this being that it was the ups and downs or the variations of return, the risk, in effect, that could be described by the asset allocation. The asset allocation was the strategic or policy asset allocation, as well as any active asset allocation that was occurring in the portfolio.

Over the years, because of that misquoting of it, there are other papers that have been done. I think one of the better ones out there that has come out over the years was actually by two individuals, Roger Ibbotson and Paul Kaplan. Ibbetson is at Yale and he had his own firm here, Ibbotson Associates. I think it ultimately sold to Morningstar. But in 2001, those guys wrote an article that looked at it in a number of different ways – from a return variation perspective, from a return variation over time, return variation across managers, as well as just return in and of itself.

I think that’s probably the best article now, after kind of having more data to work with and knowing that you want to explore a number of different things now that you have that data, that’s a very good article. Then ultimately another one which I like was one that I actually co-authorized with Renato Staub, whom I work with. The thing about the Brinson and Ibbotson articles is they actually explore what people did, what investors did. That’s different from seeing what’s actually available to investors in the marketplace.

When you look at it from the perspective of what could investors do, that’s yet a different answer. In that instance, you do really find that there are a lot of systematic aspects of a portfolio and those are macro decisions much more than they are bottom-up security selection issues. That was what we were looking at. We see it now manifest in the industry as people, as we’ve already discussed, look at risk factors – these systematic risk factors that they can allocate to in portfolio. It is one of the most often misquoted. It remains one of the most often misquoted articles, although I try to catch it every time I can.

I think there’s some good follow-ons after that from Ibbotson and Kaplan, and then again from Renato Staub and me.

Daniel: Thanks for clarifying that. Your comments about macro risk factors gave me a thought, and that is the number of potential macro risk factors that somebody can look at is probably theoretically infinite. In your experience, is there an 80/20 rule dynamic? Are there a handful of macro factors that rule the majority of outcomes and if so, what are they?

Brian: Yes. It’s interesting. You can look at about any portfolio and in the end, if it has 30, 40, 50 securities, whatever the case may be, it ultimately only has about 2, 3, maybe 4 bets in it. That’s it. The way that is analyzed is something known as principal component analysis, or one way that’s analyzed. It basically finds out how many systematic aspects there are in a portfolio and how much of the portfolio’s return variation or covariance is actually explained by those factors. In the end, you can basically look at about any portfolio and ultimately it is exposed to a few risk factors, regardless of what’s all the security selection and everything going on in the portfolio.

Are there ones that are persistent in nature? I think there’s one that is persistent in nature, and that’s the market, beta to the market. That’s the non-diversifiable risk, ultimately non-diversifiable risk in a portfolio. That persists whether or not investors are trying to capture it. That’s different from a lot of the other risk factors that people at like value versus growth or the Fama, French. They started off in big terms with the Fama French model, 3-factor model. They identified three factors in terms of value and size as part of that in the broad market.

So those were kind of the three that they looked at. Then it expanded to the Fama French 4-factor, and the Fama French Carhart. I think his was the fifth factor that they added to it. Now, there is a proliferation of factors. However, I don’t believe that those factors are necessarily unique or mutually exclusive or independent from each other. For example, a high dividend portfolio is probably a lower risk portfolio as well. If you invest in a factor high dividend and you also invest in a factor called low volatility, you’re probably getting a lot of overlap in there.

They’re both measuring something very similar indirectly. Or one may be the right direct one and the other one is proxying for it. We don’t really know what the case is. Now that we have hundreds, thousands of factors out there, I suspect it boils down to, when all is said and done, there may be a half dozen out there that are truly unique in some form or fashion. Those, however, as more and more people learn about then, can be, in fact, arbitraged out of the system, unlike the one primary factor, the one primary component, which is the market portfolio.

Daniel: That’s very interest. Your comments bring to mind the debate between Rob Arnott at Research Affiliates and Cliff Asness at AQR, and Rob’s work on the valuation of factors over time, and his assertion that many of them have become more expensive and that’s actually accounted for a large part of the return. Do you have a view on that or is that something you look at?

Brian: It’s interesting. Rob, as well, has been around the block a few times in terms of market cycles. He’s seen ups and he’s seen downs. I think one of the most astounding ones that unfortunately there aren’t that many people old enough in the industry to remember, was in the late ‘80s and then basically collapsing on into the early ‘90s, when Japan, the Japanese equity market rallied so much and it became such a large percentage of a global equity index, that the industry began to explore things like GDP-weighted indices.

That was a way of basically constraining that one big element of a portfolio. Suddenly, with that, people began to question what market cap actually meant. Because here it was, a situation in Japan, where it was clearly a bubble, but a passive portfolio that invested in a global equity index, at a huge percentage of it in that one country, even though many investors opined that it was over-valued.

That’s, I think, strong foundation for the type of thing that Rob Arnott ultimately came up with, which is what the RAFI portfolios, the fundamental index is where he’s looking at a concept more of value than of price and building a portfolio or building some kind of a benchmark or a passive exposure based on that rather than just on market cap. That’s fine. I think that’s not a bad thing to do.

However, I think our industry is generally speaking, paid as active investors to identify something like Japan as a mis-valuation and not own it because it is a mis-valuation, rather than compel non-ownership through some type of GDP-weighted index similarly in terms of an active portfolio in equities, I would suspect that we’re hired as we’re not bottom-up, we’re not a bottom-up equity manager, but generally speaking, bottom-up equity managers are hired to avoid things that are, in fact, over-valued; that are, in fact, potential bubbles in a portfolio; and to avoid those things in terms of seeking alpha in the portfolio.

I see the motivation that’s out there. I think it’s not bad motivation. I think it’s fine. But I think it’s what we were paid to do in the first place. I’m not really necessarily comfortable with compelling that on investors. That’s an important consideration from my perspective. I think Cliff, in terms of his work in risk parity and other areas, is perhaps more flexible in identifying factors that are compensated out there through various quantitative models or in risk parity, where there’s purportedly a premium to leverage because other people just don’t do it; other investors just don’t do it. That’s kind of a different take on it.

In the end, I look at it and say it’s active management of a portfolio. It can be compulsory or not. My preference is that it not be compulsory and that’s kind of what we’re paid to do.

Daniel: I think there’s an interesting nuance in what you’re just saying. If I understand you correctly, it’s this: that whether you’re using a set of rules or making decisions, you’re still making decisions because you have to decide what that set of rules is?

Brian: Absolutely the case. It gets very, very broad. The S&P 500 is a set of rules. It’s an active portfolio defined by a set of rules that is basically US only, no non-US securities, large cap securities. Generally speaking, you find a little bit of a growth orientation there because those are the ones that grew into the index and not the ones that collapsed out of the index. There’s a little bit of a tendency there to be the case. In the end, there’s only one asset portfolio and that is the entire global capital market, includes your own human capital, which is basically something that becomes imminently unmeasurable and very difficult to work with.

Anything smaller than that is an active portfolio, whether it’s defined by a set of rules or not, and it can get narrower and narrower down to what we have today – the smart beta portfolios, which are a very narrow set of rules to define what is ultimately a not-very-well diversified portfolio because these rules define it very narrowly.

Daniel: Okay. One more question on the Brinson-Beebower-Hood paper and it’s implications, and then we’ll move on to dynamic asset allocation. The question is this: if asset allocation is so important, and we can be talking about importance in terms of risk or return or any of the papers that you mentioned, why do most institutional investors spend 20 to 30 times as much on fund managers as they do on their investment consultants?

Brian: I know, it’s amazing. In the end, it’s a conundrum in the industry that really maybe you could boil down to short-termism. Asset allocation in and of itself, in a strategic or policy perspective, a static perspective, is designed to meet long-term objectives. It’s not designed to meet something this week or even this year. It’s designed to meet something that has long, that you’re focused on over the long term. Then we begin to bring in tactical asset allocation and things like that and that is basically designed to dodge things like Japan in the late ‘90s. That’s fine.

I think it’s valuable in doing that, but often investors look at something like dodging the dot-com bubble or Japan in the late ‘80s as too long term. That’s not what we want. We want quarterly outperformance, not this kind of longer term thing. As a macro investor doing asset allocation, there’s not a lot in an asset class perspective that you have to work with. You’ve got US equities, non-US equities. Generally speaking, they can be defined in many ways. US bonds, non-US bonds, emerging equity, emerging debt and credit. Okay, you’ve got seven of them out there. They you can go to illiquid assets if you want.

Building a portfolio like that necessarily has more variation in it that’s driven by those factors than a broadly diversified portfolio of equities, which basically will move predominantly up and down with the index. Over time, there’s been a good bit of research that would say that tactical allocation doesn’t work and security selection does work. I don’t really buy that argument for a number of reasons, one which I already mentioned in terms of what investors can do, as opposed to what they actually do, and what actually is systematic in a portfolio.

Even if it’s bottom-up, there are really just a few systematic elements to it, which could be considered macro or maybe even as time passes, we’re seeing as risk capital allocations. Thing that you would allocate risk capital to. But in the end, I think it’s just the case that in many instances, investing is really about the long-term and the execution becomes really about the short-term and consultants provide a good bit of information, knowledge, experience about the longer term aspects of it.

That’s really valuable, but you don’t feel like you’re doing anything if you’re hiring a consultant to deliver for you over the next 10 to 20 years. You really feel like you’ve got to do something right now to justify your existence. That means spending a lot more money on other things out there, and a lot less, ultimately, on the things that really matter in terms of meeting long-term objectives. It’s disappointing, but it’s been that way for the last almost 35 years I’ve been in the industry. It’s probably not going to go away anytime soon.

Daniel: I agree with you that there’s definitely an urge to do something. I think it’s an incentives problem. I think there’s almost a contradictory set of incentives because there’s the one incentive for institutions, I guess, as fiduciaries, not to do anything stupid that’ll get directors in court. That argues in favor of copying everybody else’s 70/30. But then you’ve got the incentive to try and outperform either to gather assets or for other reasons. That idea is in favor of trying to stuff the 70/30 with lots of active managers and try and win by picking better ones. I think it’s the combination of those two incentives that keeps it going.

Brian: I think you’re definitely right. If you do stick your neck out as a manager of a portfolio under a board or under trustees, sticking your neck out by making a significant asset class decision is a lot more painful than making just as large a size position in an individual stock or bond relative to a benchmark because the ones relative to a stock, global equities, or relative to global bonds, ultimately are diversified quite effectively.

However, if you just decide you’re going to take a large position on emerging markets, suddenly yours may be the head that pops up above the trench in the middle of a battle. That’s not the head you want to have. The other one is you find yourself in a chain of agents and basically, I like to say that the trustee with the shortest investment horizon dictates the investment horizon of the fund itself. That’s often true, but it’s really in this chain from client to consultant to adviser, portfolio or investment adviser, all of those things to the career of the person managing the portfolio.

It’s really the shortest horizon across that spectrum that dictates the horizon of the investing that goes on in a portfolio. That’s really the travesty. It becomes driven by career risk and really, unfortunately, not a lot more than that.

Daniel: That’s a great truism. I’ll have to remember that one. That the person with the shortest investment horizon is the weakest link in the principal and agent chain.

Brian: Yep, it doesn’t matter if somebody has a longer horizon. It just doesn’t matter.

Daniel: Okay. Let’s move on now to your bread-and-butter, dynamic asset allocation. A question that comes up often when I’ve had discussions with people about dynamic asset allocation is they look at me with this quizzical look as if I’m trying to pitch them market timing by a different name. Are they the same? Are they different? What are your thoughts?

Brian: I would say they’re different. I recently wrote a chapter for a book that the CFA Institute published earlier this year, that does talk about what I think is the important difference between tactical asset allocation and dynamic asset allocation. Dynamic asset allocation, from my perspective, is longer term in nature and it focuses on what something is fundamentally worth and taking advantage of things that are priced different from what they’re fundamentally worth. It’s looking at what something is worth today, what its price is today, and then positioning for that price to converge on fundamental value over time.

Tactical asset allocation is something that I tend to think of as really based on a prediction about what something will do – US equity markets, for example – over the coming quarter or over the coming month or whatever the time horizon is, it typically is shorter term in nature, but its price forecast oriented, rather that price value discrepancy oriented. That’s, I think, when I think about it, the big distinction, but it does mean that tactical is shorter term in nature and dynamic is longer term in nature. I think tactical has also gotten a bad name, probably much worse that is warranted out there.

Again, I’ve been around a long time and I’ve seen the pendulum swing back and forth where asset allocation is something that everybody thinks is important and they need to do, and then it’s something that nobody can be successful at, and then it comes back to something that could be more important and what everybody needs to, and then it become less important again. That pendulum just swings back and forth. Actually, now I believe it is shifting back toward the macro aspect of a portfolio like asset allocation, and it’s becoming, rather than dynamic asset allocation, it really is becoming dynamic risk capital allocation.

This incarnation of macro is focused on risk more than it’s focused on asset classes, but it’s the same pendulum swinging back and forth over time. It makes progress, but it does go back and forth.

Daniel: How long does each swing take? Are we talking five years, ten years?

Brian: You know, it’s kind of funny. In my mind, I think it ultimately takes about 10 to 15 years. 15 years is maybe is the type of thing that you see out there in the industry.

Daniel: Okay. That’s interesting. I like your comments about the DAA being focused on the discrepancy between price and value and TAA being focused more on anticipating value. I think that’s a very useful distinction to remember.

Brian: It helps me and I am asked the question frequently. I think there is a distinction in the mind of market participants across the board. Any basic aspect of the investment decision. The key is to try to put your finger on exactly what those people, the industry as a whole, has in mind when it uses dynamic and when it uses tactical. This is about the best summary statement that I can come up with, given what I’ve heard and seen out there in the industry.

Daniel: Well, I think it’s a good one. So, you’ve described your process and your focus on fundamental value. At the same time, we know and you mentioned Mark Carhart earlier in our conversation about factors. We know that momentum dominates in the short term. How do you reconcile those two results? The need to focus on fundamental value but the recognition that momentum dominates, at least in the short term?

Brian: Yeah, momentum is basically a lot more focused on timing of the investment decision, which is important, even if you’re a fundamental investor. You just don’t want to look at something and say it’s expensive and sell it because it could get a lot more expensive. In a way, it’s ultimate reversion toward fundamental value. Considerations like momentum are important in the timing of strategy implementation in a portfolio. Saying that we’re fundamental, for example, does not preclude our consideration of things like momentum.

Because, ultimately, it is a timing decision and we have to be right on that timing and we do have to take advantage of every single piece of information that we have out there. Any short-term momentum is an important piece of information to take into account. I’m not sure that everybody would necessarily do that. It’s my belief, however, that it is an important aspect of any portfolio management, even fundamental value oriented.

Daniel: Okay. That’s interesting. Moving on to something slightly different. A couple of months back, I was lucky to have the chance to sit down and chat with Jeremy Grantham about many of these topics. One of the questions we discussed was mean reversion, and the fact that for most of his career, it tended to work in a nice, orderly fashion. Now, not so orderly any more. Do you think mean reversion is broken? Does it still work? Or has the mean shifted and how would we tell if the mean has shifted?

Brian: Yes, I would say it has been precluded from working since the global financial crisis. However, over the long term, it will work. In terms of nuance here, I’m not a fan of mean reversion as a way to invest because reverting to a mean is reverting to something that has happened in the past and you can calculate a mean from that. That’s very good if there’s no structural change in a marketplace. There’s no structural change such as an industrial revolution or now, an information technology revolution that is changing the world around us and changes the types of means we look at.

I think investing today, even in a more kind of macro orientation, when you look at geo-political instability, the mean that I think you would want to take into consideration is the mean that existed somewhere between 1900 and 1932, because that’s really a more representative type of environment in terms of debt, central banking, geo-politics, political polarity, a number of aspects back at that time. I just feel like mean reversion is looking through the rearview mirror, as opposed to some concept of value reversion, where value takes into account the investor’s best estimate of how structural change may be changing the value of an asset or the value of an asset class.

That’s a nuanced distinction because often there’s not a big difference between the two. It’s just when there is some type of secular change, regime shift, that I find the mean reversion concept is problematic.

Daniel: Okay. Again, that’s another very useful distinction, I think, for investors. If I understand you correctly, mean reversion tends to match that sort of reversion to value in a steady state environment, but in an environment that’s more dynamic, the structural changes create a mismatch and so focusing on mean reversion can get you into trouble potentially. Is that kind of what you’re saying?

Brian: You know, I wish I had actually said it that well, but that is not only kind of what I was saying, I think you said it a lot better.

Daniel: It’s much easier when I get to listen to you first.

Brian: What’s interesting though about the world we live in today, and this is what Jeremy sees as well, I mean, he’s got just tremendous experience in the industry and through many market cycles, what I believe is that when the global financial crisis hit, central banks stepped in – not just one central bank, the Federal Reserve, but basically a significant portion of the world’s economy with the Fed, the ECB, the Bank of England, Bank of Japan, and through to People’s Bank of China, and even beyond that, we have manipulation of interest rate.

Manipulation of interest rates is the same thing as manipulation of asset prices

Brian: Bottom line is central bank manipulation of interest rates is manipulation of asset prices. When central banks are that powerful of a player, the marginal player, the marginal investor, the price setting investor in assets, it is very difficult for fundamentals to exert themselves sufficiently to bring prices back toward fundamental values. It is my belief, my opinion, my hypothesis, that what has made it so difficult for fundamental investors or in reverting oriented investors is that normal process has been short circuited and it will be short circuited until central banks begin to pull back from these ultra-easy monetary policies.

We’re beginning to see that in the US. But until that happens, it’s a difficult situation and it’s one of the reasons why if you look at the performance of value versus growth, whether in the US or globally, that value has underperformed growth since the global financial crisis. It is a statement in my mind or a symptom, an aspect of central banks actually manipulating asset prices to the detriment of fundamental.

Daniel: Okay. That’s very interesting. Thinking more about DAA, many institutions think of dynamic asset allocation or DAA as taking a +/- 5% or 10% position around their growth versus defensive asset target. Is that enough to make a difference?

Brian: It’s enough to make a difference at the margin. However, it’s really something that’s, I think, not sufficient. Historically, we’ve talked a lot about tracking error and that’s been something that ultimately has drawn people closer and closer to the index. Whereas now, there’s this concept of active share, which seems to be trying to get an investors that are willing to deviate in somewhat different measure away from the benchmark, the important thing being that active share is used as a concept to think about how far somebody’s going from the index, as opposed to how close they are going to the index.

If they’re not moving far away from an index, they’re really just going to be brought into a broader portfolio and become nothing more than expensive replication of the market portfolio. For example, if a pension plan or whatever has 10 equity managers out there, and all those equity managers are taking positions in 100 different stocks around the world, in the end, you’ve got 1,000 different stocks around the world and you’re looking pretty much like the market looks.

However, if you have investment advisers that are taking much larger positions, not just the +5 and -5, but much larger positions in the portfolio, then when you bring 10 of them together, they’re actually not diversifying themselves into just a market portfolio, they actually have positions that will sustain themselves through that consolidation across these 10 managers and ultimately have the potential to generate good or bad performance. I mean, that’s the risk side of it. From that perspective, I believe that a lot of these smaller moves just aren’t that valuable. However, I do very much realize that they are career-protecting moves.

In many instances, focusing on that trustee with the shortest time horizon, it’s better not to be the one poking your head up above trench in the middle of a battle. Better to stay below the trench and take smaller positions, rather than take larger positions. So, I see the incentives that lead to it. It’s just that it’s ultimately not in the client’s best interest in a more broadly diversified portfolio.

Daniel: Okay, very good. Again on dynamic asset allocation or market timing, there’s the classic study that William Sharp wrote many years ago, where he looked at a very basic market timing strategy, probably not one that any investor would use. But from that, he concluded that you needed to be right at least 80% of the time on your calls to break even. Do you think that’s necessarily correct? Do you need that level of accuracy? If not, what’s a reasonable expectation for a dynamic asset allocation process to work?

Brian: It is interesting. I don’t know if the percentage is 80% or 51% or whatever it is, if there are fees out there, you’ve got to be right more often than not. You also have to be able to manage things that are working correctly and allow those to work correctly, where at the same time, things that are not moving correctly to cut them off. That’s something that doesn’t come up in a measure of 80% or 51% or anything. You might be wrong more often than not, but quite capable of shutting those positions down and allowing the less frequent correct decisions to actually carry the day in a portfolio.

I understand that analysis. I’m not sure I would fully buy into it. However, I do very much believe it’s more than 50%. I just don’t know how much more than 50%. The other thing that is interesting about all of this in terms of fundamental investing is that ultimately, modern portfolio theory is a single-period model. It’s today and the end result. Effectively, when I think about the capital asset pricing model as a broad theory, it has similar structure to it as a single-period model. It’s the outcome and the covariances of those outcomes that ultimately become important, not the day-to-day, week-to-week, month-to-month, quarter-to-quarter variation between now and then.

That’s a very different concept. When people test the capital asset pricing model and in that testing they find that it doesn’t work when they look at monthly returns, I’m not really sure it was ever supposed to work. A month is not any time period where ultimately equilibrium makes a lot of sense. In that perspective, I think understanding what the capital asset pricing model is and how it works is a much longer term type of evaluation and doesn’t boil down to whether you were right 80% of the time from here to there. Ultimately, it’s about what’s the end result that comes about.

That said, path matters. It’s very important, especially after the global financial crisis, to investors. In terms of being right, I think ultimately it will be more valuable not to say how many asset allocation decisions it takes to be correct, but more how many risk capital allocation decisions it takes to be correct. That will be an ultimately interesting question to answer because dynamic asset allocation is about path. It’s not about end result. I think that’s kind of where a lot of this research will ultimately go over time.

Daniel: That was three very interesting points I got out of your response. The first one was that a good investment process creates an asymmetry between winners and losers. That’s often not captured in back-tests of things like market timing. The second was that you’ve got to use the right kind of analysis for the right kind of question. So, if you’re analyzing longer term decision making using tools best described for single period decisions, of course it’s going to say that one or the other doesn’t work because you’re using the wrong tool to measure the wrong thing.

The final point was that last statement you made about the increasing emphasis not just on what the return is, but on the path to getting there. I’d like to ask you a little bit more about that final point, the importance of the path. What are some of the things that you’re seeing in the industry in terms of how people are thinking about that path and working with that path, and communicating to their clients or members the importance of focusing on that path, not just the total return number?

Brian: There are certain things that happen to people over time that simply change their behavior until the day they die. My parents were fine. No great monetary issues there, but any stretch of the imagination. However, when they would cook a baked potato in aluminum foil, they would take the aluminum foil off, serve the baked potato and then use that aluminum foil the next time they made a baked potato. That’s just something that became part of them as they lived through the Depression.

I think that to a much smaller degree, the global financial crisis has had an impact on behavior. That behavior is about path. There were a lot of investors that ultimately felt like they were well prepared for retirement or investors that felt like they were very well funded against their liabilities. That leads to interesting behaviors, even at the individual level, where people will go ahead and buy the house that they plan on retiring in and finding ultimately that they can’t afford that house when the market goes down.

The global financial crisis was just an incredible shock, especially here in the US, where real estate was the bubble and this was an important setback to that very important aspect of people’s liabilities or their retirement ultimately. After that, what I observed is that investors are much more sensitive to path. They’re much more sensitive to downside, in particular. They want asymmetric return. They think they can get them for free, but it doesn’t always work that way. What they basically are expecting is free insurance against a fall in the market, but unfortunately, any insurance you have to pay premiums for.

But that’s a big shift. I think that is really driving a lot of the focus on path right now. The research in how to manage portfolios to an acceptable path and the way portfolios are actually being structured, a lot of factor-based portfolios. There’s smart beta portfolios that are thought to be less risky because they have better path exposures than a lot of other portfolios.

I don’t know that’s going to necessarily be a smooth transition out there, but it’s definitely something that is important in the industry from a behavioral perspective, and we see changes in the way portfolios are managed, and we’re seeing changes in the research and analysis behind all of that, in part because of that change in behavior. I don’t think it’s going to go away. It’s one of those things that I think a lot of investors will carry through them. A lot of Baby Boomers in the developed world, it will carry through them all the way up until the grave.

Daniel: That’s a very interesting observation. I think it’s also a challenge for the industry because a lot of it hasn’t thought enough about that path issue. It’s a challenge, but also an opportunity to create new and better strategies to help people deal with those issues.

Brian: I think it very much is. Like all things, it’s a challenge and, at the same time, it’s an opportunity. It’s always the flip side of the same coin. There will be a lot of mistakes made along the way as the industry slowly improves it its capability to do these types of things.

Daniel: Okay. I wanted to ask you very briefly about an interesting book that you wrote: Investment Leadership and Portfolio Management: The Path to Successful Stewardship for Investment Firms. It’s an interesting book. It has some good ideas on how to structure an asset management business. I found it very helpful. Where did the idea for the book come from?

Brian: It’s interesting. It really popped out of a very important short period for me as a leader. That was the integration of three firms in the end where there was Brinson Partners that had been bought by Swiss Bank, and then UBS had this entity, I think it was UBS, in the UK, in London, called Phillips and Drew, and then there was the Swiss entity. Ultimately, we ended up with these three entities: Brinson Partners, Phillips and Drew, and Swiss Investment Management. I referred to them ultimately as the three tribes. I had three tribes in my team. I had to figure out how to actually lead three tribes as a single unit. You can’t.

You need to have them all as one tribe. That was very fundamental in my thinking because I learned first that the most important aspect of any investment team is culture. I think that’s the type of thing that Ray Dalio often says is the importance of culture at Bridgewater. I think it is true. Not every person is suitable for every different culture, but the culture is a critical aspect of leading a team and ultimately you can’t dictate the culture. The culture is something that emerges over time and that dictates behaviors. It’s important to realize that the culture changes first and everything else follows on.

What I then had to do when we had the three tribes was come up with a way of ultimately slowly evolving that to a single culture. That involved a lot of work in terms of helping us all understand what were common elements of our thinking, that we could all circle around. Things that weren’t necessarily common elements of what we were thinking, but we decided we would agree that those would be appropriate things to pursue. Then there were things that were not a part of that cultural entity and there were people who were not a part of that cultural entity and those were the ones that had, ultimately, individuals and ideas, that had to disappear.

That was the starting point of guiding a culture to evolve that ultimately became then, as a leader, something that was actually leadable. It was that transformative event for me that ended up being behind a lot of the thinking in the book. There is a lot, as we chatted earlier about, arguing, discussion, constructive or destructive criticism. However you want to say it. That’s an important aspect of the culture of a team. All of it boils down to, in some form or fashion, an effective leader has to ultimately make sure that culture is sustained, it’s well grounded, individuals are actually on board with that culture. If they’re not, then they’re not a part of the team.

And at the same time, leading individuals from the perspective of their own aspirations, their own careers, their own interest in what they’re doing. I often say in bringing people on, it’s my job to keep them on the team. It’s their job to try to find a better offer in the market. I’m only successful as a leader to the degree that I can make sure that their marginal benefit, whether monetary or not, is greater in this team than going someplace else.

I think it’s generally worked, given the fact that this team has been together for such a long period of time, despite actually leaving UBS and now ultimately coming over here to William Blair, where we felt the culture was much more amenable to our team’s culture. That was pretty much it. That was the foundation of all of it. The rest of the ideas ultimately sprung from that other things that we found important from a leadership perspective over the years or decades even.

Daniel: Your comment about how you see your challenge as a leader is refreshing and a very positive way to look at it, in that you recognize that if you’re hiring smart people, they’re always going to have options. So, your mission is to make sure you’re giving them the best option. I think that’s a really great way to look at it. I think a lot of people can take some hints from that.

Brian: I think you’re right. It’s one of the things that I think on an individual level that helps do that is actually something I learned from my Dad. Oddly enough, he taught management at a university down in Tennessee. His was associated of management of education systems, whereas this is something different. But one of the things we’d often talk about is authority and accountability or authority and responsibility have to always go together. You’re going to have good people. You’re going to hold them accountable for things.

You have to give them authority over those things before you can actually viably hold them accountable for those things. When you give people authority over things and you meritocratically hold them accountable for that authority, that is something that is a powerful motivator in a positive way. People know they’re here because they’ve earned being here and they feel like they are an important aspect of a process. They’re just not somebody hanging along for the ride when they are given that authority. Even if they’re young, as long as that accountability goes right along with it, I think it’s something that does work quite effectively.

Daniel: I agree wholeheartedly. I think people self-sort. If you give them that authority, you’ll generally find that people put themselves into one of two categories. The category that you want to see is they’ll grab it with both hands and their motivation and their work ethic will just go up exponentially because they feel that they’re empowered to do interesting things. Then you’ll have the other group that will basically take advantage of it and use it as an excuse to slack off and then try to dodge the accountability. But either way, people sort themselves out pretty quickly.

The interesting thing about that is that you are not categorizing people, they’re kind of categorizing themselves through their behavior. You find that out basically by trusting people and letting them have a go.

Brian: Let them have a go at it and hold them accountable for it. If you don’t let them have a go at it, they quickly become bored. Boredom, I think, is probably a much bigger risk for me with an employee than compensation. Often, people will say compensation. We’re not poorly compensated in our industry, generally speaking. While many people will move for high comp, generally speaking, surveys will show that there are other motivations that often supersede compensation and feeling empowered and not being bored really are the things that run up to the top of the list.

That allocation or the giving of authority to individuals is really important in giving them that empowerment and keeping them engaged and not bored.

Daniel: Where does the job of an investment committee or board begin and end in the investment process?

Brian: I’ll start with board and then we’ll work our way to investment committee. Generally speaking with a board, your primary focus, I believe, is staying out of management. You’re not a manager, you’re a board member. That involves creating a broad strategy and bringing in a CEO to make that strategy happen or bringing in a CEO who is an integral contributor to that strategy and can actually execute it on a managerial level. In that sense, the board really needs to take a step away from. They’re not doing the day-to-day decision making in the portfolio.

Similarly, with an investment committee, an investment committee shouldn’t be making day-to-day decisions in terms of managing a portfolio. The investment committee is something that ultimately can provide that group feedback that I like in terms of making decisions, but it is, I believe, a step removed.

Often, it’s involved with a CIO, a Chief Investment Officer, just like a board would be involved with a CEO in the way they have a relationship, the investment committee and the CIO have a very unique relationship in terms of creating an environment where each portfolio manager and each analyst or each researcher can thrive, as opposed to sitting around making all the decisions with respect to a portfolio’s positioning.

Daniel: Okay. Very interesting. You’ve been in the industry, you said earlier, for 35 years. You’ve worked with some great people. What traits do good investors share?

Brian: It’s interesting what you find over time. It’s actually something you can, in many ways, learn or adopt. What do they share? A voracious appetite for reading. A voracious appetite for reading is something that is incredibly important. I don’t mean reading newspapers necessarily, or broker reports. It’s reading broader ideas that can have a significant influence on the way you think about investing as opposed to what you may think about this individual stock or that individual currency.

The second thing that I believe is important is the ability to create a probalistically calibrated assessment of the future, whether that future is 10 years or 20 years from a policy perspective, or shorter term in nature from an investment strategy perspective in the short run. It’s that calibration that is ultimately very important. That is something that is a learnable tool in terms of using an assessment of what else is going on and has gone around the world that’s similar to this that helps calibrate.

What’s unique about this what will ultimately perhaps modify my assessment of the future and, at the same time, be calibrated so that when I say there’s 70% likelihood of something happening, 70% of the time I’m actually right about that. When I say it’s 50%, it’s really pretty random and it comes out to be random and therefore I’m very calibrated. We see that calibration as something that’s important and it is something that is learnable. It is, however, something that most people don’t learn.

The third thing that I think that’s very important is the ability to change your mind. As I think it was Canes, “When the facts change, I change my mind. What do you do?” That’s really important from an investment perspective because investors often get wedded to a decision. You buy a car, what do you do? You come home and you tell your friends how great your car is. All you’re doing is selling the car to yourself. You’re not doing anything else when you do that.

You’re becoming attached to it in a sense that is inappropriate as an economic entity that the type of attachment you would need or want to have as an investor. Those three things. This voracious reading, appropriate calibration with respect to probabilities of the future – and that, again, is something learnable – and then lastly, the ability to change your mind when the world around you changes and not make yourself beholden to some past idea that you may have had.

All of those things are learnable. They’re all learnable. It’s just that generally speaking, investors don’t learn them. They don’t even try to learn them. They don’t even know to learn them. It’s the ones who can do it naturally that find themselves to be successful and the others just never went about the business of pursuing those things and improving in those three dimensions.

Daniel: Okay, that’s great advice. I don’t mean to put you on the spot here, but if you can think of an example, I think it would be great. If you can’t, that’s okay. What’s an occasion when you had to change your mind about something that may have been a little hard to do at first?

Brian: I think perhaps the biggest in my career and one that I think most people can understand in the industry today, was looking back at central bank activity after the global financial crisis, when central banks just aggressively pursued ultra-easy monetary policies throughout the developed world. My training, my understanding of economics, my understanding of monetary theory suggested that would be inflationary. If, in fact, something like that is inflationary, the right thing to do, generally speaking, is to be short bonds, not long bonds. To actually have a short position in bonds.

However, one of the interesting aspects, not to get too deep in the weeds, is that I understand money to be something more of an endogenous thing, endogenous to the system, not just exogenous from the perspective of money thrown at the system. Money can be thrown at the system right, left, and center; however, if there is no credit that evolves from that, there is no lending that evolves from that, it vastly diminishes the influence that expanded balance sheet ultimately has because monetary policy ultimately becomes less stimulating than it was intended to be.

It’s hard to, as I had to do after the global financial crisis, starting out short bonds in the portfolio, to say I’m wrong. Ultimately, I may be right. I may be the perfect stopped clock, but in this environment where credit is contracting in such a way that it is sufficiently offsetting the ultra-easy monetary policies, we’re not going to see inflation. And two, the longer this goes on, the more likely we are to see more debt deflation emerging and some of the price inflation dissipating a little bit.

Those are the type of things that I ultimately had to say I’m wrong. This is the right way to see it. It wasn’t the way I originally saw it. Get out of the short positions in bonds and move on. We did that ultimately several years ago and it was the right decision over the last several years. It was a very good decision to say I’m wrong. The question is now to come back and say when, if ever, when does a normalcy of monetary policy, monetary theory come back into fore?

Or do we basically have to say it really is different in terms of the way it propagates through the system as the financial system has evolved today, to integrate with monetary policy and create this concept of endogenous money? But that was it. I think that’s the biggest one. It was a tough one to swallow because that’s such a fundamental aspect of so many people’s thinking, including my own, to say that this ultra-easy monetary policy may not be as easy as I originally thought it was.

And it may not be as inflationary as I originally thought about it, and there may be other supply-side influences that are coming in and also perturbing any potential increase in inflation over time. Get out of the position. It’s just the wrong position.

Daniel: Thank you for sharing that. I think that’s a great example. I’m guessing you can to that realization after a period of wrestling with it for a while and sort of flipping back and forth between opinions. Would that be correct?

Brian: It unfortunately took some pain. I always wish that over the years of doing this I had enough wisdom not to be caught out in things like this. But in the end, it doesn’t matter how much knowledge or wisdom you have, you’re going to do things that are wrong. You’re going to analyze things and find out the analysis is wrong and come back and say oops, it’s wrong. The only time you’re ever going to say it’s wrong is if it proves to be wrong in terms of performance. In other words, you’ve got to have some pain, generally speaking, before you’re going to jump in and say, oops, I’m wrong. So, it’s a tough time. It’s a little bit of soul searching going on with each of those decisions to change the way you think.

Daniel: I think that’s a very important reminder that at the end of the day, markets are made up by people and behavioral influences, as much as we try to control them by using algorithms, computers, and other things, they’re always going to remain a very large part of investing. That’s basically why you have a portfolio and why you diversify, to create an investment strategy that can survive inevitable mistakes. Mistakes are inevitable because we’re dealing with the future. It hasn’t happened yet. You can’t analyze it like it’s happened.

Brian: Think about it. If you’ve got a 10% investment with a 15% volatility, you should expand to have down 15% years, if that’s the annual volatility that you’re looking at. That’s the type of thing where people don’t really understand. It’s a 10% return, but somehow this concept of risk just disappears. It’s still out there and it’s still going to cause some very difficult extremes for people.

Daniel: Definitely. Well, thank you, Brian. It’s been a pleasure chatting with you about all things markets and finding out more about the early years in your career and what you’re doing with dynamic asset allocation. Thanks for coming on the podcast.

Brian: Thanks, Dan. Really appreciate it. It was quite fun. I really enjoyed doing it.