Passive benchmarks can concentrate risk as small caps change

Transcript

From the transcript How I Invest publishes with the episode.

1. 2:06

   Now on the other side, as a CIO, how important is being in the right market for a fund manager, and how do you assess that as part of a fund manager success? I don't even know if I'd say it was a bad market so much as just people were deciding they were skilled enough to pick their own hedge funds, but then when they were picking their own hedge funds, they were kind of sorting by AUM or brand name and starting from the top.

2. 2:30

   And so if you had a small hedge fund or a fund of funds is you're neither, and so that, you know, the industry kind of went went the way it did. And now now that we're here and we're you know, we've developed our beliefs in advance of making investments, we iterate on our beliefs. And one of our beliefs is that, you know, the the I mean, I guess two of our beliefs come to mind, but one is that mean reversion is real.

3. 2:53

   It may not seem like it, and public equities, The US stock market, etcetera, but especially active management, you know, it comes and goes in waves for the most part, especially if it's a meaningful in size, you know, very low small numbers, very low vol that might be persistent. But everyone wants higher returns, tends to come with some vol, and it tends to come in waves. And so you should be looking at or investigating either managers or markets that have been out of favor or are down and out.

4. 3:21

   And where do you sit on this active versus passive debate, and what are the variables that you're looking to ascertain the market, whether you should be more active or passive? We we have some passive that can be useful for, you know, liquidity sleeve. But if you don't have a huge concern around tracking error and you are, what I'd like to say is, like, you know, people refer to the total portfolio approach or, you know, being outcome oriented unless benchmark driven.

5. 3:46

   You look at passive benchmarks. They're sort of a active decision and that you chose to participate in passive. They tend to be momentum in nature, and each cycle, they tend to become more and more concentrated or less diversified. And if the idea is that it's, supposed to be mitigating risk, I think the only real risk it mitigates is, maybe career risk or, you know, benchmark relative risk. And, but it you know, on the other hand, it may give you back some bandwidth or spare you the headaches of active management.

6. 4:18

   We kind of took a middle ground approach where we do have some passive, but we have a lot of what we call rules based strategies in especially in public equity. And that, for example, what, you know, you think of, like, value, momentum, quality, weight those a certain way, hold a certain number of names. You're getting broad market exposure. You're getting a beta of one. You're screening out, you know, bad companies, including companies that aren't terribly expensive and have some momentum.

7. 4:44

   And that seems to me to be a a low cost kind of reasonable approach to diversification that while it does include some tracking error or career risk, I think it's from a total portfolio perspective, it's a better trade off. And Fama French came up with this three factor model. Ken French was my professor in business school, which basically weighed at small in value stocks versus, I guess, the opposite is growth large in growth stocks.

8. 5:09

   Do have philosophical stance on where the future of the public markets are? Some people say value is a thing of the past. What do you say? I I think value is will make its way back, but I think it's, you know, it's something that isn't you know, it is mean reverting. It is cyclical. We're in a really long kind of odd cycle, I think, in terms of the value versus growth. It you know, what happened in the nineties, it was pretty long.

9. 5:34

   But sit post GFC with monetary policy and then now with the AI and, you know, the excitement around AI, I think it's just extending that cycle. Something I'm more convinced of is that the small cap premium, I think the market structure has changed, and I'm not sure the small caps of today are the same as the small caps of years past. There's been decent amount of ink spilt on this, And I think that's one area where I've we've changed our minds on thinking that, you know, because small cap has been out of favor and because valuations have been more attractive, that that should be a, you know, a long term overweight.

10. 6:09

    So in small cap land, we're looking for things that can do that, and that means, you know, concentrated, you know, micro caps that you hope get taken out or, for example, we have biotech hedge fund exposure as part of our small cap exposure. The CIO of Hurdle Callahan, Brad Conger, and he actually believes that small public companies are fundamentally different than they were a decade ago. What does that mean?

11. 6:34

    A lot of them are fallen angels. They were SPAC targets or direct listings that fell down or they're public companies that are now small. And then to to the second point of that is there's some companies that should never be public companies via SPACs or other metrics that are that constitute the rest of some of these small cap companies. So it's not truly smaller companies. The true smaller versions of the large public companies are actually still private companies in their middle market or large buyouts.

12. 7:00

    I agree with that. And another maybe way of saying the same thing is companies used to go public earlier, so they were small cap ish when they went public on average, and they might have been great companies that grow over time. And that that's just not the case as you highlighted it. There's just fewer of those strong companies with momentum going public at small size. They go public at massive scale.