Podcast Summary
Mutual funds' role during market turmoil: Despite concerns about the impact of modern investment vehicles like ETFs on financial stability, no major structural problems have emerged yet. The Kennedy Slide serves as a reminder of the evolving role of investment vehicles in financial markets.
The role of mutual funds in the financial markets was tested during the Kennedy Slide in 1962, when there were concerns that these new investment vehicles could worsen a stock market crash due to their ease of liquidity. However, mutual funds ended up supporting the market by buying stocks during the decline. Fast forward to today, similar concerns exist about modern investment vehicles like ETFs and their potential impact on financial stability during market turmoil. Despite the rise of passive investing and the increasing size and liquidity of these funds, no major structural problems have emerged yet. However, the construction and benchmarks of these open-ended funds continue to be topics of discussion and concern. A notable example is the concern over the connection between junk bond ETFs and the underlying junk bonds during the late 2015 market volatility. Overall, the Kennedy Slide serves as a reminder of the evolving role of investment vehicles in financial markets and the ongoing importance of understanding their potential impact during times of market stress.
Misrepresentation of High Yield Fund Redemptions in 2015: Despite a high yield fund experiencing redemptions in late 2015, it did not reflect the overall market situation as there were no similar funds facing similar issues.
The Third Avenue Focused Credit Fund, a concentrated portfolio of high yield and distressed securities, experienced redemptions in late 2015 that caused market anxieties, but it was a misrepresentation of the overall market situation as there were no other similar funds. The fund was created to offer investors an alternative to hedge funds and private vehicles in a public format. The idea for the fund originated during the 2008 financial crisis when the team, previously focused on publicly listed equities, saw an opportunity to offer access to a concentrated portfolio of these assets in a liquid vehicle due to the safety of being higher up in the capital structure. The redemptions from the fund did not represent the market as a whole, but it did reflect investors' anxieties about liquidity and the potential risks of mutual funds and ETFs. The former CEO of Third Avenue, David Barrett, will be discussing his experiences at the fund, his opinions on liquidity and index investing, and his new venture on the show.
Identifying Opportunity in Distressed Assets during Financial Crisis: During the 2008 financial crisis, our interviewee identified a valuable investment opportunity in distressed assets but faced challenges in raising funds due to lack of track record and investor preference for daily liquidity. They launched a mutual fund to tap into this underserved market and were successful despite concerns over liquidity mismatch.
During the 2008 financial crisis, our interviewee identified a valuable investment opportunity in distressed assets, specifically high yield bonds. However, they faced the challenge of raising funds in a public format due to their lack of a track record in private funds and investors' preference for daily liquidity in an industry where distressed assets don't trade as easily. They launched the Third Avenue Focused Credit Fund in August 2009, becoming the only mutual fund to do so in that format. Despite the challenges, they saw the opportunity in a unique and underserved market and were successful in attracting interest from investors. However, the issue of liquidity mismatch between investor expectations and the nature of distressed assets was a concern they acknowledged from the beginning.
Lessons learned from launching a high yield mutual fund: Maintain a diversified portfolio to manage risk effectively in publicly traded funds. Local insights and global expertise are crucial in real estate investing.
When managing a publicly traded fund with daily liquidity, it's crucial to maintain a diversified portfolio to manage risk effectively. This lesson was learned during the successful yet challenging launch of a high yield mutual fund in late 2009, which reached unprecedented growth despite economic uncertainty. However, the fund's demise was not due to market volatility but rather poor investment decisions. If faced with the same situation, the advice would be to either raise a private fund or, if managing a public fund, ensure a massively diversified portfolio. This approach has become the norm in the high yield market, with most funds tracking the index through broad portfolios. As a leading real estate manager, Principal Asset Management emphasizes the importance of local insights and global expertise in uncovering opportunities across various investment formats. While concerns about credit market liquidity persist, the impact has not been significant enough to cause alarm.
High Yield Market's Resilience and Evolution: The high yield market has proven its resilience, with energy driving demand and successful navigation of past crises, while Outvest Capital focuses on excluding assets for a unique investment approach in response to index funds' dominance.
The high yield market has proven its resilience in the face of challenges, despite traditional concerns. The market has evolved to become more stable, with energy being a significant sector driving demand for securities. The successful navigation of past crises, such as the energy sector downturn, provides evidence that the market structure generally functions effectively. Looking ahead, Outvest Capital, a new venture by David, aims to capitalize on the most forward-looking risks for investors: technological change and the continued growth of passive index investing. Outvest's unique approach focuses on what to exclude from a portfolio rather than what to include, as the market has shifted towards index funds becoming the market standard. While there isn't extensive academic research supporting this strategy, Outvest's white paper presents an alternative perspective on investment processes.
Identifying Disrupted Companies in S&P 500 using Tech Advantage/Disadvantage: Using tech-driven approach, eliminate disrupted S&P 500 companies for outperformance, focusing on eliminating losers rather than picking shorts.
The discussed investment strategy involves using a technology-driven approach to identify and eliminate companies in the S&P 500 that are likely to be disrupted by technology. This process, which has already resulted in outperforming the S&P by around 500 basis points in 18 months, divides the index into industry groups based on technology advantage or disadvantage. Qualitative industry decisions are made first, followed by quantitative analysis to determine if a company or industry group should be included or excluded from the portfolio. The strategy aims to be scalable and is different from traditional long-short portfolios, as it focuses on eliminating potential losers rather than actively selecting shorts. The example of General Electric's rapid decline underscores the importance of this approach.
Identifying tech-advantaged companies within disadvantaged industries: Active investing allows for exclusion of underperforming tech-disadvantaged companies and inclusion of financially strong tech-advantaged ones within industries, providing potential for outperformance while maintaining diversification.
While certain industries may be disadvantaged by technology, individual companies within those industries can still hold advantages based on their financial data. For instance, retail companies as a whole may struggle with technology, but companies like Home Depot, which exhibit different financial characteristics, can thrive. The quant screening process can help identify these companies and keep them in the portfolio, while excluding disadvantaged ones like GE. Passive investing, which follows benchmark indices like the S&P 500, makes adjustments to maintain diversification and broad representation of various sectors. By tweaking the index and excluding underperforming companies, active investing can offer the potential for outperformance while still maintaining a diversified portfolio.
Consider what to leave out in portfolio instead of what to add: Emphasis on identifying and investing in companies that can transform themselves to be long-term winners amidst technology disruption
The asset management industry places a strong emphasis on consistency and adapting to changing indices. However, the speaker argues that instead of focusing on what to add to a portfolio, there is an opportunity to consider what to leave out, specifically in relation to technology disruption and its impact on industries. The speaker's experience at Third Avenue and the shift towards lower-fee investment vehicles led them to believe that this approach could attract flows and differentiate their fund. The concept is centered around long-term secular decline triggered by technology disruption, with the ability to quantify this risk being a key point of interest. For example, the temporary outperformance of department stores may eventually give way to secular decline unless they adapt. The goal is to identify and invest in companies that can transform themselves to be long-term winners.
The Importance of Diversification in Today's Investment Landscape: Investors should consider broad index funds or ETFs for their portfolios instead of traditional concentrated fund management strategies to ensure diversification and avoid underperforming stocks. Public-facing, open-ended funds must also be diversified to prevent quick money withdrawals from angry investors.
Key takeaway from this conversation between David Bars, co-founder and principal at Outfest, and hosts Joe Weisenthal and Tracy Alloway on the Odd Lots podcast is the importance of diversification in today's investment landscape. With the rise of passive investing and massive flows into passive or passive-ish vehicles, the traditional concentrated fund management strategy, particularly on the equity side, is no longer effective. Instead, investors should consider broad index funds or ETFs for their portfolios, as they offer similar beta and diversification. The idea is that investors may not get fired for missing out on a few underperforming stocks, and if those stocks do turn around, they can be added back on fundamental reasons. The hosts also discussed the link between this notion and the collapse of Third Avenue, emphasizing that public-facing, open-ended funds must be diversified to avoid quick money withdrawals from angry investors. The hosts also announced a new podcast, Money Stuff, where Matt Levine and Katie Greifelt will discuss finance and other money-related topics every Friday.
