Underperformance, high fees and tight regulations are creating an environment ripe for disruption. I am constantly on the lookout for innovative technologies and business models that address the inherent problems of asset management. I recently had a conversation with a former colleague from Bridgewater Associates, Maneesh Shanbhag who founded Greenline Partners, a progressive asset management firm aiming to help investors keep a higher percentage of their returns by managing not only for performance, but also for tax and operational efficiency. A self-described engineer with a passion for efficiency and elegant simplicity, Maneesh defies the stereotype of a typical hedge fund manager. Maneesh left a promising career at Bridgewater Associates where he advised institutional investors on portfolio allocation to be an asset management entrepreneur. Maneesh shares that he did not get into this business to get rich quickly but to create a back to basics investment model that generates value for his clients at a lower cost. He and his partners at Greenline currently manage $100 million of assets under management (AUM) for private investors and foundations and have consistently outperformed their peers on a post-tax bases.
Katina Stefanova: The two most overused terms in the investment management industry are probably diversification and long-term investing. Some investors think of diversification as holding lots of different funds. But more often than not, these funds tend to have similar exposures (e.g. large cap and small cap are still all equities) or worse hold many identical positions, and hence are not diversifying to each other at all. Similarly, the way investment managers urge their clients to invest long-term is by subjecting them to the huge swings of markets and begging them not to sell after losses. The latter approach is disastrous to investors. The result is often unsatisfied clients who end up selling their investments at the worst possible time (after large losses) and frustrated advisors and portfolio managers. In this scenario, everybody loses. Diversification and thinking long-term are the most important concepts in investing but investment managers can do a lot more with properly applying these concepts and just as importantly educating their clients about what they really mean. What is Greenline’s approach to addressing these issues?
Maneesh Shanbhag: Everything an investor, individual or institution, really needs to know boils down to understanding one thing, compound returns and how they work over the long term. The difference between a portfolio growing at 10% versus 8% per year is tremendous overtime. It doesn’t take much to see how this seemingly small 2% annual difference turns into 3 times more money after 50 years. It’s no wonder that Einstein described compound returns as the eighth wonder of the world.
Arguably the most powerful trend in the industry right now is the move towards passive, low cost investing via index funds and ETFs. One can see from the chart above how reducing only unnecessary fees by 2% (the amount the average retail investor saves by moving from traditional actively managed mutual funds to low cost index funds) can have dramatic results over the long-term.
Stefanova: Institutional investors are making similar moves with the recent announcement by the largest pension plan in the US, CalPERS with almost $300bln in assets, that they will be eliminating their allocation to hedge funds due to poor performance. This poor performance was undoubtedly driven in large by the high manager fees and the poor diversification that hedge funds offer. What is your perspective on the trend of institutional investors moving away for hedge funds and managing their asset directly?
Shanbhag: Both costs AND diversification drive long term compound returns. Investors need to do everything in their power to prevent anything from disrupting the power of compounding. From where we sit, focusing on investment management fees is only scratching the surface of how most investors disrupt their own compound returns and therefore fall short of meeting their goals and liabilities. As described in this article on Forbes in 2011, investment management fees are one of the smallest headwinds investors face. In fact, trading costs and taxes eat up even greater shares of returns than fees. This is true for individual investors and institutions alike (albeit many institutions do not pay taxes but most still incur extremely high transaction costs by hiring rapid fire hedge fund managers).
Stefanova: We are potentially nearing the end of an unprecedented bulls market in equities during which many funds rode up with beta growth. However, this trend is about to end and returns will be harder to generate. What are the most dangerous mistakes investors should avoid right now?
Shanbhag Taxes are particularly interesting because the incentives of the investment industry are at odds with tax efficiency. Wall Street gets paid more when investors trade more, while investors earn higher returns when they trade less. Also, setting up a portfolio correctly at the onset can prevent large irreversible costs down the road. When an investment advisor or consultant recommends a hedge fund with high fees over buying and holding a diversified portfolio of stocks or bonds, they are betting that the hedge fund can overcome its high trading costs and tax inefficiency, consistently, over many years. While many look at the hurdle that needs to be overcome as simply the hedge fund fees in a single year, from our research on looking at this calculus over multi-year time frames and incorporating the impact of taxes, we find the average actively trading hedge fund would have to more than double the returns of that of buying and holding stocks to outperform over the long run. It all connects back to understanding long-term compound returns and minimizing everything that can reduce them..
In this example, making that tax inefficient investment in the hedge fund, would set this investor back so far after a few years that there would be no chance of ever catching up with their more tax efficient peers. Not thinking about how an investment decision may impact their compound returns over the long term is the biggest mistake investors make and the resulting underperformance is also the biggest risk investors take.
Stefanova: I completely agree with you that investor and asset manager incentives are often not well aligned. I have been writing about the need of asset management industry to change through greater transparency and better alignment of incentives. Why do you think such discrepancies exists in asset management?
Shanbhag: I will use an analogy from a different industry that is undergoing tremendous change for the better. The food industry is in the midst of a huge shift as consumers have been reminded of the benefits of unprocessed foods. Ofcourse this hurts food marketers as profit margins are highest on the most processed foods. Why sell an apple a day when you can convince people that a chocolate and whey protein smoothie with added Vitamin K, at $10/glass, is healthier? The most nutritious foods are the least processed. The same is true with investing. The most transparent and least actively traded strategies are often the best for investors. The rest is just sales gimmicks. For example the new crop of online wealth managers is touting their improved diversification and other features such as tax loss harvesting. But to us, the size of these benefits is being way oversold as they are mostly gimmicks and not (yet) adding value over what, say a Vanguard already offers private investors.
In the institutional world of pensions and endowments, our experience has been similar. Institutions found out the hard way in 2008 that the so called best hedge funds and active managers they were sold did not provide adequate diversification as all of them went down together. Institutions are learning the same lessons as private investors, that beating markets is extremely difficult and asset allocation is the most impactful decision they can make. A portfolio of only a small handful of individual stocks and bonds, held directly can be far more diversified and also lower cost to hold than large list of funds with overlapping positions.
Stefanova: What trends do you see are changing the investment management industry for the better?
Shanbhag: The move towards low cost investments is only the beginning of a far more important realization by investors of all sizes and sophistication levels that beating markets is difficult. The incentives of investment managers are more at odds with their investors than realized. Many continue to play on the fear and greed emotions of investors in order to capture the higher fees of active management.
Just as in any other industry, smart consumers have driven the trend towards indexing and increased the cost pressure on traditional investment managers who have failed to deliver any value add. More and more investors are coming to the conclusion that the world is not predictable, and that they are more likely to lose by trying to predict the future. This is a challenge for most of the industry which has positioned itself as being able to predict the future through active management. Again consumers on the leading edge will drive the next push towards smarter, more diversified asset allocations that are low cost and tax efficient to buy and hold.
Stefanova: The rise of the ETFs and Index Funds is an example of investors becoming more intelligent about not paying high fees for passive management. What is Greenline about and why is it different than most other actively managed hedge funds or passive funds?
Shanbhag The math of growing and preserving wealth is straightforward – to earn a higher return net of all costs (including taxes) than inflation. Historically a little less than half the return from stocks and bonds was eaten up by inflation. It only takes a back of the napkin analysis to see that if an investor is paying more than half their returns to taxes and fees, then the chances of them preserving real wealth is quite slim. Reducing your taxes and deferring their payment for longer is a far more dependable way to growth your money than trying to beat markets (even ignoring the headwind of the higher fees and worse tax consequences that often result).
This is why we think of our approach to investing as improving efficiency. Efficiency is just another way of saying we remove the hurdles to compounding returns, NET of all costs. Even popular index funds can be improved upon by holding diversified portfolios of individual stocks and bonds that are EVEN LOWER cost, to hold, more diversified and can be more tax efficient as well.
Stefanova: Maneesh you left one of the most established and well known asset managers, Bridgewater Associates, three years ago to try to make it on your own. What is it like to be an asset management entrepreneur?
Shanbhag I have found lessons from very long-term thinkers like Jeff Bezos at Amazon and Warren Buffett to be the most helpful: Create something profoundly valuable and relentlessly focus on your clients. People who enter our business with their first goal being a personal profit motivation would never create a back-to-basics investment approach like we have. One that is driven to do the opposite of what our industry incentivizes, minimize trading (to maximize net returns), maximize transparency (to reduce unknown risks and give clients real insight into their investment returns), and offer impactful customization (which is not as scalable as simply buying a few ETFs). It is rewarding to be able to provide significant value to clients, in our case through superior efficiency and portfolio construction.
Stefanova: Thank you for your time and perspective.