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Gaming Financial Management July 1, 2006

Posted by federalist in Finance.
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In the Wall Street Journal today Ron Lieber described Randy Kurtz’s RK Investment Advisors, a money manager with a novel product: He will invest client’s money in separately managed accounts. The core holding of every account is an S&P500 ETF. To quote from the article:

“Then, he plans to pick a couple of stocks each year and invest no more than 10% of his clients’ funds in each. … For his efforts, Mr. Kurtz keeps one-third of all returns above and beyond the return of that index. … If the portfolio doesn’t beat the benchmark, he earns nothing.”

Sounds great, right? You get your beta and, if he’s a great stock picker, you also get the alpha from that. And if his picks go south, presumably he’s in a lot more pain than you, because he gets nothing – not even a management fee! Could incentives be any better aligned?

The answer: Quite. In fact, Randy Kurtz’s money management plan is nothing but a legalized form of three-card monte. If I’m in his position, here’s how I play it: First of all, I spend $10 in commissions to get each client’s money into the ETF in a margin brokerage account. Then at random I pick a high-volatility stock or two, which I buy on margin. The trick is that I pick different stocks for each of my accounts. Then all I do is wait. Some stocks will outperform tremendously, and I will share 33% of their profit (above the relatively low cost of margin, trading, and the ETF management fee). Some stocks will tank, and I personally lose nothing. Essentially, I’m playing the lottery but somebody else is buying the tickets! Of course, my losing clients will probably leave. I may even encourage them to. After all, when I’m trolling for new money I would like to say that I have made outsized returns for the majority of my clients. I will sweep my losers under the rug and polish my winners to attract the next marks. [Update: Mr. Lieber clarifies that Mr. Kurtz claims to hold the same portfolio across all clients.  While odd, this does resolve the moral hazard I suggest here. Please see Comments for further clarification!]

The asset management industry hosts plenty of swindles. I’m not talking about full-fledged frauds here – fortunately both the industry and the government do a good job of controlling those. Rather I am thinking of fully-disclosed financial products that would never be purchased by people who really understand them.

Deferred annuities were, until recently a good example of this. An annuity is a very useful and legitimate financial tool – basically a longevity insurance policy that prevents older people from outliving their savings. An immediate annuity is very easy to shop for: You just go to each qualified seller and say, “How much will you pay me for the rest of my life if I give you this lump sum now?” Deferred annuities go two steps further by allowing investors to take advantage of a number of “features” of the tax code to defer taxes as they save for an eventual annuity income. So in principle deferred annuities are a very good financial planning tool. In practice, by the time you take an insurance policy and roll it together with investment and tax features you end up with a product so opaque that it is very easy to obscure extraordinarily high commissions and fees from all but the most savvy consumers. If agents came right out and said, “You’re paying me a 50% commission on this, and the administrator is going to take a 5% annual fee for the life of the contract,” hardly anybody would buy it.

A lot of finance products are like that – the more shadows, the more money you’re bound to be paying the seller. In general it’s a very good rule to buy the simplest product you can. If someone wants to sell you a car coupled with a great adjustable-rate home equity line of credit that has a dismemberment insurance policy and life-time oil changes – with inflation and disability protection – all for a low monthly rate of $499, you should take a step back. There’s no reason that any of those things should be sold together. In theory maybe they could accrue savings by bundling those services, and pass some of those savings along to you. But even if they say that’s what their doing, odds are that they’ve tucked a little extra margin into each product because you have no way of unrolling everything to find it. If you actually want every one of those services it might, in the end, even make sense to buy them all at the same place, but you should shop for each one individually. Some people can’t be bothered to think through each feature separately, and they’re going to end up paying for the convenience of ignoring those details. How much will that lazy ignorance cost them? They will probably never know.

Mutual Funds

Mutual funds are one of the time-honored swindles of the asset management industry. There are magazines, books, and investment advisors all making money off of the idea that it is possible to pick one mutual fund that will outperform something – a benchmark, a peer group, whatever. And there is a fund marketplace of thousands of mutual funds, all charging different fees for, in effect, doing the same thing. Ample research has established that benchmarked mutual funds underperform their benchmarks, on average, by exactly the amount of their management fees. I.e., the mutual fund industry just sells you the performance of the market and charges you their management fee to do so.

There was a time when this was, perhaps, legitimate. There weren’t always gobs of index funds and exchange-traded funds out there with 10bp annual fees; individual investors weren’t going to run out to buy index options or futures to get their beta. But today? There’s still this industry dedicated to the idea that people can predict in advance which mutual funds will outperform. Of course, in any pool of managers some will do better and others will do worse. There’s a big post-selection bias, because funds of funds can close their underperforming funds and open new ones to take their place. It’s a wonder that a shop like Fidelity doesn’t have a stable of entirely 5-star mutual funds. I also suspect, though I haven’t verified, that many less reputable managers back-date their benchmarks. Did you underperform the S&P 500? Oh, well, maybe you outperformed the NASDAQ 100.

Index funds excepted, the mutual fund world still suffers from two major flaws: 1. You don’t pay for performance, and 2. Everyone pretends you can pay for performance. A number of funds have recently made concessions on the first point, but they’re generally pathetic. E.g., they’ll take an expense ratio around 1.5% and make adjustments on the order of basis points for outperformance on the order of basis points. They gloss over the second major problem, which is that in a lot of these asset classes there is no reason to believe that these mundane long-only strategies have any potential to outperform. In other words, all they do is bring in management fees that should really stay in the pockets of investors (who should move their investments into low-fee index funds) while the fund managers go out and get economically productive jobs.

By this I do not mean to suggest that asset management is inherently unproductive. The efficient allocation of assets is one of the most important and noble callings in a capitalist society. People who are good at asset allocation have the potential to make enormous sums of money, but they earn it. (In fact, their compensation is directly tied to how well their allocations served the market’s efficiency.) A worthy asset manager doesn’t just collect money and leech an annual fee off of the pile regardless of what he’s doing with it.

I should also admit that I still own some mutual funds. I do so to get exposure to asset classes I can’t find as cheaply any other way. For example, right now I own the Fidelity International Real Estate fund (FIREX). I’m not aware of any tradable indices on that asset class, but even if there is one, I suspect that at present any decent manager with access to the resources of a Fidelity has the potential to produce outsized returns (even accounting for the 1.3% expense ratio). I.e., international real estate is still an expensive asset class to enter, and I believe there are enough inefficiencies left that a strong informational advantage could be exploited by any decent manager. I have held the Fidelity International Small Cap (FISMX) fund almost since it opened for the same reasons.

Returning to the core asset classes – developed-country money, equity, and fixed-income markets: Do you want higher returns than indices offer? Then you have to be willing to do something other than buying the index and fiddling with it on the margins. If you concentrate your investments, you will incur higher risks but can get rewarded with the potential for higher returns. Also, you can pay a hedge fund manager with the expertise to execute more complex strategies – long/short portfolios, leverage, arbitrage, or exotic asset classes – and thereby increase your return/risk ratio above the level of the market. (But there’s no guarantee he will succeed, or that he even has the potential to succeed. So if you’re investing in hedge funds you had better have a great due-diligence team.)

Portfolio Management: The Second Game

There is one other swindle whose demise is overdue: Portfolio management. There are still tons of people out there paying 1-2% a year for management teams to invest their money in mutual funds! Portfolio design is a legitimate art, and uninitiated investors tend to do it quite poorly. But there is no reason the fees for this service should be so high, or even that it should be paid for as a percentage of money under management. There are really only three factors to be considered in asset allocation: Risk aversion, investment horizon, and tax status. And once a client has described his investment circumstances in those three dimensions, he has basically told you exactly how to allocate his investments.

If you have a client with a high current income and an investment horizon of over ten years, you put him in a standard mix of two or three domestic and international index funds. That’s a high-risk, low-fee, low-tax portfolio good for anyone in that situation. Maybe you diversify it with some REIT, commodity, or corporate bond ETFs, but that’s the end of the story. After that, it’s just rebalancing. And whether it’s one client or 100, with $50 thousand or $5 million each, you do exactly the same thing. So why are you charging each an annual fee that varies with their assets? You’ve picked your fund menu and your allocation ratios, so your only ongoing expenses are annual reports and rebalancing.

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Comments»

1. Randy Kurtz - July 3, 2006

This is Randy Kurtz, CIO of RK Investment Advisors. As we all know, most money management businesses CAN be set up to swindle investors. The trick is to find a manager whom you can verify is NOT a con artist. That being said, clearly the author of this piece has an agenda. Most of the money management establishment is against what I am doing, because I pose a very serious threat to the mutual fund business model. If you recall, the industry was very against John Bogle when he created Vanguard, for many of the same reasons. What the author should be writing about is how most money managers charge a hefty fee for UNDERPERFORMING the market. That is the real story here.

As the author noted in his/her update, I manage all of my accounts in the exact same manner, picking the same stocks for each client. Again, as noted in the article, this does remove the moral hazard that could be involved. Further, I manage my money, along with my family’s money, right along side that of my client’s. I am incentivized to not take unnecessary risks because of this. If I underperform, I get no pay. I only get paid for providing a real value for my clients. I challenge you to find another money manager who is more aligned with the interests of his shareholders.

I find it humorous that in the article’s update, where it mentions that my practice does remove the alleged hazard, the author calls it ‘odd’ that I have removed this hazard. The author seems to think that aligning my interests with those of my clients is odd. Hmmm. What I find odd is that a mutual fund has very little incentive to take the risks necessary to outperform. Rather, they are incentivized to hold onto client money for as long as possible, and sit back and garner the management fee year after year. By closet indexing, any manager can produce performance that roughly resembles that of a benchmark. Most clients will not leave a manager for such index-like performance. After taxes, the client usually underperforms the after-tax return of the benchmark. Thus, clients pay hefty fees for market beta, with below market returns. That is what I call a moral hazard, being incentivized to underperform for your clients.

That being said, I do not appreciate the author bashing my business without performing any due-diligence. Clearly, he or she did not have all, or even most, of the facts. I would recommend that the author try to get the facts straight before writing articles. Well, at least that is what a responsible reporter would do.

Sincerely,

Randy Kurtz
Chief Investment Officer
RK Investment Advisors, LLC

2. federalist - July 4, 2006

Mr. Kurtz is right. I apologize for making an example of his business without researching it more diligently. Before I get into a further clarification of this, I should also disclose that I am on the portfolio management team for a hedge fund.

Mr. Kurtz alludes to an important point which is that, no matter what they say, benchmarked mutual funds in effect do what RK Investment Advisors proposes to do — but with much less transparency: They essentially buy the index, and then they fiddle with it on the margins. Whether they fiddle by taking 100 stocks and adjusting their weight by 10%, or whether they take a few stocks and adjust their weight 100%, that’s all they can do. And in every case a customer is buying mostly beta with a tiny bit of alpha.

Which, by the way, is the justification for the hedge fund compensation model: Ideally you’re paying for 100% alpha. So you could pay 1.5% for a mutual fund to give you beta you can get virtually for free and a tiny amount of alpha. How much alpha? That’s what determines whether it’s worth the fee. Because alternatively you just buy the index yourself and then put, say, 10% of your portfolio in a 100% alpha hedge fund on which you pay 2% + 20% (which on your whole portfolio gives you a management fee of just over .2%).

In Mr. Kurtz’s case, you’re in effect buying his alpha at 33%. Maybe that’s a fair price, especially since there’s no base fee. I guess it depends on how good a stock picker he is. Why would I call his model odd? Simply because I don’t know any people or businesses who would stake 100% of their livelihood on being able to pick a handful of publicly traded stocks that will outperform their benchmark. (Of course, there are a million ways this might make sense – if you can buy out of benchmark, short or use derivatives, etc.  I don’t know exactly what his plan is, so obviously any potential investor should perform his own due diligence.)

P. Harimohan - October 29, 2014

Its been more than 8 years since the above in July 2006 and it’d be very helpful to many people looking for an independent fee only advisor if both federalist and Mr. Kurtz updated their points and counterpoints Has Federalist found any advisor who betters Mr. Kurtz in all of the points he makes about Mr. Kurtz’s methodology?

federalist - November 1, 2014

I believe my argument has gone more mainstream since it was written. Meanwhile, Kurtz’s company, now BetaFrontier, says, “We don’t report historical returns.”


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