CHG Issue #154: Where's The Money?

This is a cross-post from?CHG Market Commentary on Substack . If you're subscribed to this newsletter you should consider subscribing for free on Substack to get this when it comes out on Mondays and receive more frequent market updates on?Substack Notes ?as well as other exclusive content.

In any market or industry that is financial in nature we can apply a very broad model to distinguish between the different actors in that system: there are people with money, people with products or services, and there are the intermediaries. In the financial services industry the majority of the people and firms are not actual the owners of the money; they may represent or act on behalf of the capital but they are not the actual owners and ultimate beneficiary of that capital. Large firms like Blackstone are very good at raising capital to deploy on behalf of their clients, but in doing so they are merely an intermediary. In the normal course of business this may be a distinction without much of a difference, but it is an important distinction nonetheless.

People tend to be leery of brokers. The word conjures up the image of the stereotypical used car salesman who will say anything to get you into a car, or the self-important stock broker who only sees the large commission that comes if they can get you to say yes. Intermediaries like this do not add much value and serve to reinforce the general negative sentiment towards brokers. Institutional investors tend to avoid brokers in favor of privately negotiated transactions because brokered transactions are more competitive in nature. There is also the challenge of sorting through all the different brokers and the products they are marketing. When I was a fixed income PM at a mid-sized life insurance company I might get several hundred Bloomberg messages (emails) an hour, all filled with different investment options, some of which might be only available for a short period of time. Even with AI that can read those messages and distill them down it is an impossibly overwhelming amount of information for anyone to digest. The best solution to this problem is to narrow the field of options either by imposing strict constraints on what you want the brokers to show you or only working closely with a small number of discerning brokers who will do the filtering for you.

What a lot of professional money managers do is impose a minimum investment size which narrows the field of investment options to be more manageable and impactful for their portfolios. If you have been tasked with deploying, let's say a billion dollars, to do so making $100,000 investments at a time will be very inefficient. There is a tradeoff between diversification and cost at work here. More investments means more diversification, but if each investment requires a day of work and costs $1,000 in legal fees that will end up being a very inefficient process. It's more efficient to invest in 100 different $10,000,000 investments to deploy the billion, however this gain in efficiency comes with a cost. By restricting your investable universe you have lowered your potential returns.

This happens because the smaller investments must offer a higher rate of return to the unconstrained managers and therefore they will earn a higher rate of return than the constrained manager. Jared Dillian has termed this the "Theory of Constraints." Having access to a broader opportunity set provides a diversity of uncorrelated returns which has a better probability of success than a constrained manager.

Professionals prefer to work with other professionals and actual decision makers to keep things as simple and efficient as possible. To many intermediaries in a transaction can add to the cost without adding any value. The more intermediaries in a transaction the more risk there is of something going wrong; a chain is only as strong as it's weakest link. Time is valuable and important people who oversee large portfolios will be very discerning about who gets time on their schedules and will naturally only want to interface with other important people.

This can be a source of inequality in the markets: who you know can matter as much as or more than what you know. It is perfectly reasonable for powerful and influential people to be discerning with their time, no one wants to have their time wasted by ineffective people; however, as access becomes more valuable than merit, rigid social structures form, and roadblocks to innovation are erected that eventually develop into outdated and discriminatory practices. It is all too easy to go from discernment to exclusion and it is natural for powerful people to be leery of novel ideas and new people. History is littered with stories of powerful people that eventually are done in by their own self-importance.

A whole generation of financial advisors have grown up being told that brokers are bad. This is a legacy of the "boiler rooms" and other illicit investment sales practices that have largely been outlawed by the SEC. Despite this, the ratio of intermediaries to clients in the wealth management industry is off the charts as former brokers have merely rebranded themselves.

There has been a movement away from active management based on academic research that shows how the majority of professional investment managers cannot outperform consistently and low-cost, passive investment strategies fare much better over the long-run. As a result money managers are managing more systematic and passive strategies. But if you take time to think about what a passive money manager is, they are not much more than a broker or a middleman. As the manager of the S&P 500 ETF my job is to collect your money and buy the stocks in the index; this is basically what a broker would do in the old days. What is old is new, just under a different label.

This is interesting for several reasons. First, it demonstrates how we can easily form misconceptions about things based on generalizations and that can lead to discriminatory practices which are bad for society and eventually bad for us. At some point along the way I am confident some ETF marketing people realized how the product they were marketing was really just a different version of old-school brokers and they realized they had to come up with a different label for what they were doing. The truth is they are very much acting like brokers but by marketing as passive management or an ETF wrapper, they are able to bypass the preconceived notions about the activity they were taking part in. Second, the growth of passive investment strategies, ETFs, and alternatives has drastically changed the nature of the markets. There are less and less "adults in the room" as the professional, active managers who historically acted as the adults are diminishing and the markets are increasingly on auto-pilot from rules-based, systematic and passive investment strategies. By seeing through these labels to the nature of the underlying activity of these large pools of capital we get a better handle on the underlying imperatives of who is actually moving markets.

This bull market has been on autopilot for some time as there has been so little conviction on either side of the market. Wise guys keep trying to predict a recession, a Fed move, a market top, or short the market, but they keep getting stopped out by the passage of time and no realization of their forecasts. That short covering keeps a bid under the market on pull backs and lures in price-based momentum investors. What is also taking place is that market access has been democratized thanks to the tiny supercomputers we all carry around in our pockets. Retail investors, aka the kids, increasingly hold more sway in the market today because of the diminishment of the adults and greater access for the kids. However, the distinction between kids and adults is too crude to fully express the change that has taken place. It would be a mistake to assume that the kids are on the wrong side of the trade if they are on any side at all. They very well may be the ones trying to short the market! The distinction reveals a market that is leaderless.

In finance today some of the biggest money managers don’t actually do much managing of money. They spend their time raising money and working with brokers and other partners to source investments. This has always been the case, but today as wealth and assets have concentrated in fewer hands the roles that different financial professionals play are increasingly that of intermediaries. If you look closely at private equity you will find a string of intermediaries working together. Blackstone has the ability to raise billions of dollars from their clients on the promise of finding them attractive investments. They effectively broker their clients' capital to other intermediaries who have clients that are seeking capital. It may surprise you to learn that most real estate PE funds don’t actually do the actual work of building and managing properties; they typically have relationships with "fund-less sponsors" whose job is to find projects to invest in and raise the money for it on a project-by-project basis. This is just another form of a broker and if you spend the time to look into most investment vehicles out there you will find layer upon layers of intermediaries to the point where it is hard to understand who really has the money or where it came from.

What results from all this is a very expensive and inefficient capital formation process. Financiers have historically been the wealthiest members of society and that results from many of the contradictory forces we have covered today. There is a resentment in society towards financiers because people either do not understand what they do or because they are not adding value to society. It also creates a lack of accountability as there are so many layers in a transaction that if something goes wrong there are many opportunities to pass the blame to someone else and taking the time to litigate something so complex is undesirable and even if you did take the time to do it you might find that there was no single person to blame, only a weak process full of small holes that individually added up to a large loss.

It’s important to know how things work because when things stop working you will have recourse. Making things simple and more efficient is important but it's important to remember that the complexity never goes away, it is only transformed and can come back in a big way at a later time. We caught a glimpse of this during the GFC and during COVID. The label of broker may carry negative connotations but making any decision based on a generalization is not real thinking. It's more important to step back from the labels and stereotypes that society offers and discern partners who are truly value-added.

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