The difficulty lies not so much in developing new ideas as in escaping from old ones.
John Maynard Keynes
Adding perspective is a large part of our job at Iron Capital. We are often asked to share our views on issues not directly related to investing; other times we are asked about a specific investment opportunity. To that end, we share these thoughts on our blog, appropriately titled, “Perspectives.”
The problem is not the use of the word pivot; it is this modern idea that we have to be on one extreme or the other. Today, the Fed must be either raising interest rates to fight inflation or lowering interest rates to fight a recession. This is absurd.
To be understanding, one has to be in relationship. We have lost a great deal of that relationship-building over the last two and a half years. Our reaction to COVID may very well end up doing more harm to our society than the virus itself. Human interaction is of utmost importance.
If one seeks the right answer, she must ask the right question. Should we forgive student loans? Wrong question. Why does college cost so much that one has to take out a mortgage-sized loan to pay for it? That is the right question.
The primary value, in my opinion, is independence. It boils down to one question: Who is the boss – is it the client, or someone else?
The original mutual fund scandal boiled down to large brokers getting preferential treatment at the expense of small investors. This 2.0 version boils down to the same thing: Large consulting firms are receiving preferential treatment at the expense of smaller firms and investors.
For those who pay attention to financial pundits, the word “pivot” is becoming very familiar. These sources of pseudo-wisdom keep saying that the stock market cannot maintain a rally until the Federal Reserve pivots from a policy of raising interest rates to a policy of lowering interest rates. They are, as usual, wrong, but there is something bigger afoot here.
Before I get into that, I do wish to defend the word “pivot.” I coached basketball for years and believe, as legendary coach Tex Winters did, that to pivot is arguably the most important fundamental skill in basketball. To pivot is the proper movement of a player’s feet to avoid traveling. To be able to pivot in basketball is to know how to use one’s feet to protect the ball and beat one’s defender. The lack of emphasis on proper footwork is evident in the poor quality of today’s college game.
The pivot is also the engine of the golf swing. In golf, the pivot describes the proper movement of the body during the swing. Depending on the school of thought of your pro, the pivot is a proper reaction to the movement of your hand and arms, or it is the engine that actually moves your arms and by extension your hands. I prefer the description by instructor Pete Cowen who says the body is the engine, the shoulders the transmission, and the hands are the steering wheel. But we digress.
The problem is not the use of the word pivot; it is this modern idea that we have to be on one extreme or the other. In this case, the Fed must be either raising interest rates to fight inflation or lowering interest rates to fight a recession. This is absurd. The Fed can just hold steady, maybe provide some stability.
The Fed has undue influence on financial markets, but it is not clear to me at all that they have power over the actual economy. As I have mentioned before, I believe that the Fed, and central banks in general, are overrated. If monetary policy controls the fate of an economy, then explain Japan. They have been trying to stimulate their economy with monetary policy for three decades with no success.
Economists like to focus on monetary policy because they want to be seen as scientific, and the key to that is the use, often misuse, of math. Interest rates are numbers, and numbers can go into sophisticated formulas. Similarly, tax rates and government spending are numbers, and they can also be input into formulas.
Regulation, on the other hand, is not easily turned into a number. When we were fighting inflation in the 1970s and early 1980s, one little-noticed action was the breaking up of “Ma Bell” and the deregulation of the phone system. This one act allowed phone lines to be used as a world wide web of sorts (see what I did there?). No central planner, fed governor, or economic pundit could have ever dreamed of the world that this change created.
Without that one act of deregulation, there would be no Amazon, no Google, no Netflix. Apple would still be a computer company. Almost 40 years of productivity gains would be wiped out. Iron Capital wouldn’t exist. That may be less obvious because we are not an internet company, but the internet allowed the world of equity analysis to be powered by a personal computer, when previously a firm needed loads of office space for annual report storage and teams of analysts to physically go through each company’s reports.
Today we are fighting high gasoline prices, and one of the main reasons is a lack of refining capacity. Today it would be next to impossible to open a new refinery. The Fed can raise rates forever, but that will not refine a single gallon of gasoline.
The Fed is overrated, and the role of regulation is grossly underappreciated. Of course, just like with the pivot, many will read this and accuse me of wanting to live in a world with no rules. It is one extreme or the other. That is absurd and we should call it what it is. The problem with regulation is that we never update, we only keep adding. Obviously we need rules, but the rules need to make sense. There is a middle ground, and most of the time it is the best path forward. At least that is my perspective.
Chuck Osborne, CFA
“You never really understand a person until you consider things from his point of view…until you climb into his skin and walk around in it.” ~ Atticus Finch, “To Kill a Mockingbird”
The first self-help book I ever read was Stephen Covey’s “7 Habits of Highly Effective People.” I use his weekly organizing technique to this day. Habit 5 is to seek first to understand, then to be understood. While I often fall short, this has been something I have strived to do for most of my adult life. It is one of those universal lessons.
One can find it in literature, like this quote from Harper Lee’s “To Kill a Mockingbird.” One can find it in sales conferences, where “the client doesn’t care how much you know until they know how much you care” has been a cliché for years. One will find it in prayers such as The Prayer of Saint Francis, “O Divine Master, grant that I may not so much seek…to be understood as to understand.” It is the major theme of the Dale Carnegie classic, “How to Win Friends and Influence People.”
Human beings are social creatures. We were made to be in fellowship with one another, and that requires the ability to empathize, otherwise society breaks down into violence. We have been losing this thread for some time now, and the reaction to the COVID pandemic has made it worse. It began in the most unlikely of places – universities – with the political correctness movement. What started out as a reminder to use good manners quickly morphed into a way of prohibiting any point of view that ran counter to the consensus.
A few years ago, I wrote about the problem with straw man arguments. A straw man argument is when one distorts the actual argument another person is making, then responds to the distortion they created instead of the actual argument of the other person. This happens in politics all the time. A politician will promote a healthcare program as an example. Her opponent may argue that her proposal has unintended consequences that will actually make healthcare worse, not better. The politician responds by claiming her opponent is against people having healthcare. That is a straw man: the opponent isn’t against healthcare at all, but truly believes this plan will make things worse. She ignores the actual argument and runs ad after ad saying her opponent doesn’t want you to have healthcare.
Straw man arguments have been around forever, but the difference today seems to be that we have begun to believe that the straw man is actually our opponent’s argument. This happens because our society increasingly is no longer concerned with actually trying to understand.
We have been dealing with multiple fund families in what we have named the Mutual Fund Scandal 2.0. One fund family has sent written correspondence to multiple retirement plan sponsors, an ERISA attorney representing a plan sponsor, and us. The first paragraph of each of these states that we don’t understand what they are doing. They then go on to describe what they are doing verbatim to our description.
One of our plan sponsor clients stated that she was taken aback by how little understanding of the plan sponsor’s point of view the fund company showed. Likewise, they have shown a misunderstanding of the investment adviser’s role and point of view, which is astonishing; plan sponsors are their end-clients. Almost all plan sponsors work with advisers who deal directly with the various fund families. How could they not understand? Even worse, how could they start a conversation by accusing their clients of not understanding? Even if that was correct, an effective person always seeks first to understand, then to be understood.
This particular fund family is one who historically has a reputation of client service excellence, which makes this whole episode all the more puzzling. What has changed? I believe it’s long COVID-19.
This particular firm is still not back in the office full time. For two and a half years, they haven’t actually seen clients in person. They haven’t even seen each other. Sure, they can still do all the administrative tasks they need to do remotely. The job gets done, but that isn’t good enough. When dealing with human beings one needs to be effective, not efficient. Efficiency in human interactions comes across as rudeness. Working remotely and not interacting with actual human beings for two and a half years may not have reduced efficiency all that much, but it has destroyed effectiveness.
To be understanding, one has to be in relationship. We have lost a great deal of that relationship-building over the last two and a half years. Our reaction to COVID may very well end up doing more harm to our society than the virus itself. That isn’t to say that there will not be benefits to the technology that has allowed the professional world to keep moving forward, but there must be balance. Human interaction is of utmost importance. To truly understand others, one has to follow Atticus Finch’s advice to put yourself in their skin and walk around in it. That is a hard thing to do normally; It is impossible if one never leaves the house. At least that is my perspective.
Chuck Osborne, CFA
The stock of Electronic Arts, the maker of sports-related video games, is up almost 6 percent on a down day in the stock market. Why? The official news is that Amazon may be buying them, but that is misinformation. Truth be told, the Biden administration just threw a financial lifeline to the 20-something deadbeats who can now stay in their parents’ basements playing video games instead of getting a job for at least a few more months.
Disclaimer: The above paragraph is a joke. Joke is defined by Merriam-Webster as, “something said or done to provoke laughter.” Jokes were prevalent on college campuses in the days when there were no safe spaces, trigger warnings, or student loans the size of mortgages.
NBC recently conducted a poll in which a plurality listed “threats to democracy” as the most important issue facing the country. They made a big deal about this being the first time ever this was the case; turns out it was the first time NBC had ever asked about “threats to democracy.” If one seeks the right answer, she must ask the right question.
Should we forgive student loans? Wrong question. What should we do about the student loan crisis in this country? Premature question. Why does college cost so much that one has to take out a mortgage-sized loan to pay for it? That is the right question.
The student loan crisis is real, and it is causing harm to a generation, but student loans are not the disease. No, loans are the symptom. I’m no doctor, but I know enough to know that masking a symptom doesn’t cure the disease; it often makes it worse.
The disease is the runaway cost of education. The cost of education – both higher education and private secondary school – is criminal. No other industry in the world would be able to get away with it. Education makes healthcare seem affordable.
When we had a mortgage crisis in this country in 2008, what was the government’s response? They did not wipe out America’s mortgage debt. Instead, banking industry CEOs were forced to testify in front of Congress, specifically to answer for selling mortgage products to naive borrowers who really did not understand what they were getting into.
Here are some good questions: How many of the student debt holders were first-generation college students? Did they borrow this money to go to college because they wanted to enrich their spirit with a better education, or because they were told they need a college degree to get a good job? If it was the latter, did anyone at the university explain that when it comes to employment, all degrees are not created equal? When borrowing hundreds of thousands of dollars to obtain a master’s degree in Russian poetry, was it explained that the degree would qualify them to be a slightly more interesting barista?
These are questions university presidents should be forced to answer. Quality education since the time of Socrates has required just three things: a place to meet, a good teacher, and a good book. None of those things should be so expensive that it cripples the student’s financial future.
How did this happen? Slowly over time. That is always how good people end up doing bad things. One bad decision leads to another, and then another. It is often fueled by one of the worst questions one can ever ask: What are the others doing? We raised our tuition because our peers raised theirs. Now that it costs more, that old non-airconditioned dorm that has a constant smell of stale beer isn’t quite good enough. New dorms it is. Costs are up, so we must raise tuition again. Now we need more degree programs, because a competitor offers a degree we do not; that means more professors and more classrooms. Tuition goes up again. It becomes a death spiral fueled by the most popular excuse for wrongdoing in human history, “Everyone else is doing it.”
In the meantime, what about the quality of the actual product? Evidently with all the thousands of dollars of debt being piled on these students, no one has bothered to teach basic civics. What are the three branches of our federal government? What are their distinct roles?
The biggest threat to our democratic form of government over the last 20 years is not a riot at the capitol, or the takeover of Seattle by radicals; it is executive action. The role of the Executive branch is to administer the law as passed by Congress. This abuse of power has been used by presidents from both parties, and it cannot continue. It has afforded Congress the luxury of not having to function, and has resulted in regulations that would have never made it through the democratic process. Perhaps most importantly, the use of executive action has created an environment in which we do a complete 180-degree turn ideologically every four to eight years. A stable nation cannot sustain that.
Democracy is slow and painful to watch, but that is by design. That need to compromise, and the slow back-and-forth nature of it, adds stability. How does the person who did all the “right things” and just finished paying off their student debt feel today? There is a lot wrong with this student loan forgiveness, but perhaps the most concerning issue is the idea that one person thinks he has the power to do it all by himself. Now that is a threat to democracy. At least that is my perspective.
Chuck Osborne, CFA
~The Wrong Question
“No one can serve two masters. Either you will hate the one and love the other, or you will be devoted to the one and despise the other.” ~ Matthew 6:24
When I partnered with Larry Gray to form Iron Capital in 2003, we had two driving motivations. First was the fact that the investment industry was (and still is) rife with conflicts of interest. The second was that the industry had evolved in a way that set up layers of middle people between investors and the actual investment professionals. We wanted to fix those two flaws, so we started a firm with three core values: Trust, Independence, and Service.
The primary value, in my opinion, is independence, because it is not only important in and of itself, but also a necessary element in both of the other two. It boils down to one question: Who is the boss – is it the client, or someone else? Our industry has historically broken that distinction down by using the terms “buy side” and “sell side.”
The sell side is far more familiar to most retail investors. The traditional financial adviser (stockbroker), the big brokerage firms, and investment banks are the sell side. They develop products and then sell them to investors. I’m often accused of being unfairly harsh towards the sell side, but that really isn’t the case. The sell side is necessary, and they provide needed products and services. The issue I have is that too often they are less than forthcoming about for whom they work and what they actually do.
This wasn’t always the case. When I first got into the industry, the distinction was clear. My first job was on the sell side, and we made it perfectly clear that we could not offer advice; we could only provide education and guidance regarding the products we offered. For much of my career my individual clients were from the “Greatest Generation.” When I would first meet someone of that generation and ask them who managed their money, they would say, “I do, and Bob is my broker at Merrill Lynch.” That is a correct statement.
Starting with the baby boomers and especially with millennials, when we ask that same question they will answer, “Bob at Merrill Lynch.” That is not a correct statement. Merrill Lynch is a brokerage firm – a store with products to sell, not a money manager. Bob is still a salesman, but one generation understood that while others do not. In recent years I have even met young brokers who, upon meeting me and learning what I do, will say something like, “I do the same thing.” They mean it, because they don’t know any better, but they are wrong.
I’m on the buy side and have been for most of my career. The buy-side professionals are the ones who make investments on behalf of others. We have a fiduciary relationship with our clients, and we work for the client. We are hired by the client to make investment decisions on the client’s behalf. Most on the buy side will partner with the sell side; the buy-side portfolio manager will manage a fund, and the sell-side broker will sell it. It works great for the industry – investment professionals get to spend all their time analyzing investments and managing portfolios, and sales professionals get to spend all their time in front of clients.
That was my life before founding Iron Capital. I rarely, if ever, got to meet a client back then; if I did, it was for a quick question-and-answer session, after which the financial adviser would say, “See, we do have smart people. Now let’s make that tee time.” It works for everyone, except the client. This scenario creates extra layers of cost, and the client must settle for products which are seldom a perfect fit for what she is trying to accomplish.
One day I realized that while we on the investment team often spoke of the clients, we didn’t know them, and we didn’t really work for them. We worked for the sell side; they were the ones who sold our product, and they would only sell it if they liked it. They were the retail outlet and had basically turned us into wholesalers. This is how the industry works today. Most on the buy side manage products sold through the sell side. They don’t know the client, and either give the client little thought or assume that the sell side has the client’s best interest at heart.
However, today’s “financial adviser” does not work for the client either; they work for the brokerage firm. Their legal title is registered representative; they represent their firm. What they can and cannot tell you is governed by a compliance department staffed with attorneys whose job it is to make sure the firm doesn’t get sued or fined by regulators. Those attorneys also do not work for client.
Because of this, the ranks of financial advisers who have left traditional brokerage firms to become independent investment advisers have grown, which is great. Unfortunately, old habits are far harder to break than legal structures. As we recently reported, there is a mutual fund scandal happening today in which supposedly independent advisers are negotiating sweetheart deals for their book of business with mutual fund families. This may seem harmless, or even that these advisers are doing a good thing, but when an adviser accepts a sweetheart deal from one fund family, for whom is he now working?
Independence is not as easy as just leaving a brokerage firm. One cannot serve two masters. One cannot in good conscience negotiate deals with fund families and still work solely for the client’s best interest. Independence is difficult to maintain, but for us it is a core value, and vital. At least that is my perspective.
Chuck Osborne, CFA
~Who’s the Boss?
It is hard to believe it has been almost 20 years since I left Invesco and co-founded Iron Capital with my then-partner Larry Gray in 2003. Almost immediately after we launched, the industry from which I hailed handed us a gift in the way of what was simply known as “the mutual fund scandal.”
I left Invesco because I was bothered by two things in the investment industry. First: the industry is rife with conflicts of interest, which is self-evident. Second: the investor increasingly has no access to actual investment counsel – meaning the industry evolved to put layers of middle-people between the investor and the actual investment professional. Today the investment professionals – analysts and portfolio managers – do their work in relative isolation, and support staff share information to heads of sales (who now go by myriad names other than sales), who distribute that information to brokers (now referred to as financial advisers), and then to clients. A lot gets lost on the way.
We wanted to build a firm that was truly independent and gave investors direct access to the investment professionals who actually make the investment decisions. As we launched the firm, New York attorney general Anthony Weiner announced an investigation into the practices of mutual fund companies who were allowing short-term traders to go into and out of their funds rapidly, hurting long-term investors. To sum up the gist of the scandal, these firms had given preferential treatment to large brokers and hedge funds at the cost of everyday clients.
This actually helped our business, first because we were preaching an end to conflicts of interest, and second because coming from the mutual fund world helped us have a better understanding of what was actually happening. Iron Capital got off to a great start and we successfully built a nice business; quickly we made the decision to be satisfied with doing just that. Having come from a very large firm and knowing all that goes with that, we decided that Iron Capital would remain a boutique. We ended all business development efforts and focused solely on serving our existing clients. Our clients’ referrals are our only source of new business.
Along the way we felt that the industry had improved, as firms like ours led to more independence and fewer conflicts. But I was naive. Yes, many brokers have left their traditional role to become fee-based, but as the old expression goes, “Just because a cat has kittens in the oven, that don’t make ‘em biscuits.” Just this past week I have learned of a practice that should make the first mutual fund scandal seem petty and small.
Multiple mutual fund giants, including but not limited to T. Rowe Price, Fidelity, and yes my old employer Invesco, have made deals with supposedly independent pension consultants to charge their clients less than they charge everyone else. They are doing so by aggregating the total assets of these consultants and charging them as if they were one very large client. What is wrong with that?
Let us count the ways. Traditionally many of the consultants who work with retirement plans followed Iron Capital’s model and remained boutiques. I may be biased, but in my opinion, this is what the best consultants have done… yes that includes us, but not just us. Boutiques have been able to compete because pricing in this business was always based on the client, not whom the client chose to hire as a consultant.
It works the same way for retail investors. Charles Schwab in all likelihood has billions of dollars with these various mutual fund firms. Still, if you go to Schwab and open an IRA and choose one of these mutual funds, what you pay for the fund is based on your account alone. Otherwise, Charles Schwab wouldn’t exist, because they could have never competed with the Merrill Lynch’s of the world who were huge long before anyone “talked to Chuck” as their commercials used to say.
If pricing is based on the size of the consulting firm, then boutique firms will no longer exist. This is problem number one. Problem number two is that independence will no longer exist. Once there is a business relationship between the consultant and the mutual fund company, all independence is lost. One simply cannot serve two masters, so if we build a cost-reduction relationship with T. Rowe Price for their target retirement date funds, but then come to believe that someone else’s product is better, we now have a conflict: Do we go with the best option, or do we go with bulk purchasing power? One cannot serve two masters.
Finally, and most importantly: Small plans, small firms and their employees end up subsidizing these large relationships by paying more for the same fund. Scaling pricing based on the client, whether an individual or a retirement plan, makes sense as there is some fixed cost to having a client. That cost does not increase with the size of the portfolio, so reducing the percentage charge as assets grow makes sense. However, basing that not on the client but on the consultant the client chooses to hire means a small client who hires the preferred consultant may end up paying less than a large one who chooses another path. The only way the mutual fund company can make that work is by keeping prices higher for everyone else.
The original mutual fund scandal boiled down to large brokers getting preferential treatment at the expense of small investors. This 2.0 version boils down to the same thing: Large consulting firms are receiving preferential treatment at the expense of smaller firms and investors. Iron Capital could play this game too. We never dreamed of it because it is unethical. Unfortunately, we have no choice; we have a fiduciary responsibility to look out for our clients. That doesn’t mean we can’t simultaneously work to stop this practice.
I left the mutual fund industry to start Iron Capital because I was tired of feeling dirty when I came home from work. I wanted to look into a mirror without shame. It sickens me that I have to get dirty again to protect my clients. This time I can do it in the light of day. Light is a great disinfectant, at least that is my perspective. This will not be the last time you read about the Mutual Fund Scandal 2.0.
Chuck Osborne, CFA
~Mutual Fund Scandal 2.0