“‘Be careful,’ Jesus said to them.‘Be on your guard against the yeast of the Pharisees and Sadducees.’”
~ Matthew 16:6
This is one of my favorite Bible verses. (That may seem strange as I am not sure how many top-10 lists this makes.) For those who have not studied the Bible, one is often shocked by how much of our language and culture come from that one book.
How many Matthews, Marks, Lukes, and Johns do you know? You can’t be Better than Ezra if you don’t know Ezra. How can you Turn! Turn! Turn! with The Byrds if you have never read Ecclesiastes? We know a young family who recently named their baby boy Jude, and a friend speculated they named him after Jude Law. Perhaps, but my guess is it comes from “Jude, a servant of Jesus Christ and a brother of James”, as the author of the book of Jude described himself. If it was Jude Law, I’d wager that his mother probably knew the origin, and I am almost certain the Beatles did too.
Stepping outside of the Bible for the spirit of that verse, how about the famous basketball coach John Wooden? “It’s the little details that are vital. Little things make big things happen.” Yeast is a very small thing, but the difference it makes in bread is huge.
Earlier this year, a prospective institutional client asked me what Iron Capital does to protect retirement plan sponsors from liability. This is a reasonable concern, as many employers have been sued over their retirement plans. First: everything Iron Capital does for plan sponsors helps protect them from any possible liability. However, the way the question was asked sparked something in me; for the lack of a better term, it was a yeast moment here in Iron Capital’s 20th year.
Years ago, I was at a basketball game with a close acquaintance who was on the investment committee for a local employer I was interested in pursuing as a client. While we watched the game, I let him know how Iron Capital was different than other firms. We discussed our investment process and the success we had building retirement plans. He told me something I’ll never forget. “Chuck, I’m impressed with what you all have done, and I would be all for hiring you, but my company isn’t interested in having the best retirement plan around. We just want someone big whom we can sue if things go wrong.” In other words, what are you going to do to protect us from our liability?
That time I just thanked him for his warning and moved on, but earlier this year something struck me: There is very little difference between doing the right thing for plan participants and covering one’s behind – DTRT or CYA? The difference in action is no bigger than a single grain of yeast, but oh my what a difference it makes in outcomes.
We pride ourselves on our ability to select investment managers for retirement plans. We track our results, and although it is hard to compare to others as there are no databases, I would wager we are among the best. Over the 10-year period that ended June 30, 2023 (September 30 data not yet available), the funds we have had in our client plans for 10 years or longer have delivered an excess return of 0.82 percent per year; 64.3 percent of these funds outperformed their benchmark by an average of 1.56 percent per year. The funds that underperformed (which includes all index funds, as they underperform by design) did so by an average of 0.51 percent. When blended, we get an average of 0.82 percent excess return. Let’s put that in perspective: T. Rowe Price recently published research showing that a 0.50 percent excess return over the life of a 401(k) participant equates to an additional five years of retirement income.
We are proud of that achievement, but how did we do it? There are many factors, but one of the most important is that we are patient with good managers when they go through bad periods. We don’t track the data this way, but I would wager that every one of the managers who outperformed over that 10-year period has underperformed during some shorter-term period along the way. That puts tension on DTRT vs. CYA.
I cannot count how many difficult conversations I have had with clients over the years about this. When a manager in a plan underperforms, the easiest thing for a consultant like me to do is to go to the meeting, point to the underperformance, and announce that we are replacing the manager. No one would ever argue; the manager is underperforming, and we are “doing something,” and doing something makes clients happy. What we are doing is CYA. Clients don’t like underperforming investment managers, and firing them as soon as possible leads to happy meetings.
However, it doesn’t lead to good results for participants. If the manager in question was good to begin with, then she will likely rebound and do well coming out of the short period of underperformance. Meanwhile, the managers that look good right now probably look good because they manage money in a different way.
Take Iron Capital as an example. In 2022, we experienced a bear market in stocks and a historic bond selloff simultaneously, and the more growth- oriented stocks dropped the most. Our aggressive growth stock strategy underperformed, our core stock strategy outperformed, and our income strategy outperformed dramatically. In 2023, the market has rebounded somewhat, but almost all of those returns have come from a small number of very aggressive growth stocks. This year our aggressive growth strategy is doing well, our core stock strategy is underperforming, and our income strategy is suffering.
We are the same team managing these same strategies. These short-term results are not due to us being really bad at growth investing and really great at income investing in 2022 and then flipping a switch and becoming really bad at income investing and awesome at growth investing in 2023. We are just in a different market environment. An investor can be successful over the long term with either strategy if she sticks to her strategy; the investors who lose are the ones who keep switching strategies. The industry term for this is whipsawing. If an investor switches from growth to income at the end of 2022 just to be in the popular place, he now has been in the worst place twice in a row. Some may believe that they could do the opposite, but history tells us that is a fool’s errand.
The phenomenon of whipsawing means that a retirement plan adviser who is in CYA mode and goes into the meeting with the client promising to switch out managers almost always whipsaws the participants. At the end of ten years, they can’t show the results we have, because they have never given a manager 10 years. They have, however, had peaceful meetings with retirement plan committees and always been able to point to high performance on performance reports; but the performance on the reports is all from before the manager was in the plan, so no participant experienced those good results. However, to my knowledge to-date, no employer has ever been sued for switching out managers too frequently. From a CYA perspective, success has been achieved.
How is it different when the motivation is DTRT? The DTRT adviser gets to take it on the chin. He gets yelled at, a lot (trust me on this). How could you keep this manager in the plan? It would be so much easier to say, “Sir, yes Sir, we will replace him right away. Would you like to come to our annual boondoggle, I mean plan sponsor conference?” But the DTRT adviser understands that the client isn’t always right. If she were, then she wouldn’t need an adviser. The DTRT adviser is willing to have difficult conversations because what motivates her is delivering results for participants.
This doesn’t mean there will never be any turnover in managers. Sometimes replacement is the only option. However, replacement should be done when and only when there is a reasonably high probability that the new manger will do better going forward. It is easy to find someone who did better in the past, but picking someone who will do better going forward is far more challenging. The CYA adviser doesn’t really care about that, because he will just replace the new guy as soon as he stumbles.
The CYA adviser is also going to be laser focused on fees…all the fees except his of course. CYA is expensive. This is not to say the DTRT adviser won’t focus on fees; after all, fees are a hurdle that must be overcome. If the T. Rowe Price research is correct and an additional 0.50 percent means an additional five years in retirement income, then every fraction of a percent matters. Here is another grain of yeast: fees matter, but to the DTRT adviser, value matters more. Fees are easy to poke at, but understanding what value is being driven by those fees is much harder. When the CYA adviser continually whipsaws participants then the value add is negative, so any fee at all just adds insult to injury. However, when a DTRT adviser adds 0.82 percent of value a year for ten years net of fees, then the value proposition matters more than just the fee level.
Of course, past performance is no guarantee for future results; just because we have done it in the past doesn’t mean we can keep doing it. That is true, and I would be less than honest if I ever guaranteed otherwise. What I can tell you is that the 10-year period I discuss here is the worst we have done since we have been tracking this statistic. I can promise that we are our own worst critics, and I am more than willing to get yelled at in client meetings because the client is only expressing emotions that we have already dealt with internally. I can also promise that we will continue to always strive to do the right thing, which is what has driven our success in the past.
Does DTRT provide as much protection as CYA? I don’t know, but I do know that in Iron Capital’s 20-year history, none of our clients has ever been sued for mismanagement of the retirement plan. Maybe that is because of our success at selecting good managers and building good plans, but I suspect there is more to it: DTRT advisers usually end up working with employers who themselves are not trying to just CYA, but who actually care about their employees. That also might be hard to differentiate as salaries and benefits are largely driven by market forces and regulation, so CYA and DTRT might not look that different on the surface. It shows in the culture.
Years ago, I pointed out that a large portion of Warren Buffett’s success was because he essentially fired his clients by shutting down the fund he originally ran and using Berkshire Hathaway as his vehicle for investing. The alternative to that is to have really good clients. Iron Capital owes much of its success to the quality of its clients – all of our clients, but especially the plan sponsor clients. We are fortunate to work with companies that truly care about their people. It shows in all the little things, which is why we must beware of the yeast. It is the little things that make the big things happen.
Chuck Osborne, CFA
The 2nd quarter 2023 GDP growth came in up 2.1 percent, which follows the 2.2 percent rise in the 1st quarter. The pundits continue to be overly pessimistic, and the same pattern continues. They predict doom and gloom, and the GDPNow reading through October 5 is 4.9 percent.
The official unemployment rate was 3.8 percent through September. The labor market remains tight, and participation is growing. This is occurring while inflation is coming down, so it will be interesting to see when this good news is treated as good news by the market.
Inflation is 3.7 percent based on the latest consumer price index report. Slightly lower than last quarter. The producer price index, which tracks wholesale prices, is up only 1.6 percent over the last 12 months. +
The market took a step back. For the quarter the S&P 500 finished down 3.27 percent, and small company stocks represented by the Russell 2000 index were down 5.13 percent. Growth and value were basically in line with the Russell 1000 Growth index down 3.13 percent while the value index was down 3.16 percent. For small companies value did better with the growth index down 7.32 percent, and the value index was down 2.96 percent.
Bonds were negative for the quarter. The Barclays U.S. Aggregate Bond index ended down 3.23 percent. High yield bonds rose 0.53 percent. Bond yields remain attractive.
International stocks were also negative. The EAFE index finished down 4.05 percent and the MSCI Emerging Markets index ended the quarter down 2.79 percent. +
This feels like a broken record, but pessimism remains, and results are still likely to be better than expected. This should continue to bode well for the market in the last quarter of 2023. The market broadened in July before the correction in August and September and we suspect it will continue to broaden in the 4th quarter.
In the longer term little has changed. Value stocks and small company stocks still look more attractive. International stocks look more attractive than domestic. Diversification should work once more.
Bonds still look worthwhile and are behaving like bonds should. Yields are at the top of their range once more and should trade down in the short term. +