Turning ‘Bad’ Investments into Good Profits

Jonathan Berk: Welcome back, my name is Jonathan Berk, the A.P. Giannini Professor of Finance at the Graduate School of Business at Stanford University.

Jules van Binsbergen: My name is Jules van Binsbergen, and I’m the Nippon Life Professor in Finance at the Wharton School of the University of Pennsylvania.

Jonathan Berk: Before we get into the new episode, I just want to take a few moments to thank you all for listening and providing some positive feedback to the first few episodes. It is very gratifying and inspiring to see so many listens.

Jules van Binsbergen: Yes Jonathan, I think the number of people that have come up to us to tell us how much they’ve enjoyed the show has really caught us by surprise!

Jonathan Berk: It has. Okay, Jules let’s dive into the next episode.

Jules van Binsbergen: Okay, so in the last episode we discussed stock-picking and whether as a regular investor, you should expect to make money by doing this. The conclusion that we came to was that it’s only possible to make money if you’re able to arrive at the party early. That is, you need to know something about the stock before other investors do, as soon as you can capitalize on that the competitive advantage of knowing more?. If you do not come prepared and thus do not arrive at the party early, it’s like walking onto the football field unprepared facing Tom Brady on the other team. So that raises the question: if as an individual investor you cannot make money by picking stocks could you simply hire Tom Brady to play football for you? Meaning, can you hire a professional investment manager who does the job for you and should you expect to make money that way?

And as we’re going to find out today, expecting to make money that way is yet another example of an All Else Equal mistake?. So let’s find out why that is.

Jonathan Berk: Okay Jules, this is actually a much broader problem. It’s the problem about how do you hire someone. So let’s say I want to hire a surgeon because I need a complicated operation. Question: Would you hire a surgeon with the best record? That is, the surgeon who has the least number of operations that has had something go wrong. Most likely you wouldn’t Jules, and the reason is, the best surgeons often do the most complicated procedures. So the best surgeons are going to have worse records than an average surgeon that’s just doing simple operations.

Jules van Binsbergen: Yes indeed Jonathan. You can make the same point about CEOs. The most skilled CEOs are the people who you want to have the toughest jobs. So when we are evaluating skill and we want to see who has the most skill, we want to take into account, this thing of doing tougher jobs. And in many ways, that is what the All Else Equal concerns are about. If the CEOs pick the tougher jobs, we want the our evaluation of the skills to reflect that.

Jonathan Berk: So if you have two CEOS in a highly competitive industry, both doing average, they could be very skilled. If you have one CEO, and the other is not as skilled, they wouldn’t be doing average, they’d be doing much worse. The fact they are both competing with each other and being average, reflects the fact that two highly skilled people are competing with each other.

Jules van Binsbergen: Now let’s bring up another All Else Equal concern. When you hire these CEOs, what do you pay them? All Else Equal, you would rather have Tom Brady play for you, What do you need Tom Brady to do that? Is there any surplus for you after you’ve paid his salary? If he’s so expensive to play football for you, that there’s nothing left for you after you’ve paid him, it may not be such a great idea to ask him to play football for you.

Jonathan Berk: You could hire the second best quarterback if the salary is substantially below Tom Brady’s salary, you’d be much better off with the second best quarterback than the best quarterback. It goes back to what we talked about last episode, it’s the price you pay.

Jules van Binsbergen: So now let’s bring this back to money management.

Jonathan Berk: Okay. Let’s talk about money now. And the question is if you want to hire somebody to manage your money, is the best thing to do to look at the past record of the money managers and hire the money manager with the best record? It might seem like that’s the obvious thing to do. But the funny thing is, Jules, if you look at the data, what you find is their past record is not a good predictor of future record. In other words, if I look at a money manager and I look at his record over the last year, the last five years, and I [rank] money managers, and I take the money manager with the very best record, and I then look over the next five years, how that money manager performs, what you find is he does no better than average money managers.

Jules van Binsbergen: So let’s be precise about what we mean with record, right?

Jonathan Berk: Yeah.

Jules van Binsbergen: So the record is the return that that manager has delivered to his or her investors.

Jonathan Berk: Exactly. And you know, it’s even worse than that, Jules, because you could say, well, look, what if I don’t hire a money manager? So what does it mean not to hire a money manager? It means just stick your money in all stocks proportionately. So you’re not picking stocks. You’re just putting your money in all the stocks you could invest in, what we call the entire markets.

Jules van Binsbergen: And so Vanguard, for example, has made that their entire business model to offer those types of funds.

Jonathan Berk: And they charge almost nothing for it. So it’s very cheap. You could go to Vanguard and invest in one of their funds [that] just invested all stocks that – there’s no stock picking at all. And you could ask the question, how does your investment in one of Vanguard’s funds compare to your investment in an average mutual fund manager?

Jules van Binsbergen: And what we find indeed is that that average is pretty much the same.

Jonathan Berk: Pretty much the same. The managers that are being paid to pick stocks, the returns to investors of those managers is no different to the return they would earn in a Vanguard fund that invests in all stocks.

Jules van Binsbergen: On average. Absolutely. So let’s take that back to the example about the CEOs and the surgeons. We need to ask ourselves the question, is it true in money management as well that there’re easier and harder jobs to do? And as it turns out, there’s a straightforward reason for why money management gets harder, and that is if you have to manage a larger fund. Managing a larger amount of money is tougher than managing a smaller amount of money. So let’s think about why that is. The reason why that is is that, as an investment manager, you have investment ideas. You implement your best ideas first, and gradually as you get more money, you start to revert to worse and worse ideas that deliver lower and lower returns. This is what we call in the industry decreasing returns to scale.

Jonathan Berk: So let’s think about how that might work in the economy. So we have a bunch of money managers out there, okay? And let’s imagine – make a very simple assumption – I’m not saying it’s realistic, but let’s just make it for the moment – assume we know who the best money managers are. So for every money manager out there, we know exactly how skilled they are. And now we’re all decided whom we want to invest with. Well, nobody wants to invest with a bad manager, so everybody’s going to invest with the best manager. And so all the money’s going to flow to that manager. He’s quickly going to run out of good ideas.

And so his return is going to drop until it drops to the second best manager, and then we’re going to give it to the first and second best manager.

Jules van Binsbergen: And then when you give the money to the first and the second manager, gradually the return will drop to that of the third manager, and the process continues that way. So then the question is, when does this process stop? Well, when all the money that was collectively given to all of these managers, their returns have dropped to the level of the returns of the Vanguard Index Fund, the investment strategy where you simply invest in all stocks proportionately to their market capitalization.

Jonathan Berk: Yeah, Jules, why pay the money manager? You can always invest all your money in all stocks by buying Vanguard Index Fund. And so if the money manager can’t beat that return, you’re not going to invest with the manager. So when the money manager’s return drops to that return, then everybody’s indifferent. They don’t are. They either give it to the money manager, or they give it to Vanguard Index Fund.

Jules van Binsbergen: So Jonathan, let’s get back a little bit to the assumption that you mentioned earlier. You said it was somewhat unrealistic to assume that we know the skill of all the managers so that we can first start giving the money to the best manager. What if I don’t know for sure what the skill of all these managers is? How am I going to go about the problem in that case? There’s —

Jonathan Berk: I wouldn’t say somewhat realistic. I would say totally unrealistic. [Laughter] So yes, that’s not a very realistic assumption. But on the other hand, we have some idea of who the good managers are. In economic-speak, we would say we have an expectation of who the good managers are, right? So instead of us now knowing who the managers are, we repeat the same thought experiment, but this time we do it in expectation. Everybody has an expectation of who they think the best manager is, and we give that manager money. As the size of his fund grows, it drops to the return of the manager that in expectation we think is the second-best manager.

And the same equilibrium happens until the returns of all the managers drops to the expected return of the Vanguard fund because, of course, we don’t even know what the return of the Vanguard fund will be because there’s a lot of uncertainty for stocks. It’s all done on expectations.

Jules van Binsbergen: But if we do it in expectations, there’s also going to be learning in this problem, meaning that, over time, I can change that expectation, right? What if I get good news about the manager or bad news about the manager? What if they outperform or underperform? What happens to that expectation? That’s the question.

Jonathan Berk: Yes, there’s learning. And obviously, if the manager does well, that’s not bad news. So obviously, if I see a manager do well, I’m going to update my expectation. I’m going to think to myself, okay, the manager’s better than I thought he was. And I’m not the only doing that. Everybody gets to observe the returns. So all investors are going to say, oh my God, that manager’s better than we thought he was, and they will want to invest money.

Jules van Binsbergen: And so that investing money will lead to inflows into the fund. The investors will give the outperforming managers more money and will give the underperforming managers – they will withdraw their money. And this is what we call in the industry the flow performance relationship.

Jonathan Berk: But just be clear about that. When the money flows in, the size of the fund grows. We’ve already established there’re decreasing returns to scale. So the return drops. And what does it drop to? It drops to the Vanguard expected return. Similarly, for the bad managers, money flows out, so their returns go up. And again, in expectation, we don’t know what their returns will be, but we expect their returns to be about the same as the Vanguard Index Fund.

Jules van Binsbergen: And there are two points worth noting about this flow performance relationship. The first one is it is the manifestation of investors competing with each other. The fact that they all want to be with the best manager will result in that flow. The second thing to note about it is, is this just a theory we’re talking about, or is this actually what we see in the data? Do we see the flow performance relationship play out in the data?

Jonathan Berk: And Jules, the key word here is the performance on the flow performance relation because, in the data, there is this incredibly robust result, which is that there is no predictability in future performance. That’s what we said at the outset of this episode. The best managers in the past, based on their past record, do no better than average managers. On the other hand, they attract flows. In fact, Jules, this is what I think of as one of – a perfect example of how easy it is to make an all-else-equal mistake. Even professors who are specialists in the subject made this mistake because what they used to say was that the flow performance relation was an example of investors making mistakes.

They said investors would look at past performance, invest based on past performance, even though investors knew that there was no predictability.

Jules van Binsbergen: And quite the opposite is true, of course. The fact that the flow performance relationship happens makes it such that the performance is no longer predictable because after the manager’s done well, the size of the fund increases, and due to the decreasing returns to scale, the returns going forward will be lower.

Jonathan Berk: Yeah. So to be specific about the all-else-equal mistake, all else equal, you would rather have a manager with better performance than worse performance. And you would expect that performance to continue if the manager’s skilled. But all else isn’t equal. When the manager does well, everybody observes the performance. Funds flow in, and you don’t get the performance going [forward].

Jules van Binsbergen: So once again, the competitive response of your environment is what makes the all-else-equal thinking fail. All right. So there’s still one last missing piece to this equation, Jonathan. And that is when we talked about Tom Brady and hiring Tom Brady to play football for us, we said it depends on how much you need to pay him to play football for you whether or not you think this is a good idea. All else equal, give – meaning for low salary, if I could have all quarterbacks paid the same low salary, then obviously, I would rather have Tom Brady do it. But what if everybody’s paid according to their skill level? If I need to pay Tom Brady a lot, is there anything left for me after I have to have paid him this salary.

Jonathan Berk: Jules, it’s exactly the same for money managers. Why? Because money managers are paid a fixed fraction of the size of the fund. And the largest funds are managed by the best money managers. So when the – the best money managers have the most skill, notice where that skill goes. It goes to their salary because after their salary, their earn the same return as all other money managers.

Jules van Binsbergen: On average.

Jonathan Berk: On average. Obviously, on average.

Jules van Binsbergen: Jonathan, I think this is a good time for us to introduce our guest. Our guest today is Pete Briger, who is the CEO of Fortress Investment Group, which has approximately 55 billion dollars of assets under management, representing 1800 institutional clients. Pete himself is specialized in distressed debt investing, and it’s probably a good idea to spend some time describing what distressed debt investing really is.

Jonathan Berk: Yeah, so what is distressed debt investing? So holding all else equal, investing in the debt of a company that’s either bankrupt or close to bankruptcy seems like a terrible idea.

Jules van Binsbergen: Absolutely.

Jonathan Berk: But all else is not equal. Pete has made an enormous amount of money buying the debt of companies that are in financial distress. Well, you might ask, how do you make a lot of money doing that? And by this point, we’re guessing a lot of you know the answer: He got a very low price.

Jules van Binsbergen: So Pete, welcome to our show.

Pete Briger: Thanks Jonathan, thanks Jules, I’m really happy to be here.

Jonathan Berk: Pete, when you came to my class and you spoke to my students, you introduced yourself as a garbage collector. And during the class, one of my students questioned an example of what you meant by garbage, a specific investment you made that from the outside seemed like a horrible idea. And you responded by saying, “But you know what price I paid for it?” I don’t want to mention the name of the investment, but if you could talk about it, I’d really appreciate it.

Pete Briger: I’ll mention the name of the investment, and then you’ll realize why I don’t want to talk about it right now. But the investment was buying the intellectual property out of the Theranos estate. And since she is undergoing trial right now, I think I’d best be served by keeping my mouth shut and not referring to that specific example.

But in anything, the entry price is important. I think in that case in particular, what most people would have assumed is that everything associated with that situation might have been untrue or might have been a fraud. But it’s very difficult to fake out the US Patent and Trade Association, so we felt good about the assets we were buying there. And I think that was the question that the student in your class was asking, was how could you actually go into that situation and ever make a guess on what something’s worth if you’re sitting there with a Department of Justice investigation that is current?

But a lot of what we do in our business is go into situations where the perception of risk is really high, and we can do our homework and get ourselves comfortable that the risk we’re taking in a particular investment is not as high.

Jonathan Berk: Well, one of the famous examples is Madoff, right? You were a very early investor in Madoff, and again you understood that there was a lot of money that could be recouped in that situation when others didn’t.

Pete Briger: Yes. I mean, that’s a perfect example of what I’m talking about, Jonathan. We were the biggest player in the Madoff bankruptcy fraud liquidation. If you just listen to the syntax of that sentence, it sounds like something that you shouldn’t want to touch. But, that’s the reason why, you know, when we started buying claims in the Madoff bankruptcy, they were in the sort of 20 percent of par range—maybe some of the first claims traded at lower levels than that. And right now, those Madoff bankruptcy fraud liquidation claims are trading in the 80s as a function of the work that the trustee has done to bring people who were responsible or co-responsible to the table to make sure they funded into the liquidation pot.

And so, we thought that would happen, and we were an aggressive buyer early, and we were a buyer as more information came out and more people became liable to pay into the pot.

Jules van Binsbergen: So, that’s another example of the second issue, which is the competition of other investors. Early on, you didn’t face that much competition, but then as other people began to realize the strategy, it became more difficult to make money in this strategy, right?

Pete Briger: That’s a good point. I’m 57 years old, and I’ve been doing this now for 35 years, and I would say the relative competition in the industry has increased 100-fold from when I first started doing this. And so, the competitive edge that you get in a situation like Madoff may be expressed in the context of days. There are probably 2,000 experienced credit funds in the world right now that all could potentially have been investing in the Madoff bankruptcy shortly after that was announced. And 35 years ago, there might have been two or three who could’ve potentially been interested in purchasing those claims.

Jonathan Berk: And how does that competition affect the scale of Fortress? I mean, Fortress is one of the biggest companies in this space. How does the competition affect your ability to still continue to make returns for your investors?

Pete Briger: Well, the maturity of the asset class has driven down the margin for error, for sure. These investments today are riskier than they were 10 years ago, and certainly riskier than they were 20 years ago. There’s a lot more capital chasing these investments. It’s became in most of the endowments in the world a discrete asset class where people allocate to, and that has sort of driven down the returns and made the risk-adjusted returns less interesting. I’d say that’s probably true for every investment asset class over that period of time.

But debt is a particularly competitive asset class. Most people think it provides stable returns, and you have your downside protected. And so, they tend to have a higher tolerance for a higher percentage of their portfolio being invested in what it is they think the risks we’re taking are.

Jules van Binsbergen: So, do you think there’s situations where funds should just tell their investors that the fund size is capped or turn down additional inflows? You talked earlier about there’s certain times when the market is offering large risk premium on many different things and there are more opportunities than at others. Can you imagine a situation where the number of opportunities is sufficiently small that funds should say to investors no, you should keep your money, we’re capping the fund size at this size?

Pete Briger: Absolutely. Ours is a cyclical business, and when investors don’t perceive a lot of risk you generally get overfunded and the opportunity set is dwindling. And so, I think as a disciplined investor, you want to be investing at a much slower pace when the opportunity set is not thematic, it’s idiosyncratic. And you should be prepared to give capital back or delay raising funds until you think the opportunity set is there.

A perfect example of that, Jules, was as we got into the bad news associated with the pandemic, the markets fell out of bed, and we and many others went out to raise capital based upon our prior reputations for having seized these opportunities to make money. And we invested a lot of capital, but that opportunity quickly went away. And so then you have to really slow down your investment process.

And it’s a little bit different in the context of a hedge fund, which is constantly invested. It’s evergreen capital versus a private equity structure, where you have more ability to just stop investing. At Fortress, we don’t charge fees on uncalled capital, so there is a theoretical cost to holding somebody’s capital, but it’s not the actual cost of fees on uncalled capital.

Jonathan Berk: Let me change the subject to investors and performance. If you look in the mutual fund space, which you’ll see that investors are quite sensitive to performance, that investors when they perceive the managers are not doing well they withdraw their capital, and when they perceive the managers are doing well they invest capital, and it’s a pretty strong disciplining device.

What about a place like Fortress, where often your investments are quite opaque, and often you need to make investments at times when not many people are investing?

Pete Briger: Well, that’s a great question. Investors really care about performance, especially over the long-term, because you can have signals with respect to performance in my asset class where if you’re making your best investors, sometimes it looks like you’re losing a little bit of money at the outset as prices tend to go down. But I think over the medium to long-term, you better have good performance or you’re not going to be managing other people’s money.

With respect to the nature of complex investments, you really have to articulate to your investors what it is that you’re doing, the risks that you’re taking. And so we have at least twice a year conferences with our investors where we take them through every investment that they’re invested in, in a very detailed way. And for those that really want to understand the risks, the upside and the downside, they have the ability to do that. And they can pretty much come in any day to Fortress, as long as they’ve signed a very binding confidentiality letter that they’re not going to sort of trade against us with this information to really understand the risk they’re taking. And then we write detailed monthly letters, et cetera, about what we’re doing.

Jules van Binsbergen: Well Pete, thanks a lot. This was just such a great interview. We learned so much about a part of the industry that even many academics in finance aren’t that particularly familiar with. And so, there were a couple trends that I think were very interesting for us to think about more. I think the most important one was that this space also has become so much more competitive over time, as you described that in the beginning there were high returns to be earned and now it’s so much competitive than when you started.

And I think the other thing that was so nicely illustrated with everything you told us about is that good investments and good companies are really not the same thing. Who would think that an investment in a distressed company is a good company? You can make a lot of money with that investment if you can get in at a low enough price. So, there were so many good insights that relate to the general theme of the podcast here.

Thanks again for being with us today, it was wonderful.

Jonathan Berk: I completely agree, Jules, this was really interesting. Thank you so much, Pete.

Pete Briger: Take care, guys.

Jules van Binsbergen: Thanks for listening to the All Else Equal Podcast. Please leave us a review at Apple Podcasts. We love to hear from our listeners. And be sure to catch our next episode by subscribing or following our show wherever you listen to your podcasts. For more information and episodes, visit AllElseEqualPodcast.com or follow us on LinkedIn. The All Else Equal Podcast is a joint venture of Stanford University’s Graduate School of Business and the Wharton School at the University of Pennsylvania, and is produced by Podium Podcast Co.