“As we prepare for the FOX Autumn Global Investment Forum in New York (September 12th), I wanted to highlight the thinking of one of our session speakers, David A. Salem of Windhorse Capital Managment. David will be speaking on strategies for surviving and thriving under perilous market conditions.”

–Kristi Kuechler, President, FOX Private Investor Center

An Excerpt From “Unnecessary Evils: A Critique of Wealth Management Norms Circa 2017", by David A. Salem, Managing Partner and Chief Investment Officer, Windhorse Capital Management

What’s Wrong? While many principals sense that their current investment programs aren’t likely to produce satisfactory risk-adjusted net returns in coming years and beyond, most have difficulty pinpointing with actionable precision the root causes of their discontent. We’ve assembled a list of the defects we encounter most frequently, rank ordered by their frequency of appearance.

• Unclear Aims. Examine any enduringly successful enterprise in any field of human endeavor (corporate, non-profit, military, etc.) and you’ll likely find at its core a clear articulation of not only the metrics to be used in gauging success but the time horizon over which such metrics shall be gauged. Too many investors deploy wealth without achieving such clarity, up-front or as time passes. As the age-old saying goes, if you don’t know where you’re going it doesn’t matter what road you take to get there. Differently put, if a portfolio’s owner hasn’t articulated clear and achievable goals for the portfolio as a whole, it’s hard to determine which assets and strategies the portfolio should favor and harder still to determine which it should avoid. The latter defect helps explain the depressing frequency with which we encounter the next two most common defects when conducting diagnostic reviews for wealthy families and endowed charities.

• Excess Costs. Given the growing visibility and commercial success of ultra-low cost indexed approaches to equity investing in particular, few if any readers need a lecture from us on the virtues of reducing return slippage. That said, it’s surprising how few stewards of substantial wealth have examined rigorously all forms of slippage to which their capital is subject — i.e., base fees, incentive fees, applicable taxes and appropriate measures of inflation; and it’s shocking how few principals ponder carefully aggregate slippage they’re likely to incur under not only normal or base case conditions but under abnormal conditions also, e.g., scenarios entailing very high nominal gross returns coupled with high rates of inflation. (Trust us: investment programs for taxable wealth relying heavily on managers entitled to even modest incentive fees or carries tend to produce stunningly ugly real after-tax returns under such conditions.) The key point is this: given the wide range of market scenarios that thoughtful principals should contemplate in light of today’s growing economic imbalances and geopolitical strains, investors seeking to earn satisfactory returns net of all forms of slippage regardless of how such tensions get resolved should focus laser-like attention on one abiding concern: not overpaying.

• Myopic Methods. Overpaying is endemic to wealth management circa 2017 because self-interested advisors have induced many principals to engage in bucket filling — funding managers and strategies pursuant to pre-specified targets that essentially ignore such exposures’ current price tags. The targets in question ignore current prices because they’re typically derived by applying backward-looking asset allocation models to historical data, the operative premise being that historic returns, correlations and volatilities (a/k/a standard deviations) can serve as reliable prologues to the future. They can. But the history of investing is littered with examples of investors who extrapolated past phenomena into the future without adjusting such data to reflect the very labors in which they were engaged. The poster children for such behavior are behemoth state pension funds whose mean-variance models commend gigantic allocations to niche strategies whose alluring past performance is attributable largely to a historic dearth of human or financial capital.

• Faulty Structures. Many contemporaneous asset mixes include “asset classes” unworthy of the name: pseudo-classes like “Hedge Funds” and marketing gimmicks like “Infrastructure” that no sensible investor would fund if they knew they’d earn from them over time the average return of all investors engaged in such activities. To be sure, the securities or properties held within such portfolio segments or buckets might themselves have a logical place in well-diversified portfolios, provided that (a) the reasons underlying their purchase are clear and compelling and (b) the costs of acquiring and holding them are reasonable on an absolute basis and relative to competing alternatives. In general, the criteria just mentioned preclude or, better put, ought to preclude the purchase of so-called structured notes: bespoke contracts between financial services firms—typically large, multi-line banks—and customers of their brokerage arms that provide the latter with exposures incompatible with a proper understanding of their long-term goals and that, even if compatible, can typically be acquired far less expensively by cutting out the middleman.

• Dicey Dynamics. We’re surprised and alarmed by how many otherwise savvy principals we’ve encountered of late who can’t furnish even minimally satisfactory answers to two basic questions respecting their evolving portfolios: what do you own and why? We’re not talking about detailed info on each and every holding; just a general sense of what’s held and the reason(s) why. Of course, the behavioral roots of such befuddlement are clear and plain: lacking as they do the expertise needed to determine objectively whether a given potential investment’s future is truly as bright as its past, many principals or hired guns employed by them commit capital on the basis of the only verifiable facts known to them: past returns, with an emphasis on the recent past. Eventually if not immediately, they become the beneficial owners of a mish-mash of securities and properties whose names let alone fundamental attributes are wholly foreign to them — assets selected typically by an unduly large cadre of external managers none of which is sufficiently well understood or trusted by the portfolio’s ultimate owner to merit a potentially needle-moving allocation (5+%).

Toss a few more perturbations into the mix (e.g., price insensitive portfolio moves consummated on behalf of robo-advised individuals and institutions, and momentum-driven sales consummated by algo-directed hedge funds and high frequency traders) and you have the makings of a market in which wealth eventually gets transferred from jittery investors scrambling to convert longer-dated assets into cash to those who’ve been patiently awaiting opportunities to do the converse.

To see the full agenda for the 2017 FOX Autumn Global Investment Forum, click here.