New clients at Telarray are offered a session at the beginning of our relationship to discuss the Telarray approach to investing. It’s a lot to process in an hour or two, and we know that there may be questions as our relationship develops.
Of course, you may call your Advisor at any time with any of your questions, but we thought a multi-part series discussing our approach to investing might be helpful. Enjoy this latest installment.
During this series, we have spent a lot of time discussing the things we do in Telarray portfolios, which are completely invested in public mutual funds and ETFs. We believe this is a feature of our approach, not a shortcoming. In fact, we believe that often exciting private investment opportunities out there, including hedge funds, private equity, and VC funds, are often affinity traps — vehicles designed to attract the wealthy without providing the long-term performance necessary to make them worthwhile. Many managers of private investments do have their investors’ best interests in mind, but nevertheless, there are structural issues that create headwinds for private investments. Here are a few reasons we avoid these kinds of private investments entirely at Telarray.
The entire investment of a typical Telarray portfolio can be sold in a single day, with proceeds to your bank account within 1-2 business days. You might take this for granted, but it is a very special privilege of public funds that not every investment enjoys. Many private investments have redemption gates, limiting investors to selling only on specific dates or only redeeming a certain amount at a time. Investors are often required to notify the fund of their intention to redeem shares long before the actual redemption date. There are additional unusual provisions in some investments, such as the infamous “side-pocketing” used by some managers during the 2008 crisis.
Ironically, this illiquidity has been touted as a feature of private funds since it locks in the investor and compels them to hold when they might have otherwise exited. While there might be some truth to this for some investors, we believe it’s not worth giving up optionality simply for behavioral purposes. We can assure you that your Telarray advisors and investment team stand ready to talk you out of selling at the bottom, and you don’t need a contractual lockup for that!
Fidelity recently began offering certain index funds with zero management fee and, in fact, a zero overall net expense ratio — the joke being they will “make it up on volume.” We have discussed our factor-based investing approach earlier in this series, where we get aspects of indexing and aspects of a more active approach with very reasonable fees. While our fund expenses are greater than zero, as of this writing, most of our funds have expense ratios of less than 0.30% per year, which we think is very reasonable.
The classic “2 and 20” hedge fund model is to charge well in excess of this; they charge 2% of the value of the account each year plus 20 percent of the annual profits over some hurdle rate or high-water mark. While overall private investment fees have trended downward, these fees are still likely to be far in excess of what can be found with our types of funds. Does the performance of private investments make these extra fees worthwhile?
Glad you asked. Beating an investing benchmark is really difficult. To make a compelling case, a private investment needs to demonstrate:
- A sufficient track record in the past (if for no other reason than you probably wouldn’t know about it if there wasn’t one);
- Evidence that suggests future performance (after fees, taxes and expenses) will be in excess of performance achievable in public markets and make up for illiquidity and other risks.
When evaluating investments, everyone focuses on item 1, but not everyone thinks as hard about item 2. Just recently, a professor was talking about the long-term (18-year) performance of a student-led investment fund which had consistently trounced the S&P 500. He pointed out how the students were early adopters of stocks which ultimately became very successful, like Facebook and Snapchat. This sounds compelling at first glance. Should we sign these students up as Telarray’s first hedge fund managers?
What he didn’t mention is that the lifetime of the fund overlapped closely with the tech sector’s trough following the 2000 tech bubble and has coincided with one of the greatest periods for technology stocks in history. While the students probably did a great job, if they were running a hedge fund and charging 2 and 20, it’s unlikely they would have beaten a simple technology index fund for the same period. Even if they did, a true analysis of their performance would have to examine if their performance was due to a few big lucky bets or a consistent, repeatable investment process. What matters to us would be the next 18 years of performance, not the last 18. We would have to be confident that whatever they were doing would work in the future. Also, the benchmark matters. This investment approach probably should not have been compared to the S&P 500.
Telarray portfolios are comprised of mutual funds and ETFs from a diverse set of providers, and diversified across sectors, markets, and countries throughout the world. We focus on providers with evidence-based approaches, reasonable fees, and transparent processes.
When evaluating private investments, the question is not, “is there a private investment that has put up incredible numbers over the last few years that I wish I had owned in retrospect?” Of course, there are investments of all types which dramatically outperform the market for a given period.
The real question is, “Can we pick a private investment that will reliably outperform not only its benchmark but also the additional layers of taxes, fees, risk, and complexity that go into it in the future?” That’s the question that matters, and so far at Telarray, the answer is no. We continue to be very satisfied with our public Telarray mutual funds and ETFs.