Hello, and welcome to another edition of The Bots Podcast. I'm Tracy Alloway and I'm Joe. Joe. Do you remember what was happening in nineteen sixty two? I mean from a financial markets perspective. I thought I thought you were asking me, like what my personal recollection was from nineteen But no, not only do I not personally remember what happened in nineteen sixty two, probably couldn't actually tell you anything that I know about financial markets in nine sixty two.
So I'm I'm drawing a blank here. Okay, well you're going to enjoy this, then I find this really interesting. I think you will too. But in nineteen sixty two, there was a little stock market crash and it became
known as the Kennedy Slide. Not many people remember it now, but it was really interesting because it was basically the first crash that happened in a stock market that had mutual funds in it, because mutual funds hadn't really been around in nine or in the Great Depression, So it's interesting. So it was the crash associated with something mechanically with the funds or is it was it just sort of like a coincidence that there are these new vehicles at
the time. Ah okay, So this is where it gets really interesting because as stocks started to fall on this one particular week in nineteen sixty two, there was this real concern that all these new fangled mutual funds we're going to end up making the crash worse. Basically, people thought that investors would be able to sell their holdings much more easily because they were in they were wrapped up in these mutual funds. Now, in the end that
didn't actually happen. The mutual funds actually came in and bought a bunch of stocks, so they ended up supporting the market and everyone was kind of saved thanks to mutual funds. But it's clearly interesting because it gets to this big question of how open ended funds behave when there's trouble. And you and I both like to talk
about market structure. We talk a lot about the rise of passive investing, but we also talk about e t f s and sometimes mutual funds, right exactly, and you hear it a lot these days, people warning about e t f s are getting so big and so enormous, and there's so many, they're so liquid, and people are concerned about the underlying assets in them, and we haven't
really seen any big structural systematic problems yet. But if you ask people like, oh, what are you most worried about or what could bring on another financial crisis, even if people are sort of vague and hazy about how it would work, there's like this suspicion that modern rappers of assets or modern vehicles are somehow going to be involved. Right,
that's exactly right. And of course there's an overwriting discussion as well about how mutual funds are constructed and how the benchmarks that they follow are actually defined and constructed. And that's something that we've spoken about before in terms of these worries over mutual funds or e t F basically open ended vehicles wrapped around certain assets. There was one moment in time that happened relatively recently, certainly much
more recently than in nineteen sixty two. Do you remember that one, Joe, Yeah, I think it was was that late and everyone started reading white papers about the connection between junk bond ETFs and junk bonds and whether that was going to create a problem. Yeah, that's exactly right. And we also had a credit fund. Uh, you know.
I think at one point this credit fund was worth about three point five billion dollars, the Third Avenue Credit Fund, and it experienced about of redemptions that base sickly spooked the entire market. Yeah, I remember that. And in the end, the market overall was fine and we didn't have many sort of big systemic problems. But people sort of thought it was like, Okay, this could be like a harbinger.
I mean, hey, I think people were relieved that it didn't, but it seemed like the type of thing that spoke to a lot of these anxieties which we've been talking about for a while. Yeah, exactly. So today I'm I'm quite excited about our guest because our guest is actually
the former CEO of Third Avenue. It's David Bars and he's not only going to be talking about his experience at the fund and his opinions about general liquidity and mutual funds and e t f s, but we're also going to go into a really interesting discussion about indexes specifically, and also his new venture, which is kind of an interesting tweak on existing index investing. I can't wait. Alright, So, without further ado, David Clarks welcome to the show. So
it's great to be here. I thought when you mentioned nineteen sixty two you were going to talk about that was the year I was born, and this was the significance of that, And you came up with this very interesting story that I didn't know about myself. So so you as your your barn you like me, You don't have any recognition now I do not, but I do have a pretty good recollection of what happened in two
thousand fifteen. Shall we start with that then, um, and I wish that I could claim the nineteen sixty two thing is the result of my um deep research ahead of this podcast, but unfortunately it's just a happy coincidence. Let's start with late two thousand fifteen. David, do you want to maybe just explain what was going on at that time? Yeah, I mean, look, the name of the
fund was the third Avenue Focused Credit Fund. Focused being emphasized here for making the point that we were a concentrated portfolio of highled and distressed securities that you could not get in that format in a liquid mutual fund format pretty much anywhere else. We were unique in what
we had created for the marketplace. But the The fact that people thought of that fund as some representation for an overall market is sort of a misnomer because if you think back to the financial crisis, where you had many many funds git themselves in effect right put up the gates which there were permitted to do, you really didn't have much of a different story here. This was a fund that was the focused credit fund was set up to offer investors really an alternative to to a
hedge fund, to a private vehicle. Uh and we were doing it in a in a public format. So what happened with that one fund really was not representative representative what was going on the markets. That weren't any other funds like that fund. So how did you have the idea originally before we get to even the events of late tell us a little bit about the evolution of the fund itself and how you saw an opportunity to offer access to a concentrated portfolio of these assets in
that liquid vehicle. Okay, so two thousand eight, the financial crisis is is coming upon us. We were deep value investors. Pretty much most of our assets under management were in publicly listed equity securities. We had had a historical participation in debt and distress debt, both in public and private vehicles, but had really not had much exposure to that asset
class leading up until the financial crisis. But as the financial crisis came upon us, obviously being higher up in the capital structure of a business is a safer way to invest. And our idea was to try and gather assets into that wave, if you will, and and do that in a in a way in which we can participate, cause we were like any other opportunistic value investor. That's where we saw the value really and really were excited
about the opportunity. The problem is, how do you raise money going into a financial crisis when most people are taking money off the table, and we were experiencing that with our open and mutual funds, the equity funds. So the only solution that I could come up with at the time, because I was out pitching investors literally the week before and after Lehman Brothers went into bankruptcy, was to launch an open and mutual fund because that's what
we had successfully done historically. And it took about nine months to get that done. So it's August two thousand nine and we read we file our third Avenue focused credit fund, and the opportunity was pretty clear, right. You had high yield trading at twelve hundred over as a spread, and and so you could pretty much pick your litter.
It was like shooting fish in a barrel, quite frankly, because you could buy very plentiful supply of securities out there that you could buy and diversify the portfolio even though it's a focus fund, but diverse by the portfolio across industry, and that was an easy opportunity for us. The challenge was there weren't many funds being launched in
that format. In fact, I believe we were the only one, and most people, if they were trying to access these securities, were doing it in private funds and hedge funds, So we were very unique. And in fact, I remember going on CNBC to announce the launch of the fund and a lot of folks took interest in what we were try iring to do at that time. So that was the that was the spirit for the launch. The idea
and the opportunity was clearly there. Did it ever cross your mind to start a hedge fund or a private fund like other people were doing. I mean, you mentioned that you you've had success in other open ended mutual funds, so that was your expertise. But did you ever even
think about it? Not just thought about it, attempted it in different derivations, especially since we had going into the financial I think two thousand seven rssets under management peaked at close to thirty one billion dollars, so we had a pretty broad client base. But those clients in two thousand eight were more interested in getting their money back than allocating capital, and so raising funds in a private format.
And even though we had that kind of a u M, we were in a private fund what you call a first time fund man GERM, right, because most of our funds, in fact, all of our funds were in public format, right, and mutual funds or separately managed accounts. So when you launch a private fund, private fund investors like to see track records, and this is why you have many of the successful private equy firms out there launching Fund seventeen right now, because there they've got track records for the
sixteen prior funds that investors make their decisions on. Unfortually, we are backward looking industry, right, So that was the challenge for us, and and it became really uh almost the only way we could get the money was to do it through this public format. Now, one of the concerns that was that we were already talking about and that was really spotlight in late is this idea of
a sort of liquidity mismatch. People want daily liquidity, or if it's in an e t F form, they want a minute by minute liquidity, but just dressed assets, junk bonds, they don't just trade. You know, a minute by minute is easily is the same the same way as a
stocks do. When you launched the fund, was this something that was on your mind as a concern, Yeah, of course, and and so the goal was to get to a critical mass so that you could have size and enable yourself to have a diversified portfolio, not have any heavily concentrated positions where liquidity constraints would mismatch investors needs or desires. Because investors in mutual funds have the right to redeem daily.
Uh you know, there are certain redemption fee features that you can put on funds, but that's that's the nature of the vehicle. So of course we were very conscious of that, and we wanted to get the size that
we did quite. I think my recollection is that the fund got to about seven million in a u M and within three or four months, which was sort of an unprecedented at the time raise, especially given the time framework in right, it's the fall winter of two thousand nine, right, still anount of time when people were thinking about getting back into the market. Right, we hadn't even had the green shoots conversations yet. So it was it was a very successful launch, if you will, and that helped create
liquidity for investors if they chose. And there were points of time, especially as you think about what happened in two thousand eleven with the downgrade of US treasuries, right, you know, you had issues over time where markets were volatile and people wanted to take look, take capital off the table. So we have to be able to manage that through that period. The ultimate demise here was the fact that you know, you have I had a portfolio manager in charge of the fund who who made some
bad investments. And at the end of the day, in any construct, whether it's a mutual fund or or a private fund, you have to be making good investments. That's what you're charged with doing. And and when you have investments that turn out to be non performers. That's what ultimately lead to the challenges with the fund. It wasn't the market issue as much as it was individual investments. So can I ask, if you were doing it all again, is there something that you would do differently or what's
your biggest takeaway from that experience? Well? Yeah, I think if you're that the learning is twofold. Work harder to try and raise a private fund. That's a that's an easy one. And secondarily, if you're going to do something in a in a public format where investors can can access you daily and redeem you daily, then the only way to properly manage risk is to massively diversify the portfolio. So it's it's sort of what has ended up really
transforming into the high yeld marketplace. You have. Most hield funds are basically benchmark trackers, right They own wildly diversified portfolios of securities that track the high heeled index. So basically, if you're going to have a daily vehicle or liquid vehicle for the public, your lesson now is there's almost no way to do it on a concentrated basis. It just has to roughly more or less everything. That's correct
if investors are going to demand daily liquidity. Right when it comes to credit market liquidity in general, we hear so much noise about, you know, trading having become more difficult, the market any more liquid, more e t f s, more open ended funds that are investing in you know, high old bonds and things like that. Are those valid concerns in your opinion? Well, I haven't seen it manifest itself in any way that that would cause me to
be concerned about it. I think you had a point a little less than a year ago, maybe in January of this year, where HYLD was almost trading at perfection, probably maybe unprecedented in terms of where it was from a from a yield basis, and and the spread as as thin as I think it's ever been, and you didn't really have any any issues, and we weathered through what was a pretty challenging energy market a couple of
years ago that we're now seeing. I think there were articles about it today that energy is now maybe the largest percentage of the High Heeled index right now, and you're seeing a sort of a robust demand for securities in that sector. So the market has seemed to evolve itself into a pretty stable place, notwithstanding all of these traditional metrics that might cause concern for folks, But it hasn't done anything to um to spook the market from
what I can see. So the going back to a couple of years ago when we had the energy crash and a lot of high old dead tied to energy, that was obviously when people were most worried. In your view, the fact that we got through that period that it was pretty smooth, that none of the concerns really turned out too much, it's pretty good evidence that the market
structure roughly works. Yeah, And if you had asked how old investors what their biggest concerns where maybe a year ago that's a healthcare was going to be the next energy sector and where what happened? Right, We haven't read or heard much about that sector getting disrupted in a in any kind of material way. So I I just think people keep trying to look for problems. It's just for the sake of looking for problems, and and the market seems to have worked itself out pretty efficiently, which
tends to happen. So David, let's talk about your new venture. I alluded to it in the intro. But it's kind of an interesting take on investing. And I guess the clue is in the name. You know, you're now principal and co founder at outvest Capital. Can you tell us quickly what exactly it does, what the what the mandate is? Yeah? So out test is is really an intuitive, simple, scalable
idea for how to do two things. One take advantage of what we think is the most forward facing risk for all investors, which is the rate of technological change and how tech is disrupting all industries. And secondarily, the wave of flows into the passive index investing marketplace, which I personally witnessed in my prior role, and as something
that I think is going to continue infinitum. And so what simply one should think about is it may be important, more important what you leave out of your portfolio than what you put in. And thus the name and branding of our enterprise called outvest Capital. So this is really interesting. We typically think of funds as trying to select the very best assets within some sort of broader family, whether
it's large caps or small caps, whatever. Your view is that perhaps the best way to go is to more or less by the index, but try to avoid the losers of the index so that you can gain from that. What is the Is there an academic research or backward looking data that suggests that that may be a better approach,
So there isn't that we could identify. We wrote our own white paper which talks to this concept because if you really think about what you when you go to business school, you're given Harry Markowitz's book on modern portfolio theory, and it is pick concentrated portfolios of best ideas and
over time you will beat the market. Right, that's the basis for the way most people are educated today, and still today we take issue with that and actually say that really flip the investment process and it's more important what you leave out than with you put in. Because the market has evolved, index funds are the market today. They are continuing to grasp more and more of what's
happening where flows are going. And we decided to launch this concept after simulating back testing it for a little while. But we have chosen the SMP five hundred, the most broadest based domestic US market where more flows are going than in any other index, and simply by excluding as you call them the losers. We look at it as we're trying to eliminate from the portfolio those companies that are or likely will be disrupted by technology. And again
technology disruption being a forward facing risk. And there's no better example for me to to share, and I think you you guys have talked about this in the past, is General Electric. General Electric was the top five i've company in the SMP from a market cap weighted basis, and now it's market cap is close to a hundred billions, and now I'll blow a hundred billions, Okay, So look, and that's happened in such a short period of time.
And I think in May of two thousand seventeen, the Wall Street Journal wrote an article about how Jeff Emo was one of the great technology innovators in the way in which he'd you know, taken and transformed g GE. Well, that clearly hasn't happened. So it's it's think about that if you own the SMP, you were buying that stock at its weight, and if you've simply eliminated what kind of outperformance just from one security? Now we do this.
We ended up out vesting through our process about a hundred and fifty close to of the market cap, and we have been able in eighteen months of live performance outperform the SMP by clist of five hundred basis points. So we're just trying to prove move this out. But that's where we're that's what we're doing. So how do you go about identifying those hundred fifty companies or how
do you identify the next g e? And is the process for identifying something that you want to take out of your portfolio any different to identifying something you know under a traditional investment strategy that you would want to put in. So yes it is. And and the number of folks who we've talked about to say, why aren't you just doing a long short portfolio, because really the short selling mentality is to is to do that, to fundamentally select a security you think is going to not
perform or under perform. But we're we're really trying to make this a scalable business, and short selling by definition has been non scalable. You have I think only one fund in the marketplace that's over a billion and a u M. So what our process entails is it's really two prong The for is simply dividing the index into industry groups through a technology taxonomy. In other words, we're not using the global industry classification codes to divide the index.
We're using our own industry group determinations. And we we've divided the SMP into thirty four industry groups, and that may change depending upon how the SMP evolves over time, because there are new entrants and companies that leave the SMP from time to time. So we look at industry groups through our own lens and then we make a simple determination as that industry advantaged or disadvantaged by technology, and if it's advantaged, by default, that industry group and
the securities in it will be in the portfolio. And if it's disadvantaged, that secure those securities and industry groups will be out vested from the portfolio or eliminated. So that's step one. It's a qualitative determination. It's an active approach, but it's merely making industry decisions, not company specific decisions. We then apply a quantitative model that we built to take that advantage group and make a decision whether to
own it or not own it. So if it meets the quant screens, and the quant screens are are a lower bar for advantaged industries than they are for disadvantage. And similarly, if a company is in a disadvantaged industry, the quant screen will either keep it out or kick it back into the portfolio. So you can avoid situations where there are certain companies within an industry group. And I'll give you an example of that. Retail would clearly be a industry group that is likely to be disadvantaged
by technology. I don't think many people would debate me on that, but there are companies within that industry group, like home depot, that we view as through our quant screen as having certain advantages and therefore it got kicked back in. And this is a fundamental quantz quant screen fund. This is looking at financial data of the company and something in that suggests that it's different than other retail.
That's right now. You mentioned the advantage and investor could have by say, investing in the sp and not being exposed to G like even that would have been pretty good. Is there something that your screening would have picked up three years ago or two years ago or five years ago and never g E started to enter a tail spin that would have prevented that from getting into the portfolio.
And can you identify what that is. Yeah, And indeed, in the case of G was our model that kicked the company out because we actually view industrials, which is this the industry group that G falls into, as an advantage sector. I mean that's industrials are clearly looking to technology, whether it's through robotics or otherwise to improve efficiencies and what they do. So long term, we we see that
as an advantaged industry group. But the model kick G out, and primarily the the one particular signal for for for that company was was revenue growth rate. And so you had a situation where it's declining revenue growth and it's very hard for companies and publicly reported financials to fudge revenue. They can make all kinds of adjustments to EBITDA and other earnings metrics, but in the case of revenue, it's pretty tough two the fudget. So they triggered the model
and got kicked out of the portfolio. Not long after we launched our fund, you mentioned that you had thought a lot about passive investing, the rise of passive investing. I assume that means that you've also thought a lot about the benchmark in disease and how those are constructed, and in fact, you know what you're talking about. It outvest is basically tweaking the SMP five hundred, which is
itself a benchmark index. What do you think about the decisions that go into making the indusseries as as they currently stand. Yeah, look, we were having we're in the moment right now right where you have probably the most significant change to the SMP in terms of get classification. Right.
You have a single person, David Blitzer, CEO of the SMP, who has the ability to make these changes in and now all of a sudden, we have something called communication services because Telecom had only two of the index when in two as we started this thing, I think Telecom was a significant percentage of the SMP, right so certainly was even ten years ago as compared to today. So they had to make adjustments two maintain the broad diversification
of the index from a sector standpoint. That to us is sort of a statement of support for what we're trying to do because we we look at the SMP as a diversified portfolio where people if they want to diversified exposure the market, and we think all investors they've shown us that they want to have a diversified exposure to the general market, and in fact, institutional investors really need to have it, as most of their investment policy
statements require them to have exposure. If if they can get that exposure in the same diversified way like our beta is is is almost one point oh even though we we excluded a hundred and fifty names, if they can get that and outperformed by the kind of margin that we've been able to generate in a very short period of time, and we think we can consistently do that over time, and consistency is a is a keyword in the asset management industry. Uh, they have to pay
attention to that. So how the the indices change and evolve over time is going to be a significant impact, I think on the overall market. But there is no one that we've seen who's approached it as we have that is flipping this process to think about what to leave out as opposed to what to put in. Can you tell us sort of what if, if in what anything in your experience at Third Avenue or even with the collapse of the concentrated credit fund sort of led
to you seeing this opportunity. Yeah, look, I I was a a student for a long period of time of my mentor and the founder off Third Have and being taught about concepts like diversification as a surrogate and a very poor surrogate for knowledge and and investing right, because you should know more about research, what you can fundamentally learn about a business, invest in that business, and over long time you'll be rewarded for that patience and and
work right research. Yet consistently from the financial crisis forward, we were able to outperform indices. And so what asset managers like us did was we change the benchmark that we ended up getting compared to because we looked better against another benchmark than the original benchmark. We chose right. We were a SMP five hundred originally measured fund and we changed right. So what I was informed about there is you cannot I think you cannot beat the market.
And if you can, then you're going to be in a hedge fund charging two percent management fees and the profits because you're a special individual who has skills that are more extraordinary, or you're a quantitative, purely quantitative manager who has come up with some concept that can beat the market. And we're seeing more and more asset flows
into those types of vehicles as well. So the the informed judgment that I made was I now believe fully that these the market is going to evolve with more and more flows going into these types of entities, if just for fees, right, just just because fees are are much less, So if we can, if we can participate in capturing some of that flow, because we've come up with this intuitive concept and we're thinking about a forward risk.
This is about technology disruption, which nobody's talking about. You guys will spend all day talking yesterday about what what's going to happen with the FED, and people study it up upwards and downwards. But how much time do you spend focusing on Moore's law and how that's impacting decision making and people's rate of change? Right? I was just
I'll push back a little bit. I mean, I would say, we we do talk about this stuff, and we talk about vulnerable industries, and we talk about, say the clash between Amazon and physical retail. The thing that intrigues me most as a theory here is the idea of being able to quantify the disruption risk and the you know, we could talk you know one of the best performing
sectors this year has been the department stores. And so this idea of actually being able to identify in a systematic manner and not just sort of your gut feel of these guys are in trouble is the part that I find to be I'm most interested in trying to understand. Yeah, and I would tell you that the fund and the concept is really about long term secular decline, but it will be technology that will be the the triggering for
that long term secular decline. So maybe department stores are out performing because they were so under performing, but that's a I'd argue that that's a temporary a temporary blip, and that over time you'll continue to see deterioration in
cycular decline unless they're able to transform themselves. And there are businesses that have been able to adjust, and it's those companies that adjust that I think will be the long term all Right, Well, David Bars, co founder and principle at Outvest, thank you so much for joining us.
Thank you, Joe, Tracy really appreciate thank you. That was great. So, Joe, I found that conversation really fascinating, not just to hear the thoughts about what happened at Third Avenue, but also to hear his thoughts about diversification and the rise and passive investing, which is something that you and I have talked about quite a bit at this point. Yeah. Absolutely. I was going into the conversation thinking, oh, definitely the sort of Third Avenue fun collapse would be the most
interesting part. But now I'm really intrigued sort of by the second half. And Okay, accepting this reality that we have now of mass of flows into passive or passive issue vehicles, what are the approaches that makes sense for now? Because as David said, it's pretty obvious it's just the sort of concentrated fund management strategy, particularly on the equity side.
It's just not working for anyone. It looks like, right, and there's actually a link with um, you know what you said about Third Avenue, this notion that you know, if you're going to have a public facing fund, and especially an open ended one, you better make sure that it's diversified because otherwise people tend to get angry very quickly and tend to pull their money out very quickly, Whereas if you're investing, you know, in a broad index,
it's kind of like that old maxim, that business maximum. You know, no one ever got fired for buying IBM, No one ever got fired for buying the SMP five hundred and making you know, little tweaks to it right absolutely, And this idea that maybe you could basically get the exact same beta, the exact same diversification with three fifty or four hundred of the SP stocks is pretty interesting.
And you're probably not going to get fired for missing out on one of those hundred stocks they've got kicked out. And I like the idea that if they did turn themselves around, so maybe like some department store really does figure out the magic sauce to save retail, then maybe you could get back into the fund. On fundamental reasons, I am rooting for Sears. I have a soft spot for Sears. I hope they they are one of the ones that can redeem themselves. Who knows, I'm rooting for
them to it. Okay, all right, Well this has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway, and I'm Joe Wisa though. You can follow me on Twitter at the Stalwart and you should follow our producer on Twitter He's told for Foreheads. His handle is at for headst and followed the Bloomberg head of podcast Francesco leaving at Francesca Today. Thanks for listening.