A man called John Hays Hammond was awarded ‘the highest salary in the world’ in 1904. That’s how the press reported the deal that mining expert Hammond signed with the Guggenheim family, to head up their exploration company Guggenex as it looked for new finds in South America.
Hammond was to be paid $300,000 annually and a share of the profits from any mines the family bought or established as a result of his prospecting. It was a partnership that not only made Hammond very rich – it paid off handsomely for the Guggenheims as well.
On the wall in the Manhattan office of Guggenheim Advisory are framed cheques for tens of millions of dollars – the returns those South American mining projects delivered for the family just a few years later.
The relevance of this story for Charles Stucke, CIO of Guggenheim Investment Advisors, is that paying big fees is fine so long as you get big returns.
Stucke’s arm of the Guggenheim organisation manages money for a relatively small number of sizeable clients, selecting external managers as well as deciding on overall asset allocation.
Between $50 and $60 billion is supervised collectively by the advisory businesses at Guggenheim. That money is invested on the basis of risk analysis rather than any traditional asset class breakdown, but behavioural finance is also a key influence.
‘Our asset allocation process combines the principles of modern finance with the principles of behavioural psychology and behavioural economics,’ explains Stucke.
‘We start by profiling the risk tolerances of an investor. In particular we focus on time horizon, risk of dissatisfaction with different levels of drawdowns in the portfolio, or loss aversion, and we focus on levels of dissatisfaction when the portfolio doesn’t keep up with different headline market risks. We call the last factor “gain regret”.’
Guggenheim Investment Advisory (GIA) is a business unit of Guggenheim Partners, LLC. GIA provides investment and wealth management solutions to strategic partner clients, along with independent registered investment advisors (RIAs), private banks and trust companies and similar financial intermediaries, helping them scale their businesses and meet the diverse needs of an increasingly sophisticated client base.
This concept of ‘gain regret’ is fundamental to Stucke’s thinking. ‘People are unhappy when they lose more money than they think reasonable within their expectation for risk,’ he explains.
‘They are also unhappy when the S&P is up 18% and they’re only up 3 or 4%. So we have to understand both sides of the risk equation and approach them differently.
‘The industry has adopted measures like volatility and the Sharpe Ratio as pre-eminent determinants of risk and risk-adjusted return. Those two-way measures really don’t answer well as independent solutions for loss aversion and gain regret. Traditional asset allocation doesn’t fit with our thinking and we don’t think it fits with the way the client thinks,’ he says.
Behavioural finance concepts have always generated a lot of interest among professional investors but Stucke and his team believe they have an edge – they draw on the work of Nobel prize-winner Daniel Kahneman. A Nobel laureate in economics, Kahneman is also a consulting professor of psychology.
‘He has served as an adviser to our business since 2006,’ says Stucke. ‘His thinking has really driven our process forward in terms of how we use information in our research process and how we assess an investor’s risk tolerance and return expectations.
‘What Danny has shown us is that, regardless of whether people are novices or experts, they may be subject to certain behavioural biases and decision-making flaws. It may be wired into their genetic code.’
But for Stucke, Kahneman’s work has also shown that those flaws can be minimised or overcome if you have the right frameworks and some simple decision-making tools.
Many of those who have been attracted by behavioural finance concepts have found it difficult to implement them. Stucke doesn’t want to give away any secrets, but he believes his team has found a way to do this.
‘It’s hard to take the academy to the practice,’ he acknowledges. ‘Some of these ideas are simple but people just haven’t jumped the gap yet.
‘Advisors have historically tried to build one portfolio for their clients. And that portfolio is a blend of all the different goals of the client. The problem is that when the market rises, that blended portfolio underperforms the rally and makes people unhappy due to gain regret.
‘On the other hand, when the market tanks, and that portfolio’s equity portion drops, people are unhappy due to their loss aversion. So they have a portfolio that loses in both environments, relative to their expectation. And that’s because there’s a mismatch between the goal of the portfolio and the goals of the client.
‘So we have applied a combination of the concept of mental accounting with Daniel Kahneman’s observations on loss aversion and gain regret.'
'To do this means framing two accounts, one conservative and one bold, the conservative account managed to meet an investor’s objectives around loss aversion and the bold account managed with respect to a reference index, to handle the issue of gain regret.’
Dividing the portfolio in this way solves individually the two very different sets of risks the investor perceives, says Stucke, making them more comfortable with the collective portfolio.
‘We do this to avoid clients rushing reactively into all equities after a big market run, because of gain regret, or into all bonds after a big market fall, due to loss aversion.’
When it comes to manager selection, there is always a preceding strategy decision.
‘So before we even get to the manager we want to make sure we’re in the right strategies, and then within those strategies, we want to select managers with the highest expected alphas, with outstanding levels of integrity and incentive alignment, and reasonable economics.’
Expansive investment view
There is a perception that US-based investors can be slow to look beyond their own borders. Guggenheim’s more international mindset is reflected in the fact that across the team they speak around 10 languages – unusually high for a US-based firm.
‘We have clients, counterparties and investments in every major economic region globally.'
'We believe successful management of such a practice requires a deep understanding of local markets and local cultures, if for no other reason than it allows us to make a bridge to a client or manager, to be able to have a more personal and informative dialogue. It reduces the formality of discussion and gets us to a different level of understanding, if we have a cultural and linguistic connection.
‘It’s true that when I speak to Asian families they tend to anchor their perspective on what’s going on in Asia. With Latin American and European families we see the same. So people do have a home bias in the way they perceive opportunity and risk.’
The importance of such connections has always been recognised at Guggenheim. ‘My personal development into this mindset is something I came into over time,’ says Stucke. ‘I was raised in Missouri with a very US-centric view. It took me years to peel myself away from that.’
With this new wide-angled lens Stucke is now scanning the world for opportunities.
‘We like markets which are going through fairly substantial evolutions or structural changes. Such markets often provide very interesting opportunities for active management to intermediate and make excess returns.’
Markets to watch
One market that fits that mould is Brazil. ‘We’ve been quite interested in the development of the Brazilian equity and hedge fund market for a number of years, but we have not invested materially in the country to date.’
He has been held back by concerns about incentive alignment and, when it comes to hedge funds, the economics of the Brazilian business.
‘There are very high quality, very bright managers in Brazil. The hedge fund marketplace is quite developed. However, the market has grown primarily with local capital rather than international capital, and that local capi historically had the expectation of ready liquidity.
‘When Brazilian hedge fund managers constructed their businesses, they often allowed local capital to have daily or weekly liquidity, whereas the offshore funds available to international investors have offered monthly or quarterly liquidity.
‘We have been uncomfortable sitting in what is effectively a subordinated share class to local and perhaps better-informed investors in this emerging market.’
Asian credit is another area which looks interesting from a top-down perspective, but is challenging in practice.
‘As the Asian economy develops, the size, volume and diversity of the Asian credit markets have and will continue to develop as well,’ says Stucke.
‘Asian credit markets are vastly under-researched, underdeveloped and potentially under-appreciated in comparison to American credit markets. That said, to date, there are few managers pursuing active Asian or emerging market credit strategies in a rational liquidity framework.’
The importance of key players
While the strategy may come first, the focus on the individual portfolio manager is an issue which strikes a chord with Stucke.
‘Firms always want to encourage investors to attribute attractive track records to the firm. And they’ve worked hard with organisations like the CFA Institute to create performance standards that do that. This is protective of the firms’ economics at the expense of the economics of the portfolio managers.
‘Most of us in the professional research and allocation business know that in many cases it’s not the firm, but the portfolio manager, that matters. So it’s somewhat frustrating that we’re always involved in this game of attribution. While not true in all cases, for many equity strategies, the portfolio manager is the person to watch.
‘For investment businesses such as quantitative equity trading, well-developed CTAs and certain types of credit strategies, the infrastructure of the organisation together with the seat or position of the organisation in the market, matters as much or more than the individual portfolio manager.
‘So you have to first ask the question: is this an individual skill and insight business, or is it an infrastructure business? Once you answer that question, you can prioritise your analysis.’
Why we don't apply risk parity
‘The concept of risk parity is very popular today. Risk parity is a volatility-based risk framework and so is VaR. We’ve all seen the problems that VaR has caused for people. Risk parity is driving many consultants and major allocators to push enormous amounts of capital toward US government fixed income markets at a time when rates are at or near 30-year historical lows,’ says Stucke.
‘Ten years from now, investors may look back on risk parity and ask, as an industry, what on earth we were thinking? We do not apply risk parity in the advisory practice as an asset allocation framework.
‘In addition, its use of volatility as a base makes it rationally inconsistent with the idea of prioritising or focusing on fat tail risk. Volatility is only a useful measure of risk in a normal distribution, which doesn’t describe many hedge fund strategies and other financial assets.’
Concepts that come along and become very popular very quickly should always ring alarm bells, Stucke believes.
‘That said, I think it’s exciting and encouraging that the industry continues to try to develop new approaches to tackling the problems of investing, which is an old science. I don’t want to say that new ideas shouldn’t receive attention, because they should. I just would argue that the popularity of the idea isn’t always related to the quality of its intellectual foundation.’
Another trend that has been gathering pace since 2008 is, of course, an increased focus on regulation.
‘And this is a global phenomenon, not specific to any market. Singapore, once the bastion of free market entrepreneurialism, has now taken steps to tighten the noose on start-up fund manager activity within the city, for example.
‘Increasing regulation and regulatory complexity favours incumbents and it favours larger incumbents.’
So the challenge for the fund management businesses, he believes, is whether it can continue to be as meritocratic as it has been.
‘Can the brightest people still step out and easily go into business so they have a shot at unleashing their talent, or are they going to be funnelled through platforms, consolidators, larger firms and banks? That’s the question.'
'Will we be able to maintain the capitalist spirit – and it’s a dangerous thing to say in this political environment today – will we be able to maintain the dynamism, the entrepreneurialism and the meritocracy of this industry in an environment of rapidly escalating regulatory complexity?’
With the story of John Hays Hammond still being retold, the capitalist spirit looks to be alive and well in the Guggenheim offices. His finds, as Stucke recalls, catapulted the Guggenheims to being one of the 10 wealthiest families in the US.
‘We ascribe to the philosophy that paying fees for value absolutely makes sense. The key is to understand when you’re really getting value.’
Charles Stucke is a senior managing director for Guggenheim Partners and CIO of Guggenheim Investment Advisors.
He also serves as chair of Guggenheim Investment Advisors’ investment committee and is associated with Guggenheim Investor Services and Guggenheim Advisors.
Prior to joining Guggenheim in 2006, he was an executive director on the portable alpha team at Morgan Stanley Alternative Investment Partners, where he opened and managed the firm’s London-based European alternative investments research office.
He has experience in the alternative investments, private equity, mezzanine, structured debt (public and private, taxable and tax-exempt) and interest rate derivative markets in New York, Chicago, London, Philadelphia, Berlin and St. Louis.
This article originally appeared in the November issue of Citywire Global magazine.