Long-time clients of Newfound and readers of our weekly research briefs will know that we have historically been loath to write quarterly performance commentaries. We have written enough about the largely random nature of markets over the short-term that, barring the most unusual of cases, we generally feel that trying to explain short-term performance with any sort of narrative is disingenuous at best.1
We are, after all, quants. We have no tightly held views on the short- or long-term macroeconomic outlook and we, by and large, do not care about the positions in our portfolios. We care about the process.
Which leaves us little to comment on, in the traditional sense: no wonderful narratives to weave about our holdings or economic views to wax philosophical about. Yet there are updates that we wish to share that do not fit into our standard weekly format. So, going forward, we expect to publish a firm-level update from time-to-time. Our goal is to keep them transparent, brief, and only communicate when we have something meaningful to say.
Towards Improved Capital Efficiency
In August 2018, Newfound celebrated its 10th birthday. In our tenth year of business, we remain firmly committed to a risk-first approach to investment management. We express this philosophy in big, bold letters on our website:
While other asset managers focus on alpha, we focus on managing risk first.
We believe that for the vast majority of investors, being less wrong is more important than being more right. In light of this, our aim has always been, and continues to be, to help investors introduce new ways of managing risk in their portfolios by expanding their exposure across the diversification axes of what (asset classes), how (process), and when (frequency) within their portfolios.
The risk-first philosophy that permeates the objectives of our portfolios also permeates our approach in building them. Long-time readers of our research will recognize this in our continued focus on not just the ingredients that go into building our portfolios, but also the recipe that dictates how those ingredients are combined. We believe that true craftsmanship, and long-term success, is found in these details. A perfect example of this is our paper Rebalance Timing Luck: The Difference between Hired and Fired which was published in the Journal of Index Investing. In our opinion, timing luck is a big little detail; one we began wrestling with back in 2014 and have yet to let go of.
But innovation rarely comes from looking at where we’ve been. Therefore, we constantly re-evaluate our strategy offerings and ask ourselves a simple question: “would we launch this strategy today?” If the answer is ever no, we have two choices: evolve the strategy or shut it down.
It is a simple question but the Herculean effort and cost it can take to get a strategy off the ground and to scale can create incredible pressure to keep a strategy alive far longer than it should be.
If we answer honestly, however, a no can arise for several reasons. Sometimes the answer is business related: perhaps the strategy fails to gain investor interest, a competitor has come to market with a superior offering, or the strategy is no longer cost competitive. Other times, ongoing research has evolved our view as to the efficacy of an approach or how a strategy should be managed.
Of course, we try to avoid ever getting to the point of an outright no. If we answer yes with tempered enthusiasm, we know it is time to dig in.
This is where we found ourselves two years ago with respect to our advised mutual funds. We faced several simultaneous pressures: (1) an investment approach that optically had not evolved much since 2008, (2) an influx of lower-cost competitors, and (3) industry-wide fee compression.
Now, we should state that at the right cost, we still believe these remain innovative investment programs. For example, on overlay/model manager platforms (e.g. Envestnet, Vestmark, FolioDynamix, and FOLIOfn) and via our model/index delivery program where we can offer substantially more aggressive fee structures, we believe the offerings remain very attractive.
The associated fixed costs of running a fund structure, however, are another matter entirely. For a boutique asset manager, lowering fees outright is rather difficult without significant asset scale. Administrative fees, compliance service costs, accounting costs, transfer agency costs, legal costs, blue sky registration costs for different share classes, and annual platform fees lead to an extremely high operational burden. In fact, even if we were to forego our management fee entirely – which would mean no revenue to support portfolio management and client services – our advised funds would still be expensive.
Thus, we undertook an exercise to:
- Find ways to reduce costs in our business so that we could reduce fees in our funds;
- Introduce additional return streams for investors; and
- Innovate strategy design.
Explicit Fee Reductions
In our three advised funds, in the last 12 months, we reduced our management fees from 1.15% to 0.79%, 1.00% to 0.69%, and 0.90% to 0.79%.
Further, we waived any fees that had accrued to us as a manager over the last several years from fee waivers and expense reimbursements so that the fee reduction would be felt immediately for current investors. We also eliminated the C share class in each of our funds, as it has, for the most part, fallen out of favor the last several years.
Additional Sources of Revenue for Investors: Securities Lending
To attempt to further offset effective costs, we engaged with eSecLending to initiate a securities lending program for our fund family. eSecLending is an independent, 3rd party agent who provides operational expertise and risk management oversight to our program. They have been named Securities Lender of the Year numerous times by several different agencies (including Risk.net, Global Pensions and ICFA) over the last decade and count the likes of CalPERs and the New Zealand Superannuation Fund among their past clientele.
After an arduous nine-month setup process, we began lending on February 8th, 2018. The volatile market proved fortunate timing as a number of ETFs we held were in high demand and could be lent at premium rates.
Even in less volatile environments, we believe that lending ETF units (sometimes called “outside” lending) can prove to be a potentially profitable added source of revenue due to the relative scarcity of ETF units in lending programs. For example, as of June 2017 over 25% of the Russell 3000’s market cap was available for loan, while only 5% of the total ETF AUM was in lending programs.2
This scarcity is coupled with a potentially added demand for borrowing in the ETF space from authorized participants (“APs”), the market makers responsible for the creation/redemption process of ETFs. For example, when there is excess demand in the market, rather than immediately engaging in the ETF creation process, APs may quickly source units through borrowing. This allows the AP to later purchase the underlying exposures, create the ETF unit, and return the borrow at a pace that creates less market impact, particularly for less liquid underlying securities.
Lack of loan supply can mean high demand in ETFs like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). For the 12 months ending June 2017, IHS Markit estimated the return to lendable for HYG at 73 basis points.3
While we are taking an incredibly conservative approach to our securities lending practice by investing the collateral in money market funds as opposed to higher yielding bonds, we believe that the revenue generated has the opportunity to be a non-negligible, independent additional revenue stream for the funds’ investors. While it will not reduce our stated fees, we believe that it is a source of return that can help us overcome our fee hurdle.
Below we plot the return to lendable (measured in basis points) for our three funds over the last year. Note that the revenue generated from a program like this will depend both on market demand (both in terms of asset utilization and total fee generated) as well as fund positioning. As we operate highly tactical strategies, there are times where we may not hold securities that are in high demand.
Strategy Innovation: Portable Beta
Finally, in January 2018, we filed a form 485(a) with the SEC requesting an update to our prospectus which would allow us to employ a U.S. Treasury bond futures overlay program within our advised trend equity funds. At face, this change may lack sizzle. In many ways, that’s the point: we believe it is relatively low-hanging fruit as far as leverage-based capital efficiency improvements go. We have taken to calling the concept “portable beta.“
Strategically, we believe that using bond futures helps increase internal diversification within the strategies. Furthermore, it allows us to increase the total capital exposure investors receive for every dollar invested with us, potentially enhancing returns by providing investors access to the term premium.
Consistent with our philosophy, the futures positions will be tactically risk-managed. For those that read our research, it should come as no surprise that we will be applying the traditional quantitative styles of value, momentum, and carry to manage the positions.
As of 5/31/2019, momentum was positive across almost all lookback horizons and model specifications, real yields appeared over-valued, and carry is historically low. With these readings, momentum tilts bullish while both value and carry tilt bearish.
Source: Federal Reserve of St. Louis; Federal Reserve of Philadelphia; Stevens Analytics; Calculations by Newfound Research.
After over 18 months of research and operational setup, we just recently began to implement this portable beta overlay.
Our Plan for the Next Decade
In our tenth year of business, total combined assets under management and advisement have approximately doubled and late last year crossed above the $1 billion threshold (only to quickly dip back down below; thanks, Q4).
While we pause to celebrate these milestones, we also look toward the next decade. What are we trying to achieve?
The answer is simple: we are dedicated to helping investors, financial advisors, and institutions proactively navigate the risks of investing.
How we will achieve this vision is another question entirely. So, to close out this letter, we want to share our plan for how we will go about achieving exactly this over the next decade.
Over the next several years, we will continue to build awareness for our brand through our ongoing research commentaries, social media, and podcast platforms. We will use these platforms to push back on our industry’s fetish with alpha with our own obsession with risk.
These are not endeavors in brand vanity; they are endeavors in transparency. We believe that this transparency is critical for maintaining an open dialogue with our clients and setting appropriate expectations. Furthermore, these content initiatives provide a rich catalog of educational material to those that are coming across us for the first time.
Our sales efforts will be focused on distribution channels where we can be cost competitive, including sub-advisory relationships, index licensing, and model delivery to broker/dealer and advisor platforms. We will then use revenue growth in these channels to help further offset fee reductions in vehicles with higher structural costs (e.g. mutual funds and ETFs).
As assets scale, we will expand our offerings to include new investment strategies and diversifying exposures. We will accomplish this both through organic, internal product development as well as acquisition. Our “north star” for product development will be the simple question: “does this strategy help investors better manage risk?”
That’s it: our plan.
And if it sounds like a plan you want to be a part of, let us know.
Corey Hoffstein & Tom Rosedale
- Though we are always willing to run a portfolio decomposition for investors curious as to what the primary drivers of portfolio return and variance are from a position, strategy rule, or factor perspective where applicable.
- Ibid. “Return to lendable” is the return standardized for the percentage of securities available to lend within the fund (e.g. 50% of the total assets).