Research Roundtable Publication
To gain more insight into the evolution of institutional investing and how their approaches may apply to families and individual investors, we spoke with Richard Ennis, founder of EnnisKnupp, one of the largest investment consulting firms that was focused on providing advice and counsel to large pension funds, foundations, and endowments.
During his career, Ennis has received lifetime achievement awards from the CFA Institute and the Investment Management Consultants Association. His research has also won Graham & Dodd and Bernstein Fabozzi Jacobs Levy Awards.
Our conversation with Richard touched on many of his valuable experiences and research findings related to institutional asset management, the performance of active management versus indexing, public versus private investing, and the Endowment Model.
In addition to an edited transcript of our talk, we’ve included links to many of Ennis’s papers at the bottom of this post under Related Reading.
We enjoyed this talk and hope you find Richard’s insights as useful as we did.
Research Roundtable: Thank you for spending time with us.
Tell us a little bit about your story.
How did you get into the business and what experiences have shaped your views?
Richard: My work goes back to graduate school when I discovered the work of Harry Markowitz and Bill Sharpe.
I became interested in what I call the economics of institutional investing.
By that, I mean the economic tradeoffs that exist related to diversification, risk, and return.
When managing money, you need to understand how these various elements, and their costs as compared to their benefits, relate to one another.
Research Roundtable: We agree.
Having an appreciation of the potential benefits, pitfalls, and costs of investment opportunities is important.
Where did you start your career?
Richard: I started in the business in the go-go growth days of the late 1960s and 1970s at Transamerica Investment Management. It was another era of “story stocks.”
I learned a lot and had a promising career in money management.
Even though I was focused on fundamental analysis, I became interested in the research findings starting to circulate about efficient market theory.
I realized that I could earn a nice living doing what I was doing but, based on what the evidence was starting to show, I started to wonder about the meaning of my work.
Looking to dive deeper into this, I joined up with a fellow by the name of John O’Brien and his colleague Dennis Tito at a firm called O’Brien Associates in Los Angeles.
At O’Brien, we developed some of the first quantitative investment models. We provided tools designed to help large institutional investors better understand and quantify return, risk, and diversification.
Research Roundtable: We just finished speaking with Robin Wigglesworth from the Financial Times about some of this.
In his book, Trillions, he details how, at about the same time, just up the coast from you, a group at Wells Fargo was working with some of the same ideas to start the first index fund strategy.
Richard: That’s right. Exactly.
It was quite the time.
We had all taken a particular interest in Bill Sharpe’s work.
Dennis Tito was our quant geek back in the office – cooking up research and models. John and I were out on the road trying to explain them.
We were some of the only people quantifying academic research about capital markets – it was the beginning of the application of modern portfolio theory.
At the same time at Wells Fargo, Mack McQuown was trying to get regulatory approval for a leveraged S&P 500 fund. It fell through, and one of his bright young lieutenants left and joined us – David Booth, who went on to found Dimensional Funds.
I was fortunate enough to work with a very interesting collection of folks.
John, Dennis Tito, David Booth…
It was a pioneering time of quantitative investing.
Research Roundtable: You and others were really the first to quantify what the returns and the volatility of the market had really been.
Among other things, we worked to create what was originally the O’Brien 5000, which went on to be called the Wilshire 5000 – the first total stock market index.
Dennis Tito ultimately left to found Wilshire Associates.
John, David Booth, and I joined forces with A.G. Becker.
I then started working with James Knupp and, in 1975, he and I formed A.G. Becker’s investment consulting arm, which was one of the first institutional groups focused on offering advice to large investors such as pension funds.
Not long after this, Jim and I went on to found EnnisKnupp in 1980.
We grew it to advise approximately $2 trillion, merging with Hewitt Associates, what is now part of Aon.
I retired not long after the merger and kind of drifted away from the industry.
I became a beachcomber on Sanibel Island, played a lot of pool, and became a Jimmy Buffett fan.
Research Roundtable: We could talk about that separately someday – big Buffett Parrot Heads here.
What got you started working on investment research again?
Richard: About two or three years ago, one of my sons, who is with Dimensional Funds, encouraged me to write a memoir, which I did.
We ended up calling it, Never Bullshit the Client. It is about my life as an institutional investment consultant.
Doing the book drew me back to what I have always really been focused on – exploring what the data says about the answers to these questions:
How are institutional investment portfolios really being managed?
Are they achieving economic efficiency?
And, if not, why?
Research Roundtable: Any analogies in this back to playing pool?
Richard: Never do anything if you don’t have a good reason for it.
Research Roundtable: That it is important to understand all of your positions and the probabilities of the shots you are looking to take?
Richard: Yes. It is good to explore all possibilities but you have to be a realist.
Research Roundtable: What changes have you seen in the investment advice given to large asset owners over the years?
Richard: At the start, we emphasized the importance of first understanding what you are looking to achieve – identifying your risk tolerance and quantifying appropriate levels of efficient diversification.
Then, in the early 1970s, Frank Russell and Ed Callan started promoting their ability to help institutional investors add value through selecting managers. Other firms also came along striving to do this, like Evaluation Associates, Rogers Casey, etc.
Adding value through manager selection has always been an uncertain proposition and it should not be subordinated to the important work of investment policy construction.
Most of the industry seems to now promote their ability to pick winners, though. There are not many in the institutional consulting world that eschew active management.
Research Roundtable: We see a lot of this as well.
The evidence consistently says that trying to pick an active manager at the correct time may be what Charley Ellis calls a Loser’s Game, but many seem to say that they are different.
Richard: I think that is unfortunate.
It’s led to a situation where large investors are spending tremendous amounts of money for what research continues to show has a very low probability of adding value.
Fifty years ago, large investors spent practically nothing on investment management. They were buy-and-hold managers.
They ultimately started hiring outside managers that were more active, but fees were 0.10% – 0.20% per year of assets under management.
Large investors now routinely pay 1.00% per year or more.
However, nothing has changed related to what independent research shows…
The probability of any person or firm being able to find managers who can outperform going forward is very low.
If I was told many years ago that this would have happened, I would say that the person was crazy.
I would never have expected that $20, $50, $100 billion dollar investors would be paying 1% or more in investment fees per year. And, based on the latest numbers, some endowments seem to be paying twice that.
Many seem to continue to go this direction, though, representing that they’ve got the keys to the kingdom – that they are able to add value through canny manager selection.
Research Roundtable: We’ve written a lot of about this, including having fun with the title of a piece we called Do the Kingmakers Have Any Clothes?.
It touches on multiple pieces of research, which show that institutional investment consultants haven’t been adding value with their manager selection recommendations.
Richard: It’s empirical.
Each year Standard and Poor’s publishes their SPIVA scorecard. It tracks how many managers have been able to outperform best-fit indices over long periods of time.
Research Roundtable: Yes, in addition, they publish how many managers who have outperformed in the past, continue to outperform in the future. We also wrote about this playing off how often previous top managers outperform in the future – Once Famous.
Richard: Yes. The results show the same thing each time.
80% or more of managers do not outperform.
As I’ve looked at the performance of institutional managers, I see the same thing – they have overwhelmingly underperformed.
When I did a cross-sectional analysis looking at individual public funds and endowments, I found only one public pension fund to have a statistically significant positive alpha. The same story was true with endowments.
Underperformance as compared to an index fund approach is overwhelming.
Research Roundtable: How about the “you get more if you pay more” narrative?
The underperformance gap has been widening as large investors spend more and more money.
Research Roundtable: Based on your experiences of being there at the start of the investment consulting business, how did this all come to be?
Richard: Early on, large investors would hire an investment firm to provide them with a list of approved investments – a buy-list that was offered for a fixed fee.
Research Roundtable: This was common in the Trust and Private Banking world as well. In Boston, for example, many trustees hired Wellington Management to provide them with a “prudent” list of investments.
Richard: Yes. Funds were managed in a basic buy-and-hold fashion.
It was kind of a form of passive management.
Firms like Loomis Sayles and Scudder started going to institutional consultants and large asset owners saying that they needed a more active approach. They suggested that investors could do much better if they hired specialty money managers.
The overarching thesis was that if you take money away from an old passive Trust Bank, and give it to a specialist to manage in a more lively, active fashion, it will pay off.
Research Roundtable: The exact pitch we’ve seen given many times, successfully.
Richard: Indeed. It worked from a business perspective.
The state of Oregon was the first large investor to do this in the early 1970s. I was involved in managing the account at Transamerica.
Investment consultants also started about the same time, promoting an ability to find top specialty managers.
From this, it mushroomed.
Research Roundtable: If we are not mistaken, the State of Oregon was also one of the first large investors to venture into alternative investments, with a focus on private equity.
Richard: They established something called the Oregon Investment Council. I’m not sure if it still exists but that is where it began.
Research Roundtable: This is what we found as well. In addition, they have been keeping track of their results. We wrote a summary of this we titled, The Triumph of Hope Over Experience. The title somewhat gives away the punch line as to how they have performed.
Richard: I think Oregon is a good story of the way things have gone.
There are a few that are starting to take a different path, though.
One is Georgia Teachers’ Pension Fund, which has no alternative investments and has kept costs very low – approximately 0.30% of assets per year.
And, by the way…
Georgia Teachers’ was the only public fund I found that has produced statistically significant positive alpha.
Research Roundtable: Your papers touch on this in more detail.
What have you found as it relates to what adds value and what does not?
Richard: One of the very first studies I conducted looked at the results of 46 public pension funds as compared to best fit index benchmarks.
When I saw the results, I didn’t believe them.
The analysis showed that the performance of these large well-resourced investors had basically tracked the market.
Research Roundtable: Does this go back to your economic questions about the value of activities?
What the data showed was that these investors could have invested in just two index funds, allocated 70% to global equities and 30% to bonds, and produced the same results.
The implication being…
Active manager selections and alternative investments have not added any value.
Research Roundtable: How about your work on endowments?
Richard: The same thing was true there.
Research Roundtable: This is what we have found as well.
For quite a few years in a row, we’ve looked at the performance of top quartile endowments and compared them to the long-term rolling period performance of an all-index fund portfolio. We found that what we call The Simple Alternative has performed in the top quartile every single 10-year period – 10 for 10.
Richard: Yes, it matches up.
Research Roundtable: You’ve also looked at how allocations have evolved, though.
What did you find about this?
Richard: Starting in the late 1990s, based on the reported success of investors such as David Swensen at Yale, more and more assets started flowing into private equity and hedge funds.
What seems to have happened is sort of textbook.
Early on, when the number of players were small, inefficiencies existed and returns look to have been higher.
Now, though, three or four trillion dollars have flowed into these markets and they have become more competitive.
And, so it has followed – the returns of these investments have become more highly correlated with public stocks and bonds.
Research Roundtable: Charley Ellis, David Swensen’s old boss when he was Chair of Yale’s Investment Committee, and Michael Mauboussin, now at Morgan Stanley, have talked about this as it relates to players at a poker table.
Maybe the same goes with players around a pool table?
When more and more people are attracted to a game, more and more skilled players develop. The enhanced field then continues to drive the skillset higher and higher.
To win, you have to continuously be able to outperform better and better players.
Richard: Oh yes. Absolutely.
Investors trying to add value in more active ways have been hit with a double whammy.
One is that they are now paying a lot more than they did in the past, so the hurdle to add value net of all fees and other expenses is a lot higher.
Next, competition in the market is now much higher.
When I was a junior investment analyst at Transamerica in the late 60s and 70s, we didn’t even have pocket calculators – forget spreadsheets or real computers.
Access to information was also very inefficient.
We had no email or internet.
Data from Boston for example, came to us via a teletype machine and research came through what is now called snail mail – postal service delivery.
Now, you have tens of thousands of more analysts around the globe that are all well-educated and have access to similar technology.
Players are much better and, to win or outperform, you need to beat this enhanced competition – consistently.
Research Roundtable: In the past, it was much easier to have a true informational or process edge.
Having an edge, though, gets harder and harder over time.
Richard: I’m glad you used that word – edge.
At EnnisKnupp, we had about 30 people in our manager research group.
I spent a lot of time and resources trying to figure out how to identify superior investment managers – ones that had an edge.
I would constantly ask managers what they believe their edge or advantage over the competition was. Consistently, they would say that it was their education, technology, access to better information, process, or a combination of these.
When pushing them, though, as to how they were really different than what all the other managers were telling me, nine out of ten times they would fold.
Research Roundtable: As we heard the head of a large pension fund once say about the thousands of manager interviews he had conducted – they all sound like they come from Lake Wobegon.
Some outliers do exist. The challenge is finding them at the correct time when they are still small, hungry, and nimble.
I remember a manager that I met with one time who did seem to know about things that I had never heard about before.
Little areas of the mortgage-backed securities market that were so illiquid and obscure that nobody really bothered with them. The guy had built his own database and there wasn’t anything else like it that I knew of.
The problem was that the market was so small that he couldn’t take more than $100 million or so.
Research Roundtable: Agreed.
An issue to consider is that outliers might be outliers due to the size of their market.
The problem is that if you allocate large dollars to them it might change the dynamics of their market and impact their ability to efficiently implement trades and ideas going forward.
Richard: Pausing a bit on this, let me just say something.
What you’re doing is not simply indexing.
By virtue of the fact that you run your research roundtable, that you’re conducting this type of interview to garner insights to share with your clients is indicative that you are doing something that is different.
Research Roundtable: Thank you.
We try to be different – try to be transparent about what the evidence says adds the most value and let the chips fall where they may.
This doesn’t mean that we shouldn’t keep our eyes open. We want to be able to find unique investment strategies.
When we look at the data, however, we feel compelled to say that the probability of anyone in our industry being able to find managers that can outperform in the future is very low.
Richard: Indexing can run against human nature.
Hunter Lewis, who was one of the founders of Cambridge Associates gave an interview with the Financial Times that talked about some of this and the allure of alternative and private investments.
Research Roundtable: We saw that one and know of a few other ex-investment consultants that have similar views.
This is a nice transition back to your more recent paper – what your research showed about how large endowments are allocated.
Richard: One of the things that really surprised me in my most recent analysis is that many endowments have equity exposures that are approaching 100%.
People talk about a 60/40 or 70/30 blend of stocks and bonds as good benchmarks for endowments. But, they haven’t been allocating this way for many years.
Research Roundtable: This is what the self-reported data from endowment investment offices that is published by NACUBO shows as well.
Richard: They seem to be reaching for higher and higher returns without a nod to how much risk and illiquidity they are taking on.
In addition, some are adding leverage to portfolios.
Research Roundtable: It will be interesting to see how this gets covered and plays out. We hope well for all the beneficiaries involved.
In the meantime, it seems like the benchmarks we use for many large investors should have a much higher weight to global equities.
Richard: I wrote a paper on endowment performance for the Journal of Investing last year that looked at the allocations and performance of endowments back to the earliest time I could find – 1974.
I found that there were three distinct periods of how endowments were allocated.
The first I call the stock and bond era – 1974 through the late 1980s. During this period, when endowments basically held only stocks and bonds, they underperformed a best fit balanced index benchmark by about 0.8% per year – a figure that roughly matched their costs.
During what I will call the Golden Age of Alternative Investing, which ran over the next 15-years, endowments did well and outperformed by about 4% per year.
In the most recent period, though, they have underperformed by 1.5% per year – again by about what their annual increased costs have been.
To be fair, when you put all three periods together, endowments have outperformed by a small margin.
If it was not for the golden period I mentioned, however, when the Yale’s of the world might have had an edge…
The move into alternatives and private investments does not seem to have added any value.
Research Roundtable: How do you think this all translates back to our primary investors – taxable individuals and families?
More and more it is being suggested that public investments aren’t as prudent as they once were and that they need to increase alternatives and invest more like endowments.
Richard: Importantly, regardless of how you look at the data, endowments do not pay taxes on gains. Based on this alone, right off the bat many of the strategies and allocations that endowments employ, which can be quite tax-inefficient, may not be appropriate for individuals and families.
Next, their investment fees are high. On average, endowments are reported to be spending about 2.5% per year as a percentage of the assets they manage.
Finally, endowments on average have well over 100 managers across a multitude of asset classes. This increases other expenses as it relates to administration and reporting, which are often not fully factored in.
Bottom-line, it is important to keep taxes down and total fees and expenses low.
Research Roundtable: Agreed – again.
Thank you very much for your time and good thoughts.
Your research insights and perspective from someone who was there at the start of the investment consulting field are very valuable.
We’ve learned a lot and appreciate all you are doing to increase transparency.
Richard: Thank you as well.
The Modern Endowment Story: A Ubiquitous United States Equity Factor
How to Improve Institutional Fund Performance
Cost, Performance and Benchmarking Bias of Public Pension Funds