Blackswan Growth (EP.36)

Episode Summary

Executive Summary: This episode ranges from conference highlights to a tour of market data and industry critiques. The hosts discuss S&P 500 additions/deletions, index-fund flows, hedge fund fees, pension fund compensation, fraud risks, and wealth preservation. The recurring theme is that markets are driven by incentives, flows, and human behavior—not neat narratives.

Main Topics: Conference takeaways and speaker highlights (Priority: 4/5): The hosts recap their California conference and praise non-investment speakers like Annie Duke, Ryan Holiday, and especially Mike Lombardi, whose football analysis and business lessons resonated with them. Research Affiliates on index rebalancing and market effects (Priority: 5/5): A long Research Affiliates paper argues that index funds effectively buy high and sell low around S&P 500 changes, with additions and deletions showing large relative performance swings before and after announcements. Hedge fund economics and fee pressure (Priority: 4/5): They discuss declining hedge fund fees, the shrinking relevance of the classic 2-and-20 model, and Whitney Tilson’s view that fee structure norms are deeply entrenched and often irrational. Private equity, predatory lending, and financial ethics (Priority: 5/5): The hosts react to stories about hedge funds entering mass-tort investing and PE-backed consumer lending, using them as examples of how capital finds new ways to profit from vulnerable borrowers. Pensions, compensation, and talent constraints (Priority: 4/5): A New Jersey pension chief’s modest salary relative to assets under management sparks a broader discussion about politics, underpaying investment staff, and why Canadian pensions may be more effective. Fraud, fiduciary duty, and investor protection (Priority: 4/5): The episode notes former Morgan Stanley advisors going to prison and stresses that ordinary investors must remain engaged, verify statements, and not outsource understanding of their portfolios. Wealth, lifestyle inflation, and staying rich (Priority: 5/5): The hosts revisit the idea that staying rich is harder than getting rich, emphasizing generational wealth decay, lifestyle inflation, and the discipline required to preserve assets.

Key Arguments: Index funds can appear to 'buy high, sell low' around index reconstitution, but that reflects the non-normal distribution of returns and the concentration of gains in a few stocks rather than a simple mistake. The market’s biggest winners and losers often reverse over time; historical turnover among top global companies is high, so diversification matters even when dominant firms feel permanent. Hedge fund fee averages have fallen, but the industry’s economics are still skewed toward large, elite managers who continue to command expensive pricing. Charging nonstandard fees can backfire because investors often interpret unfamiliar structures as riskier or inferior; convention is a powerful force in fundraising. Private-equity and hedge-fund expansion into lending and litigation finance shows capital’s tendency to seek yield in hard-to-defend niches, sometimes at the expense of vulnerable people. Public pension systems struggle when politics suppress compensation, making it hard to attract top talent for massive asset pools. Most people cannot fully outsource financial judgment; good investing requires ongoing understanding, verification, and skepticism. Building wealth is often less about outsized returns than avoiding lifestyle inflation and preserving discipline over time and across generations.

Data Points: Research Affiliates reading time: 60 minutes - The hosts note the paper was labeled as a 60-minute read and they skimmed it. S&P 500 announcement policy change date: October 1, 1989 - Before this date, S&P announced index changes after the market closed, effective the next day. Addition vs. deletion performance gap: 2,200 basis points - From October 1989 to December 2017, additions lagged discretionary deletions by over 2,200 bps in the 12 months after changes. Largest mutual funds/ETFs by AUM: 7 - As of February 2018, the seven largest mutual funds and ETFs by assets were all index funds. Top-10 market-cap persistence: 3 stocks - On average, only three stocks in the top-10 global market-cap list remain there ten years later. S&P 500 sample size: 1,125 additions and 1,123 deletions - Study period from 1970 to 2017. Pre-announcement gap: 64% - Additions outperformed deletions monotonically in the 12 months before announcement, accumulating to a 64% gap. Addition return: 36% - New S&P additions beat the market by 36% in the period discussed. Discretionary deletion return: -27% - Discretionary deletions underperformed by 27% in the period discussed. Top 10 market caps in 1990: 8 of 10 from Japan - Used to illustrate how dominant-company leadership changes over time. Top 10 market caps in 2010: 5 of 10 from emerging markets, mainly China - Shows global leadership shifting away from Japan and toward emerging markets. Hedge fund average fee: 1.4% - Institutional Investor story citing HFR data on first-quarter averages. Hedge funds still using 2-and-20: 30% - Estimated share of hedge funds still charging the classic fee structure. Whitney Tilson performance (1999-2010): 184% - Tilson’s cited returns during value-investing’s golden era. S&P 500 performance (1999-2010): 2.6% - Benchmark comparison for Tilson’s reported returns. Mass tort industry size: $10 billion - New York Times article about hedge funds profiting from personal injury suits. Personal lending interest rates: 30% - Mariner Finance/Warburg Pincus example of cash-strapped consumer loans. New Jersey pension chief salary: $200,000 - Salary for managing a $78 billion pension system. New Jersey pension assets: $78 billion - Used to illustrate compensation limitations in public pensions. Salary equivalence: $256 per $100 million - Normalized comparison of the pension chief’s pay relative to assets managed. Baby boomers born: 76 million - Birth cohort from 1946 to 1964 used to fact-check retirement estimates. Boomer retirement pace: about 11,000 per day - Derived from dividing 76 million by 19 years. Wealth half-life: 8 to 24 years - From Arnott/Bernstein discussion of dynastic wealth decay. Vanguard AUM: $5 trillion - Eric Balchunas discussion of Vanguard’s scale. Vanguard fees: $3.7 billion - Annual fee revenue from $5 trillion in assets. Active mutual fund revenue: $70 billion - Revenue generated by active mutual funds. Active fund trading revenue: $140 billion - Wall Street trading revenue tied to active fund turnover. ETF revenue: $7 billion - Revenue estimate for ETFs. ETF trading revenue: $3 billion - Trading revenue estimate for ETFs. Tech flows: $37 billion - Bank of America/Merrill data showing record flows into tech. Defensive sector weight in S&P 500: from almost 35% to 15% - WSJ/Luthold data showing the decline in traditional defensive sectors since 1990. Esports facility size: 100,000 square feet - Arlington’s new esports stadium project. Esports industry revenue: $905 million - Projected revenue cited for the esports market this year.

Pivotal Quotes: "Rate is every time someone says there's a lot of cash on the sidelines, a tiny part of my soul dies." — Cliff Asness: Used to rebut the common market-timing trope that investors are holding cash waiting to re-enter. "Easier said than done." — Ben Carlson: Said about stoicism and the idea that you can control only your response to life events. "It's basically a way of monetizing poor people." — Host commentary on private equity lending article: Reaction to the Mariner Finance / Warburg Pincus consumer-lending story.

Implications: Listeners are reminded that market leadership, fees, and wealth persistence are all unstable; disciplined behavior, diversification, and skepticism matter more than narratives. The episode also warns that finance continuously creates new products and niches, sometimes at the expense of ordinary people.