Jon Hirtle, Hirtle, Callaghan & Co. – OCIO Pioneer | #503

Episode Summary

Executive Summary: John Hertel explains how he helped pioneer the OCIO model by building an independent, client-first investment office that combines open-architecture manager selection with disciplined, dynamic asset allocation. He argues that successful investing requires planning for mission-defined outcomes, paying active fees only where true skill exists, and using private markets and bonds more effectively in today’s environment.

Main Topics: Origins of the OCIO model (Priority: 5/5): Hertel describes founding Hertel Callahan in 1988 after seeing the advantages of independent investment offices at institutions like Yale and the R.K. Mellon Foundation. He says the firm was built to bring that structure to a broader set of serious investors. Asset allocation then and now (Priority: 5/5): He contrasts the simpler U.S.-centric stocks/bonds/cash world of the early 1980s with today’s far more complex multi-asset landscape, noting the rise of international investing, hedge funds, private equity, and broader opportunity sets. Planning, mission, and the role of the CIO (Priority: 5/5): Hertel emphasizes that the CIO is not a consultant but a master portfolio manager responsible for translating client goals into a coherent plan, with risk defined around mission failure rather than just volatility. Active management skepticism in public markets (Priority: 5/5): He argues that many long-only managers add little or no value net of fees because industry structures, especially ERISA and tracking-error constraints, incentivize closet indexing rather than differentiated behavior. Private markets and alternatives (Priority: 4/5): Hertel says private equity, venture capital, and private credit remain structurally inefficient and therefore attractive, while traditional hedge funds are less compelling unless restructured into high-conviction, lockup-based strategies. Current market outlook: bonds and real yields (Priority: 4/5): He sees today’s higher rates as a constructive return to normal, making bonds useful again for income and portfolio stability, and views this as a meaningful shift after a decade of near-zero rates. Behavioral discipline through crises (Priority: 5/5): Using the 2008 financial crisis as the key example, he stresses the importance of disassociation and method—sticking to a prebuilt investment discipline instead of reacting emotionally to market stress.

Key Arguments: Independent investment offices create better net results because they combine best-in-class managers, open architecture, and dynamic asset allocation under one disciplined framework. Most sophisticated large investors already use an independent CIO structure, which is evidence that the model works. Risk should be defined relative to mission failure, not just short-term volatility; clients may need volatility to achieve long-term goals. Most long-only public-market managers cannot earn their fees because they are constrained to track benchmarks too closely and are often effectively closet indexers. Private markets offer a larger and more inefficient opportunity set than public markets, with greater dispersion between good and bad managers and less informational parity. Bonds are attractive again because real yields have returned, allowing them to contribute both income and portfolio stabilization. Successful investing depends as much on planning and client conviction as on security selection or manager selection. Behavioral discipline is essential during crises; investors must follow a pre-established method rather than improvise under stress.

Data Points: Firm founding year: 1988 - Hertel says Hertel Callahan started in 1988 and has been in business 35 years. Firm assets under management: $20 billion - He states the firm manages about $20 billion today. Employee count: 110 people - He says the firm has 110 people across its offices. Office locations: Philadelphia, Pittsburgh, Chicago, Denver, Houston, Minneapolis, Scottsdale - He lists the firm’s physical offices and emphasizes in-person teamwork. Money market yield at founding: 10% - He notes that money market funds were paying 10% when the firm was started. Early Mellon Foundation assets: $3.5 billion - He recalls the R.K. Mellon Foundation’s assets when he first encountered Arthur Miltenberger. Public companies traded in the U.S.: About 7,000 - He says the U.S. public market universe is limited and shrinking. Russell 3000 constituents: 2,500 names - He notes the Russell 3000 contains about 2,500 names. Privately owned businesses in the U.S.: 27 million - He cites the size of the private-business universe as a reason for private-market breadth. High-yield public bond yield: About 8 - He compares current public high-yield yields to private credit opportunities. Private credit yield: About 11 - He says private credit can offer about 11% with stronger covenants. Private-market dispersion: As much as 25% - He says the spread between good and bad managers in private markets can be as much as 25%. Public-market manager spread: About 2% - He contrasts private-market dispersion with public-market manager spread. Tracking-error rule of thumb: 20% of tracking error as return - He gives an example that a great manager should earn roughly 20% of tracking error as excess return. Example tracking error: 2% - Used in his rule-of-thumb example for active management compensation. Example implied excess return: 0.4% / 40 bps - He calculates 20% of 2% tracking error. Example manager fee: 38 bps - He cites a wholesale active-manager fee example. Custom index covariance: 0.95 - He says the firm can create custom index portfolios with roughly 0.95 covariance to a manager. GFC market decline: Almost 40% - He says the market fell nearly 40% during the 2008 financial crisis. Private-market lockups: 10 years or more - He notes some private investments require very long illiquidity periods.

Pivotal Quotes: "We created what we thought was a better solution for serious investors, and it's in the form of an independent investment office." — John Hertel: Explaining the origin and purpose of the OCIO model. "Risk is a funny thing. I often say here, we should never use the term risk without a qualifier." — John Hertel: Describing his view that risk must be defined precisely, not generically. "The only way you get differentiated outcomes is to have differentiated behavior." — John Hertel: Arguing that benchmark-hugging managers cannot plausibly outperform.

Implications: Listeners should expect more value from disciplined planning, selective active risk, and private-market access than from closet-index public managers. For institutions, the message is to define mission clearly, demand conviction, and stay methodical through cycles.