Philip Maymin: Welcome back to the Myron Scholes podcast On Time, Chief Investment Strategist at Janus Henderson, Professor of Finance at the Stanford Graduate School of Business and Nobel Laureate in Economic Sciences among many other accomplishments and responsibilities that would take too long to list. Myron shares his unique insights with us here. These podcast episodes are aimed at sophisticated investors and those who wish to be sophisticated investors and are intended to be thought provoking and perhaps even controversial. We hope you leave each episode with more questions than you started. And we invite you to send feedback or questions to Myron at askmyron@janushenderson. Today’s episode is about trust and constraints.

Myron Scholes: Thank you very much. Following on from what we talked about previously, under uncertainty, trust of others becomes a primary importance. Monitoring costs increase with uncertainty. The more uncertain the world, the more uncertain your investment strategies are and your hiring advisors, then the more monitoring one has to do and the cost of monitoring goes up as you monitor more. The monitoring I’ll describe in a moment is actually figuring out how to evaluate what they’re doing and how to monitor what they’re doing, what types of testing to do and how to evaluate the process of their investment advisory services. Constraints become necessary as well. Trust is a substitute for monitoring and constraining the investment managers or advisors’ way of doing business.

Trust is a belief in the reliability, ability of and forth rightfulness of others and trust building and maintenance is of paramount importance in investment management. Trust competes with monitoring and constraints compete with monitoring and compete with trust. And the calculus is to figure out the balance between trust among trust and constraints and monitoring.

Since delegated investment responsibility to others comes with myriad unknown inputs and output comes many promising great performance with excellent skills investors need to build and maintain trust in their investment managers. How to build and maintain trust affects the investment process, the risk taken and the time trading off searching for better investment outcomes and reporting results to investors with more uncertainty. As the stock market and risky investments provide us with shocks and changing distribution of return outcomes, the more difficult it becomes to build and maintain trust and delegate investment responsibility to others.

This is a fundamental problem in investment management. The outcomes of an investment program are not easily decomposed into those due to skills and those due to good or bad luck. It becomes expensive to monitor and assess the investment managers. Monitoring activities are costly and rational in the investment domain. The more uncertainty outcomes are coupled with less trust, the more constrained is the investment program. For example, the investor might constrain the manager not to take on risks outside a pre-specified band of outcomes or not to invest in foreign securities or not to hold derivatives.

In part, the growth of passive and factor investing, the ultimate constraints stay at the benchmark. Don’t deviate from the benchmark. It reduces monitoring costs dramatically and reduces the ability of managers to outperform the benchmark as a result of the constraint. There’s trade-offs between the monitoring costs and the constraints imposed. With high monitoring costs, greater constraints are justified.

When my girls were young children, we did not trust them to look after their own well-being and we greatly constrain their freedoms. Obviously, now they’re old ladies in my view, and we don’t constrain them at all. I have learned to trust them and do not need to monitor their activities or constrain them whatsoever. When investment managers maximize an objective function, say to achieve the greatest expected return for a given level of risk and they impose additional constraints on the investment program, the constraints if meaningful, reduce expected returns.

Constraints are binding have reduction in returns. When my children were not younger but in high school, they were always saying that my constraints, having to come home early at night, don’t go to parties and drink, those constraints were hindering their objective function, which is maximize their well-being. But over time, they go to parties now, I don’t constrain them in any way whatsoever because I trust them to make the correct decisions. By meaningful, the unconstrained performance would have been superior to the constraint performance. The constraint might be that the manager cannot deviate by more than a set percentage from a benchmark. The set percentage is called the tracking error constraint. No more than 5% from the benchmark. Stay close to the benchmark. You can take risks, but stay close. Or even then, managers with skills to differentiate themselves might still stay close to the benchmark and not deviate too far from the benchmark because they’re afraid that the investor will not be able to distinguish bad luck from bad skill.

If a manager has skills to differentiate among superior and inferior asset, the constraint to be an index fund provider or to stay very close to the benchmark could be whole costly and therefore, hard to fulfill the mandate in terms of making excess returns to enhance the compound return to the portfolio. As a rule, if a manager does garner the trust of investors, the constraint is relaxed and the objective function can be maximize with fewer if any constraints to enhance returns. That is the key. Build trust with your investors. Investors will then enable you to reduce the constraints and the monitoring costs will fall with more trust.

Hedge fund managers build trust or attempt to build trust to allow for fewer constraints and add value over time, build a franchise and manage the risk of their portfolio to sustain their business and to maintain their franchise. There is a difference in any business between a franchise and the value added of that franchise in a one period spot market. I don’t trust a deal which only involves one transaction and it’s anonymous. But if I have myriad transactions or repeated interactions with individuals, I build trust through the way they treat me and the reputation effect becomes dominant. Obviously, I worry that they might figure that reducing the reputation is valuable at that moment but in general, building trust comes through repeated interactions and successful interactions.

Most managers however, don’t know under what conditions trust will be lost and constraints reimposed or whether investors are able to discern or not discern why performance was inferior and as a result, withdraw their capital. So they try then to constrain themselves to stay closer to benchmarks.

Shocks and bad tail events cause the value of trust to be lost. Losing clients is costly. Trust is costly to regain and to maintain. Constraints explicitly imposed by investors or imposed by managers on themselves not to deviate too far from a benchmark are costly. The portfolio will underperform an unconstrained alternative. This loss return is what I call an implicit cost. Anytime you have explicit cost, you can measure that, monitoring costs or cost to build trust. But in loss return, that’s an implicit cost. By not enabling one to maximize the compound return of a portfolio because of a constraint, there’s a loss return and that’s an implicit cost on the portfolio. It comes from lower performance than otherwise. And this implicit cost might be impossible to observe for the unconstrained alternative is not explicitly recorded.

Monitoring is expensive and more so with greater uncertainty. Constraints are expensive in terms of implicit give-up in returns. And trust is expensive to build and maintain. There is an economic calculus here. How do investment managers build trust? Obviously, being associated with a large established firm is one way to do so. There are many monitors and controls in place within entities with a long tradition of advising clients. Controls are in place there to substitute for the knowledge gathering costs and other costs associated with investors doing this information gathering on their own. They trust these firms knowing that taking uncompensated and not well thought out risks will hurt these entities and reduce their franchise value.

Investment managers build investment solutions close to promises. They document this through meetings and performance reports. This combines monitoring and constraints. Many meetings are held that explain performance and approach. Education builds trust. With a more proprietary investment process, investors need to monitor more thoroughly, require more detailed performance attributions and controls. The proprietary process however presumably provides superior performance which through time and understanding of the process, leads to less constrained possibilities.

Hedge funds and private equity firms for example, may become less constrained over time that are open-ended mutual funds which stay close to a benchmark. Countering this however, is that many managers do not provide explicit comparisons or don’t mark their portfolio to market, but approximate market returns. This allows for cheating and a lack of understanding of losses and potential mitigation of trust. One of the interesting things as referring to the compound return or the time diversification issue is that it’s hard to measure the effects of the performance of the portfolio over time versus when you compare the returns in a portfolio to a benchmark. And that is harder than to garner trust to do time diversification strategies.

Education is another way to earn trust. Academic papers or internal research papers providing information and learning to investors builds trust through information sharing and working with clients to pass on expertise and knowledge, acting as the advisor or lawyer just the same way as outside law firms help inside legal counsel making decisions. Trust is built through interaction and through education. It is far superior moreover and this is key to have an economic theory as to why results will come. This is a cornerstone. Many do not do this to have an economic model or understanding of why it is that returns can be generated and this is really a cornerstone I think, in building trust.

It is easy to lose trust if the truth is shaded or promises and explanations look random and opaque. Truth telling is easier than lying for it is difficult to remember the truth that you’re telling, that you know and it’s much more difficult. 10 times more difficult to remember when you lie because the lies when continued discussions will be discovered over time. The inconsistencies will occur because it’s so hard to remember a sequence of lies. The timely idea that I had is that it is easier to make money understanding the constraints of others than it is to outsmart others. In other words, you can be the smartest person in the room but basically, it’s very hard always to be the smartest person. But constraints allow for the ability. The constraints of others which are myriad in the markets generally, allow for those who have trust to add value for their clients because they can understand what are the constraints of others.

In bargaining theory, deals are generally not zero sum. One party understands the wants or the constraints of the other party and reduces the shadow cost of those constraints by making an offer that reduces those costs. Unlike our former President Trump who believed everything in life was zero sum, if I win, someone else loses. Life is not that way because of so many constraints and what we have in the way we act. So understanding what constraints are, what are the constraints are the way you could add tremendous value for your clients because you can help mitigate those constraints if you have the trust of your clients to take actions to help others mitigate their constraints.

In the market as I said, there are myriad constraints that show up in the prices of assets, a general constraint. Unlike the bargaining with restraint the market has constraints and if one can deduce these constraints, it’s possible to add returns. Constrained investors accept lower returns. To buy an index fund means that one is giving up the expertise of an advisor or potential advisor who can select assets that add returns in excess of the excess risk taken and that constraint has a cost.

So constraints provide lower returns, generally. They’re hedging some risk such as the lack of trust in their managers. Those with fewer constraints swoop in to rescue them by bidding up the prices of those assets, carrying the risk forward and a return to doing so. So constraints, lack of trust monitoring costs lead to the opportunity for those who have trust to garner excess returns. This is exactly the hedge or speculator model in commodity and other markets, generally. Hedgers, the ones who are willing to hedge their risks by not deviating from a benchmark or not deviating far from the norm, are willing to pay speculators to carry risk forward in time. Time is the key. Time is necessary to mitigate constraints and carry risk over time create huge value. Speculators earn return by carrying risk forward in time.

Hedgers have constraints. For example, the miller makes money by buying wheat from the farmers, milling the wheat into flour and selling it to bakers. They are constrained. They can’t hold the risk of the inventory. Their business is not to hold these risks. Their business is to mill the flour. Buy the wheat from the farmers, to store it, then to sell it to the bakers as they buy the wheat to make the bread and cakes. There’s a time interval. The time between the time they have to buy the wheat from the farmers until they mill it and during that time period, there’s risk of inventory. They need to hedge those risks. If they don’t, they’re constrained. They have to hedge the risk. If they don’t do it, they could be out of business because the price of their inventory might fall so dramatically that they would have to go out of business and they couldn’t refinance themselves. Their business is not to do that. So therefore they’re constrained. They then transfer the risk to the speculators knowing that transferring the risk to the speculators will give the speculators reward for carrying the risk forward in time.

So time is a crucial element in constraints and creating value for those who have trust and can garner trust either through education, creating monitoring devices and the like or creating constraints. And so our world is based on how we can reduce time by allowing for intermediation to occur to carry risks forward and reduce the cost of constraints.

Maymin: Suppose you’re managing or advising a manager of I don’t know, $100 billion or something. The traditional approach is basically they decide this is my equity bucket. I’ll have this much and then they’ll find a manager for that. Then this is my fixed income bucket and so on. And those are all constraints. What would be a better approach?

Scholes: Constraint for that manager will be trying to develop a strategic portfolio. And is the strategic portfolio static or dynamic? Is their strategic portfolio one and done? I put 60% of my money into equities, 40% of my money into bonds. Within the equity portfolio, I might diversify among managers and within the duration portfolio or bond portfolio, I might do the same as well and duration or maybe some risk assets there through credit. And then that’s a static allocation and that could be a constraint. Maybe it’s better to manage that portfolio more dynamically over time garnering information you have. So if there is information in the market that tells you about the risk ahead, then basically one should use it.

The analogy I use a lot of the time in my thinking is driving a car. You can always drive the car on the road home from your work or visiting grandmother and you always stay on the road regardless of traffic or congestion. Never leave the road. That’s a static allocation. And within that static allocation, your time taking various risks. On the other hand, you can use the reports in the market as the signals of what the risk of the road ahead is and maybe deviate the route, change the route and take a better route or avoid the traffic in the road ahead and get home from grandmother’s house more quickly and reduce the cost of the constraint.

My sitting in traffic coming home from grandmother’s house was very expensive. That was a constraint. But without information, when I went to grandmother’s house when I was younger, there was no information about traffic and the road ahead. You just didn’t have anything. There was no signals. You just stayed on the road because that’s all the information that one had. But over time if I were going to grandmother’s house now, I would use Waze or Google Maps that would show me where the congestion, the road ahead is make decisions of how to move away from the traffic jam because I trust Waze or I trust Google Maps to tell me a better route or I listen to the radio and they tell me that there’s a traffic jam ahead. And maybe it’s better to go on Route 26 as opposed to stay on Route 44.

Maymin: And investors in a similar way can learn to trust these risk-based signals from the market.

Scholes: Correct. If they trust these risk-based signals or they’re educated or there’s different monitoring costs or performance measures that are developed which help them gain trust to deviate from the constraint. In the Miller example, the wheat example you know, people have to be careful about what business they’re in and what risks to keep and what risks to transfer. Staying on the highway, you’re keeping all the risks without you know, if you want to transfer the risks, you may want to leave the highway and get another speculator who wants to stay on the highway to stay there you know, and take the risk of…  In a reality, in a world what we’d have is that enough people would step in and banish the constraints so that the traffic going from Grandma’s house to home would be completely smooth in any direction you went into. But that isn’t what happened. People stay.

Maymin: You mentioned for compound returns, volatility is bad. And the volatility of volatility is bad bad. Is it the same thing true for constraints? Constraints are bad but if the investor is not aware that their constraints are changing over time and they’re not the same as they were maximizing to originally, does that make it even worse?

Scholes: Yes, constraints can be dynamic as well. I mean that’s the interesting thing about constraints is that the constraints we have today are different from the constraints we might have had years ago you know. One of the interesting things is that just think about it when I was a younger person, I used to go from Paris to London and I had one route to take. I would go to the car and we’d drive in a car and then we’d go on the ferry across the channel to London. So I was constrained to only go by the ferry.  When a storm came, it was horrible. It was there. And then they got this thing called the airplane you know, you can fly from Paris to London and that was an alternative route. So when the ferry was blustery and that, we went on the airplane. And so that reduced the constraint, the cost of the constraint. Because if I was stuck in Dover at high seas, I wasn’t going to make it to London very quickly. And then later, they developed this thing called the chunnel.  You can go by train now from Paris to London. No constraints. You know, the weather, the planes are grounded, the ferry was grounded. Just do it. No problem. So as time creates… Society does, creates ways to reduce these bottlenecks or these constraints. So the constraint was very costly when I was young, you know. Now the chunnel, if the chunnel is blocked off by immigrants or whatever trying to get from the continent to England you know, now maybe the chunnel is blocked, you would go by the ferry. You know, so there’s just… It changes over time, for sure.

Maymin: For investors, would they be better off if they invested in managers that they just trust more or better off if they imposed more constraints?

Scholes: That is a tough question to answer because, but a good question because building trust with a manager is very important if that manager can demonstrate skills. So the way trust is generated is through demonstrating skills. If I trusted Google Maps to tell me how to get off the road, if I didn’t trust them at all because they sent me the wrong way you know, that it’s difficult. When I use Google Maps or Waze or Apple and they tell me when I’m around my house you know, to get off the road here, go this way to my house, you know, I don’t use it. I don’t trust it because I know my why my house, what the best route is and I figure that out. But I think they’re wrong in what they say. But when I go on a trip in an unknown area, I’d be stupid to use my intuition relative to using what Google Maps was telling me or Apple was telling me the route to take. So yes, it depends on what you know and how you build trust.

Maymin: Thanks Myron and thanks to our listeners for joining in. If you’d like to listen to any other episodes in the series or explore our other podcasts, you can subscribe on Spotify or Apple podcasts or wherever you listen to podcasts. Also, check out the Insights page on janushenderson.com for additional timely content from our investment experts.