“We’re breaking beta from alpha. That doesn’t exist anywhere. We’re literally saying, ‘Only pay us for alpha and define beta. Nobody has done that.” That’s an energized quote from legendary Wall Streeter Peter Kraus. For those not familiar with the lingo, I’ll translate: Kraus’s new company Aperture, which has just launched a new mutual fund offering (yes, you read that right: a new financial start-up is launching mutual funds in 2019), is seeking to create a true blue pay-for-performance model that emphasizes beating a market benchmark, not just tying it to an index as most passive funds do.
Why not offer a slick ETF, give it a cool name and make it “smart” so as to add some spice? If you have to ask that, then you don’t know Kraus. In breaking bread with him last year at a dinner held by Marstone (where he is chairman), I was given a first-hand education as to why ETFs — which have assumed their place in the millennial hall-of-fame alongside toast points, craft beer and Patriot Act with Hasan Minhaj — are not always the right answer for investors.
Who is Kraus to say that? Well, Kraus worked at Goldman Sachs for 22 years (several of which were before Goldman’s 1999 IPO), ultimately co-heading the firm’s investment management division and chairing its strategy committee. He has also served as chairman and CEO of AllianceBernstein, and while he’s had his triumphs and challenges, one thing is beyond dispute: Kraus doesn’t need the money. As such, his consistent banging of the drum about the structural considerations of ETFs isn’t a case of a heavy-hitter talking their own book for economic gain. With Aperture, Kraus is looking to re-energize mutual funds and passionately push back against the idea that investors can’t beat the market. If you can pick talented managers, incentive them properly and target the right area, alpha, says Kraus, is still there for the taking.
Here’s my recent conversation with Kraus in Aperture’s New York office:
Gregg Schoenberg: What was the overarching thesis that led you to start Aperture?
Peter Kraus: I took a step back and looked at the financial ecosystem that’s been created over 50 years and the changes in that ecosystem. Then I asked myself the question of whether that system makes sense for the next 50 years, or if there was something that we’re missing.
GS: You have fully acknowledged that you’ve been a big beneficiary of that system.
PK: I have.
GS: Is the next phase of your career, the start-up phase, an attempt to right some wrongs?
PK: Not so much right wrongs, but it’s recognizing that you have an industry today that’s quite large, very fragmented, and unwilling to change. It’s also not actually serving the investor in a way that it was originally intended to many years ago.
GS: So why you?
PK: Who better to actually unmask what’s happened than somebody who grew up in the system? I actually do understand all the pieces of it and want to make it better.
GS: Let’s talk about first-time investors who eschew the idea of trying to beat the market and who look to well-known robots, like Betterment or Wealthfront, or to one of the incumbents that have upped their game. What’s your core pitch?
PK: I tell people that you’re making an assumption that managers can’t perform. So what do people do? They say, “I’ll just do what’s simple,” meaning allocate money across a platform of existing ETFs and get the market. By the way, it’s minus fees. I don’t really think people understand that. They don’t actually get market returns. They get the market minus fees.
GS: Are you saying there isn’t a place for index investing?
PK: No; I do believe there’s a place for indexation.
GS: So what’s your beef then?
PK: I have two big beefs. Beef number one is that people haven’t thought hard enough about how you redesign the ecosystem of active management, so that you can improve the odds of choosing a manager that actually performs net of fees. That’s really what Aperture is attempting to do.
GS: What’s the second?
PK: The vehicles that are available for investing in passive break into two camps: mutual funds and ETFs. Lots of people now like ETFs because they’re fast money. You can buy them at 10:02 and sell them at 11:03.
GS: Liquidity is a beautiful thing, no?
PK: But they don’t actually understand what they own. They think they have a security, but it’s really a reflection of a derivative. It’s not a security, and it’s not like buying IBM. It’s buying a basket of securities that are estimated values based upon how authorized persons in the market trade that basket of securities. That’s a very different concept than what you think you’re owning. So when you talk about ETFs, you have to talk about them with a lot of nuance, because it’s not so simple.
GS: Why should the everyday investor care?
To think that you’re not going to have inflation at some point that could cause market volatility is wrong. It’s not dead forever.
PK: The big ETFs on the S&P, which is a large percentage of the money, they are pretty stable and don’t have a lot of tracking error — maybe a couple basis points — and they don’t cost a lot of money. But if you buy high-yield ones like HYG or JNK, those securities are complex, they’re expensive, and there’s the tracking error.
GS: When I hear you say that, it seems clear why Aperture just launched an emerging markets fund. I’m thinking that you concluded that emerging markets is an obvious place to begin a relationship with customers, where you can show that the indices are not always reflective of what the investor gets, etc…
PK: Number one: It’s in an area where we believe there is a significant opportunity for alpha and where indices are very inefficient. Number two: It also reflects the fact that I’m basically attracted to talent.
GS: So you were being opportunistic?
PK: Yes. I didn’t go out and say, “I want to find an emerging market debt manager.” I went out and said, “I want to find the smartest investor I can find who has the most talent.”
GS: For context, how many people have you interviewed so far?
PK: Over 145 portfolio managers in the last year alone, three hours with each person minimum. And Peter Marber (Aperture New World Opportunities Fund’s portfolio manager) is one of the three that I’ve found so far.
GS: How do you think about manager compensation?
PK: There are lots of good managers in the world, but almost all managers are paid based on a fixed fee arrangement — i.e., I pay you whether or not you perform. Think about the paradox of that. If you’re the portfolio manager, your value proposition to me is whether or not you perform, I have to pay you. That’s just inconsistent.
GS: It’s nice work if you can get it.
PK: Well, you go home at night not performing, feeling bad you didn’t perform, but not very bad because you’re getting paid. How’s that making sense for the investor?
GS: I agree with you on that and took note when you launched some fulcrum funds at AllianceBernstein. But to me, the story here is that you would lead with mutual funds in a new entity in 2019. Can you go deeper on that?
PK: As I said before, ETFs are essentially derivatives. To put it differently, the ETF is a representation of a basket of securities that is publicly disclosed to the whole of the ETF. When you buy and sell the ETF, what happens is the underlying securities have to actually change hands. In order for these underlying securities to change hands, two authorized persons independent of the ETF literally have to buy and sell those securities.
GS: For those that don’t understand the inner workings of ETFs, which is basically everyone on the planet, what is the importance of that distinction?
It is illogical to believe that someone can charge zero for a product, make no revenue and continue to offer that product forever.
PK: There is an underlying assumption that this liquidity or exchange process happens seamlessly at a very low cost to you, the holder of the ETF. When the markets are benign, that pretty much happens. But when markets become volatile, though, then the buyer and the seller of those underlying securities could be saying to themselves, “What’s the price of that security?”
GS: Where does that lead?
PK: Maybe I have to widen out the bid-ask spread, so now the cost is getting bigger. Maybe one of them says, “You might fail to deliver that security, so I’m not actually going to make a market in that security or I’m not going to accept that as a transaction.”
GS: Does the NAV (Net Asset Value) calculation get messed up?
PK: It’s not a NAV problem. What happens then is that pricing becomes discontinuous. This occurred before, where the market breaks down and the price of the security drops significantly. That will occur again in a discontinuous market, and that risk is not well known by investors. So if you own a big ETF on the main equity market, you’re probably not going to experience a problem of any significance. But if you own one on high yield, emerging markets or small caps, you could see much more volatility around price.
GS: Let’s turn to credit ETFs. Now that banks have much less capital to facilitate liquidity, how does that play into the Aperture story in general and the specific emerging markets fund you launched?
PK: For the product we launched, we’ve selected a very stable benchmark with a very low level of volatility, in part because we know that that market can become discontinuous in market turbulence. We’re trying to give investors a very low-level volatility base return that we have to beat. As we just discussed, there’s much less capital deployed today against the market, so the volatility in times of turbulence will be higher, period.
GS: I think one of the challenges with your case is that many investors today don’t have first-hand memories of—
PK: —Think about the last time we had inflation. That was 1978 to 1982. How many investors remember that? If you’re a 40-year-old investing today, you never saw that. If you’re a 50-year-old investing today, you were 10. If you’re 60 and you’re investing today, you were 20.
GS: So essentially, you had to be—
PK: —Essentially nobody. But to think that you’re not going to have inflation at some point that could cause market volatility is wrong. It’s not dead forever.
GS: I want to talk about the inverse problem. You are undoubtedly familiar with the race to “free.” You now have no-cost funds and even so-called negative-fee ETFs. You’ve also got Robinhood, and commission-free ETF trading on several platforms. So while I get your valuation proposition, Peter, I think the power of free, or at least the perception of free, is a pretty formidable hurdle facing you.
PK: Absolutely.
GS: How do you face down this wall of money that comes from earnest investors conditioned to expect free or near-free?
What irritates me about the ETF market and the race to zero is that the investor doesn’t understand all of the costs.
PK: Wall Street continues to be an extraordinarily creative environment. On the West Coast, tech entrepreneurs have come up with very creative ideas too. But the business is complex; money and financial structures are actually very complex.
GS: What are you implying?
PK: That it’s easy to use a headline to attract people to a product and for them not to see all the costs that they bear in that product. But it is illogical to believe that someone can charge zero for a product, make no revenue and continue to offer that product forever.
GS: It’s a loss leader.
PK: If it’s a loss leader, they’re spending money on that because they’re going to make you spend money somewhere else. To think that you’re getting it for free is silly, because of course you’re not getting it for free. They’re trapping you or asking you or pushing you or getting you to go somewhere else where the charges are much greater.
GS: Could you give a simple example?
PK: Sure. What do the brokerage platforms do with the cash? You get on a platform, fees are very low, and you don’t have all your money invested. You give the entity cash. Do they pay you a return on the cash? Yes. But what’s the return that they’re getting? There could be a hundred basis points’ difference.
GS: So the spread on cash between what the platform is earning and what it’s paying out to the customer is real.
PK: Yes, and the firms don’t care how the math works. They just care that at the end of the day, they’re making money. The real problem is these things are not transparent.
GS: Which isn’t just an issue related to the spread on cash.
PK: Right. What irritates me about the ETF market and the race to zero is that the investor doesn’t understand all of the costs. For example, does an investor actually understand how much money the ETF or passive provider is making on securities lending? How much of the securities lending revenue is being passed on to the investor?
GS: It’s a great point.
PK: For argument’s sake, let’s say you’ve got five basis points of securities-lending revenue. You’re earning two and a half basis points of return, but you’re giving up two and a half basis points to the ETF. They say they’re “charging you” five basis points for the ETF, but guess what? That’s now seven and a half basis points. But it goes further than that.
GS: You mean the tracking error?
PK: Yes. Let’s say the tracking error between the ETF and the index is three basis points. Now you’re up to ten basis points. You’re actually spending ten basis points in that ETF relative to the return that you think you’re going to get.
GS: Double.
I’m the first person to say to anybody, “If you can get two and 20, great. But I’m not paying you two and 20, because that’s a dumb thing.
PK: But they’ve got to tell clients. Theoretically, let’s say I show up with Aperture’s large-cap US equity fund and I charge ten basis points. I’d actually be charging the same number, and the manager is incentivized to perform because if they don’t, they don’t get paid. Which deal do you want?
GS: I hear you, Peter, but I want to push here again. You do realize that your pitch is going to take a fair bit of time to get through, right?
PK: It will, but people will figure it out. They don’t know what the specific numbers are, but people know that by just buying passive, they’re giving up on extra return. They just don’t know how to get it.
GS: I want to shift over to the late, great Jack Bogle, who as you know, in the twilight of his life, sounded the warning bell over index funds.
PK: Passive does not set the price. If we were in a world where 100% of the money was passive, there would be no price setting. Apart from going public, we wouldn’t know how to price anything. Now, as I’ve said many times in the past, we don’t know where and when passive gets so large that it swamps the active pricing process. We don’t know if it’s 50% passive, 75% passive or 35% passive. But we don’t see evidence of it having happened yet.
GS: What about in another asset class, like high yield?
PK: Yes, yes. There’s much more inefficiency in the fixed income markets. That impact can be from both the passive flows and thin liquidity. Both issues are in play there, and I have said this to regulators in Washington.
GS: Said what exactly?
PK: What I believe, which is that in a healthy capital market, we must have a level playing field between active players and passive players. Because if we have a level playing field, then capital will actually move to where it actually gets a fair return.
GS: I think you may be referring to the fulcrum fee structure issue, right? Can you describe that issue?
PK: I went to Washington and said, “I need regulation that will permit me to compete with ETFs.” The old fulcrum fee structure that the SEC allowed didn’t work. Fortunately, the SEC showed foresight and approved changes.
GS: Which are critical to the business you’re building now. But what’s also critical is the partnership with Generali. I’m assuming that you needed that partnership in order to attract talented managers.
PK: Absolutely. There are two ways to attract managers in the world. One is to guarantee them compensation for a period of time. Another is to say, “I’m not going to guarantee your compensation, but I’ll give you a large amount of money, and so if you actually perform, you’re going to get paid even more.” I’ve done both over time. It’s unquestionably more attractive to provide managers with serious amounts of money for reasonable periods of time.
GS: That’s very compelling to the right kind of manager.
PK: Yes. There’s a lot of nuance to managing money in this very intense and very personal business. I don’t think that’s understood particularly well by external users of the business. By the way, I’m the first person to say to anybody, “If you can get two and 20, great. But I’m not paying you two and 20, because that’s a dumb thing.”
GS: Another interesting aspect to your challenge, I think, is that running a registered company is very expensive from a regulatory and compliance perspective.
PK: Your point is accurate. The business of being a registered fund company in the US and Europe is both more complex and more expensive than being a privately organized fund. Why did I do that? Because I believe what I’m doing is as valuable to the retail investor as it is to the institutional investor.
GS: Do you foresee a day when you decide to do a big equity fundraising to increase the number of fund offerings?
PK: I knew that if I could start with enough money, I could basically pay for the expense of building the regulated platform as necessary. And if we started with $4 billion and built a regulated platform, we knew we could provide to institutions, high-net-worth accredited investors and retail the same product at the same fee. That seemed fair.
GS: How do capacity constraints play into your vision?
PK: These are capacity constraint products. I’m not building a $50-billion emerging market fund, where I need everybody to give me as much money as possible. That’s when people start to compromise.
GS: Speaking of compromise, what was your reaction to the recent SEC settlement that required 79 firms to give back $125 million to clients for not disclosing conflicts of interest in the sale of funds? I know the firms self-reported, but it still looked like a slap on the wrist.
PK: I completely agree with that, but I think you have to look at the trend of where the SEC is going. Plus, there’s nothing wrong with charging the client for monitoring your managers, doing due diligence on managers and finding good managers. That’s a valuable service, and the client should pay for that. But the client should know what they’re paying for.
GS: You know as well as I do that the reason there continues to be obfuscation is because platforms are afraid that the client will say no.
PK: Of course. Then you have to convince the client your service is worth it. To quote Louis Brandeis, “Sunshine is the best disinfectant.”
GS: Well, I suspect that as Aperture builds up a presence in the marketplace, you’ll have your chance to make your case. Thanks for your time, Peter, and congratulations on the launch.
PK: Thanks, Gregg.
This interview has been edited for content, length and clarity.