Joel Greenblatt: The Opportunities for Active Managers are Getting Better

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Joel Greenblatt: The Opportunities for Active Managers are Getting Better April 3, 2017 by Robert Huebscher Joel Greenblatt serves as managing principal and co-chief investment officer of Gotham

1 Joel Greenblatt: The Opportunities for Active Managers are Getting Better April 3, 2017 by Robert Huebscher Joel Greenblatt serves as managing principal and co-chief investment officer of Gotham Asset Management, the successor to the advisory business of Gotham Capital, an investment firm he founded in Since 1996, he has been a professor on the adjunct faculty of Columbia Business School where he teaches "Value and Special Situation Investing." Mr. Greenblatt is a director of Pzena Investment Management, Inc., a global investment management firm. He formerly served on the investment boards of the University of Pennsylvania and the UJA Federation. Mr. Greenblatt is the author of You Can Be A Stock Market Genius (Simon & Schuster, 1997), The Little Book that Beats the Market (Wiley, 2005), The Little Book that Still Beats the Market (Wiley, 2010), and The Big Secret for the Small Investor (Random House, 2011). He is the former chairman of the board ( ) of Alliant Techsystems, a NYSE-listed aerospace and defense contractor. He holds a BS (1979), summa cum laude, and an MBA (1980) from the Wharton School of the University of Pennsylvania. The Gotham Index Plus Institutional Fund (GINDX) was introduced on March 31, GINDX is in the 1st percentile of its Morningstar peer group (Large Cap Blend) for the period since inception (March 31, 2015) through March 31, 2017, significantly outperforming the S&P 500. Its expense ratio is 1.15%. You ve been a value investor for over 35 years. Where are you seeing valuations today in the U.S. equity market? We look at stocks on a bottoms-up basis, particularly the S&P 500, but even more broadly. If you just look at the S&P 500 stocks individually, and we ve done that for the last 25 years, and valued them using our valuation methodology, we can actually contextualize where we stand today versus those 25 years. We stand in the 17th percentile of the most expensive valuations over those 25 years, which means the market has been cheaper 83% of the time and more expensive 17% of the time. We can take a look at what s happened over the next year or two from these valuation levels in the past. It s not a prediction, but it is saying from similar valuation levels in the past what s happened over the next year or two. What that says is, over the next year markets average 3% to 5% annualized Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 returns, and over two years, 8% to 10% from these levels. After a number of years of outperformance for growth, many industry experts are calling for the next decade to be the decade for value. Do you agree? We don t discern companies between growth and value. Our definition of value investing is to figure out what a business is worth and pay a lot less. It s not low-price to book or low-price to sales. So neither Morningstar nor Russell, or services like that would classify us as value. As Warren Buffett would say, value and growth are tied at the hip, meaning part of the value of a business is its growth prospects discounted back to today. We are looking at things like a private-equity firm would when they are deciding whether to buy a business or not. Those are much more cash-flow oriented. Making the distinction between traditional value and growth will lead us to the wrong conclusion. There is an opportunity a nice opportunity for value going forward. But that s what investing is; it is buying things at reasonable valuations and making returns from there. What are some of the biggest challenges that investors and allocators are facing today? One of the biggest challenges that investors are facing today is the move to passive. For many, it s a smart move because the nature of investing has changed a little bit, although it has always been very short-term oriented. But it is even more so now with the availability of information. The big picture is to beat the market. If that s your goal, you have to do something different than the market, which means returns are going to zig and zag differently. Investors with good long-term performance zig and zag differently. That means sometimes you are going to outperform, sometimes you are going to underperform. If you are not patient, and you re following returns and just keep taking from people underperforming and giving to people who are outperforming, you are going to move in and out at all the wrong times. The biggest challenge for investors is patience and that is in short supply. You used to get a quarterly statement and often throw it in the garbage; now you can check your stock price 30 times a minute. There s a lot more data, a lot more ability to crunch numbers and compare people. That works against investors, and patience continues to be the hardest challenge. It always was, but now it is even worse. You are a classic active manager. Why did you launch a long-short fund like the Gotham Index Plus Fund (GINDX)? What is the fund s mandate? We are trying to address the issue I just brought up, which is that people chase returns, mostly because that s all they know to do. They don t know the idiosyncratic hypothesis that a manager has behind each one of his or her picks. What they have are the returns and that s what they use, so they are always chasing their tails. My partner, Rob Goldstein, and I sat down and tried to figure out how could we take advantage of what we believe is a very good ability to value businesses and then buy them at a discount, or if so inclined sell some when they are overpriced. How could people take advantage of that without bailing out during Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 those necessary periods of over- and underperformance? We came up with Gotham Index Plus to take advantage of our active stock picking, and to minimize what people call tracking error, which is the underperformance relative to an Index, so people can stay with it. We assumed that most people use the S&P 500 as their benchmark to decide whether their manager is outperforming or underperforming. When you give us a dollar we invest a dollar in the underlying stocks in the S&P 500, using the weights of the S&P 500. We put a dollar into the stocks in the S&P 500 on market-cap-weighted basis. We don t think of ourselves as charging for that portion. But then we go out and buy $0.90 more of our favorite S&P stocks and we short $0.90 of our least favorite S&P stocks. We add a 90-by-90 active overlay, buying $0.90 worth of our favorite, cheapest stocks and shorting $0.90 worth of our most expensive stocks in the S&P 500. We do certain things with that 90/90 portion to keep it from moving too far away from the index. We keep it at a zero beta, so the entire fund still has a one beta. We balance the portfolio both fundamentally and from a market cap standpoint to keep it from deviating too much from the index. But we are still buying our favorite and shorting our least favorite stocks. We think that our long book and our short book in that 90/90 portion is attractively set up right now, meaning the difference between our longs and shorts is even better than usual over the history that we studied, so we think we can add meaningful return to the S&P 500. You give us a dollar and we invest a dollar in the S&P, plus an active, long-short overlay that can add value but doesn t deviate too much from the Index so that you can stick with us over the long term. Benjamin Graham defined investing as follows, An investing operation is one which upon thorough analysis, promises safety of principal and a satisfactory return. How do you reconcile shorting stocks with that definition of investing? We short stocks only in the context of stocks that we are long. Stocks are ownership shares of businesses; they are not pieces of paper that bounce around on which you calculate Sharpe and Sortino ratios. They are ownership shares of businesses that we value, and either buy at a discount or short when they are overpriced. Usually, when we are shorting, it enables us to buy more of what we like. In other words, we are selling something that we think is overpriced, but at the same time we are buying something that we think is underpriced and we are trying to make the difference in that spread. Everything we do there has a long component, meaning, buying our favorite stocks, or in the case of GINDX buying our favorite stocks in the Index. It fits very nicely in with Ben Graham because what we do is all valuation-based. We never forget that what we are doing is valuing a business, and then either buying it below that value or selling it above that value. Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 Is a short-only fund a good investment business? If not, why does merging a poor business with a value investing business make it a better business? The market goes up over time because businesses make progress over time, so their value goes up. Investors expect to make a return over time, so they would never pay a price where they didn t expect to get a future return. On average, that is what happens. Businesses make progress and therefore their value goes up. Shorting in general means you are sailing into the wind. But what we do provides us an opportunity to buy more of what we like. It s not only buying a certain allocation to our favorite stocks, but trying to make the difference between our least favorite and our most favorite stocks. That is additive, so that if you can buy more of what is cheap on a relative basis and short what is expensive on a relative basis, all you have to do is make the difference. Your shorts don t actually have to make money; it s just that your longs have to make more money than your shorts. That s how you go about making money in a long-short portfolio. You ve run long-short portfolios during your career as a hedge fund manager. How do you feel about the growth of ETFs and increasing the focus on index-based investing and in particular, smart-beta products that are positioned as value-based offerings? As Warren Buffett said, for the vast majority of people, indexing makes a lot of sense. They don t know what their manager is doing or how to go about valuing businesses, so they basically chase returns. That s not a very good strategy. If you don t understand the process of your manager, and you can t tell whether they are sticking to it, you are better off owning an index. But the market is throwing opportunities to us all the time. As Benjamin Graham, Warren Buffett s teacher said, It s a very emotional in the short term; only in the long term does it get the answer right. As I tell my students at Columbia and I ve been teaching there 21 years go back to when they learned how to read in From 1997 to 2000 the S&P 500 doubled; from 2000 to 2002 it halved; from 2002 to 2007 it doubled; from 2007 to 2009 it halved; and from 2009 to today it has roughly tripled. That is my way of telling them that people are still a little crazy. Indeed, that is understating the case because there is significant dispersion within the S&P 500, between which stocks are in favor and which stocks are out of favor. The doubling and halving of the index of 500 stocks is really mitigating that dispersion that is going on underneath the covers. If you have a disciplined philosophy and take advantage of when the market is being emotional about stocks, you can make a lot of money. But you can only capture that opportunity set if you stick to a process that makes sense of valuing businesses. Since most allocators and individuals don t know what that process is, or don t even know if their manager is sticking with it because they don t know the thesis behind it, it is a very difficult task. That s why most people should remain passive, whether it is through an index fund or through an ETF. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 However, if you understand the process and we have an advantage here because we have a very disciplined process of valuing businesses that we explain to our clients that we stick to it is very straightforward. It s just like you would buy a house. How much rent could I get for it? What are the other houses on the block going for, and the block next door? Historically, how cheap is it? We re very disciplined and coldhearted. We cover a wide universe of stocks and buy our cheapest and short our most expensive, and we keep doing that whether it s working in the short term or not. When the market eventually gets it right we should benefit. We can explain that philosophy and we have an advantage being able to do so. There will always be a future for active management. As far as fundamental indexes are concerned, most of them are just different ways of randomly selecting stocks that are not market-cap weighted. There are inherent problems with market-cap weighting, which favors overvalued stocks and disfavors undervalued stocks. If you can randomize those results you can get slightly higher returns. It s just that those fundamental indexes are fairly random so those factor-based ETFs will also zig and zag differently than the market. I don t think people will stick with them either, especially if there s not some underlying philosophy behind them, which I don t believe there is for most of them. Does GINDX fill a need that advisors have for alternative exposure? GINDX was set up to be an alternative for money that you wanted to be long. If you decided your client should be 60% long, the question is, What is the best way to be long the market for that 60%? We are trying to give the index return plus an extra return, but not deviate too much from the index, meaning we will have a beta of one. We are trying to add 6 or 7 points of additional return on an annualized basis, and to make the ride not too painful by basing everything off an index. We are limiting the types of things we do in the long-short portfolio to make some compromises. Even though we are buying the cheapest and shorting the most expensive stocks, we are doing that within constraints that keep the deviations from the index from getting too great. We believe GINDX is a good solution for that portion of your portfolio that you want to be 100% net long. Is GINDX essentially giving investors the index plus your stock picking? That s exactly right. GINDX starts with the index. You put a dollar to the index and then we buy $0.90 more of our favorite stock and short $0.90 of our least favorite from the index. It gives you the opportunity to get the index return plus a return from some of our active stock picking ability, which just uses our valuation methodology, which is what stocks are in the first place. They are ownership shares of businesses that you value you and try to buy at a discount or sell at a premium. What is the key distinction between GINDX and other long-short funds? GINDX is 100% net long, so that is one distinction. In addition, it is meant to be 100% long the index plus an active component that isn t so active that you can t stick with it. It is specifically designed to keep people invested over long periods of time, and not to zig and zag too wildly from the index so that the periods of underperformance are minimized both in duration and in amount. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.

6 What has been the historical turnover in the strategy? Do you consider taxes in how you manage GINDX? Most people talk about turnover because they do care about taxes. With GINDX, the base of it the index portion- is very tax efficient. We think we can manage the taxes of the 90-by-90 long-short component very well over time. We hope to defer over 90% of the excess gains on top of the index over the long term. Our first choice of course is deferral; delay paying taxes. But we believe we can defer over 90% of our realized gains over the long term. Turnover happens because either the value of the businesses or prices change. Prices are changing daily, so we are re-ranking our portfolio daily, and we are trying to own the cheapest stocks relative to our valuations and short the most expensive. We have so many choices within our fund, since we own the whole index, and we own hundreds of stocks on the long and the short side. We have a lot of flexibility for taxes. That s why we believe we can make it so efficient. Over the last several years flows to index funds have dominated those to actively managed funds. Why are investors abandoning active management and what would cause that trend to slow or reverse? If you average all the active managers, they are going to do about average and then they charge a higher fee than the index. So on average, active investing is a losing battle. The only way to win that battle is to find managers that are doing something that makes sense, that have a process that makes sense and that you know they are going to stick to over the long term. Those are few and far between. The movement to passive will continue. There is a strong argument to say your portfolio should have both an active and passive component. But it will still be challenging to find those active managers that meet the criteria I just mentioned, because they are subject to a lot of behavioral and agency biases that cause them to worry about and be influenced by short-term returns. It is up to the allocator to find those few active managers that have a disciplined process that makes sense. There will be years where active managers have a big advantage over the indexes. But predicting when that time occurs is very hard. You have to spend your time finding active managers with a great process. Those are in the vast minority, and therefore it is always going to be a challenge. The move to passive is because it is cheaper and there s not much of a benchmarking problem. But the opportunities for active managers to outperform, because there are fewer people trying to beat the market, are becoming even greater. It s counterintuitive and it seems strange that opportunities will get better for active managers as the environment for attracting money gets worse. But that is exactly what happens. It makes the world for us active managers even more exciting going forward. Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.

If you are over age 50, you get another $5,500 in catch-up contributions. Are you taking advantage of that additional amount?

If you are over age 50, you get another $5,500 in catch-up contributions. Are you taking advantage of that additional amount? Let s start this off with the obvious. I am not a certified financial planner. I am not a certified investment counselor. Anything I know about investing, I ve learned by making mistakes, not by taking