Thread by @choffstein

1/ As markets continue their ugly streak, I thought I’d take a few minutes to take my CIO hat off and just share some thoughts about running a boutique asset management firm during times like this.

2/ For (most) asset management firms, revenue is generated as carry (i.e. the fee) on the assets they manage.

3/ From a revenue stability perspective, the things that matter are:

1. What’s your revenue-weighted asset allocation?
2. What’s your idiosyncratic risk?

4/ A all-equity boutique is likely seeing YoY revenue forecasts dropping by 20%+ right now. A core fixed-income shop, on the other hand, is likely much more stable.

5/ Of course, this cuts both ways. In a bull market, that all-equity boutique benefits from equity market tailwinds. In a way, charging carry ultimately means you capture the risk premia associated with your revenue-weighted assets.

6/ But even if you are able to get to something like a 60/40, you can still see assets decline by 30%+ just from market moves, not to mention redemptions.

7/ The idiosyncratic risk part is also really, really important. This hits on both your actual investment performance as well as your ability to actually grow and maintain your business.

8/ So where does asset growth come from? Three primary channels:

1. Net new assets from sales + marketing
2. Growth in existing advisor assets
3. Revenue-weighted portfolio returns

9/ The second often goes overlooked, but can be a hugely powerful network effect for a well established firm. As advisors get new clients, or existing clients contribute savings, you can see natural flows.

10/ In a market like this, pretty much all three channels shut down.

1. Advisors aren’t typically allocating new money.
2. Advisors typically aren’t getting new clients.
3. Markets are going 📉

11/ In the long run, #1 and #2 generally drive overall AUM levels (assuming performance supports it). In the short term, #3 can have a huge impact. Especially on the downside.

12/ The big risk are “knock-out” effects. If you run your business at a 20% profit margin and your assets drop 20%, you have to start making some tough decisions.

13/ So during growth periods, you have to ask yourself some difficult questions like, “do I run my business very conservatively and grow slowly to avoid knock-out risk, or do I grow on lean margins and 🤞🙏🍀 markets cooperate?”

14/ The risk with being too conservative is you have to compete with firms that aren’t being conservative at all. Their lavishly spending on sponsored events, fancy materials, T&E, etc. And so you can end up failing to grow because you can’t compete.

15/ Some costs are easy to cut quickly (sponsorship, T&E, materials, etc). Others are not (technology, compliance, etc). Some are theoretically easy, but emotionally difficult, and in the long run potentially crippling (e.g. personnel).

16/ The other big risk is maintaining a strong balance sheet. If you run a mutual fund or ETF, you have to maintain a certain level of balance sheet strength. So if revenue declines and you need to draw on cash, you can risk a knock-out even there.

17/ For Newfound specifically, we’ve always tried to be extra conservative in with our margins. We also run strategies that, in effect, coarsely replicate 50/50 portfolios + option straddles. So as markets decline, we tend to de-risk significantly.

18/ I’m also fortunate in that the first lever I can always pull is my own “salary.” In fact, I don’t take a salary: at the end of each year, my partner and I calculate firm P&L and then pay distributions.

19/ But it’s worth pointing out that “fee compression” has already put a ton of margin pressure on asset management firms.

Past market drops have recovered quickly. A sustained drop could lead to lots of firms – big and small – making some tough decisions.