Jonathan Hirtle, founder and executive chairman of Hirtle, Callaghan & Co., explains how he aims to outperform markets in four stages. The four stages involve thorough planning, selecting an index core, applying dynamic asset allocation, exploiting market inefficiencies, as well as being selective about the portfolio managers the firm works with.
On the latest episode of Opto Sessions, Jonathan Hirtle, whose firm Hirtle, Callaghan & Co. has celebrated 35 years of success to date, summarises the key ingredients to the success of his approach as follows: “A lot of time planning, index core, shifting asset allocation on the margin, and then looking and creating inefficiencies in the market so you can sustainably create outsized return.”
Hirtle’s philosophy takes inspiration from the time he spent in the US Marine Corps, prior to moving into investment banking.
Step one: Preparation
The clearest example of that is Hirtle’s emphasis on being prepared. He sticks to a mantra of “don’t predict — prepare” when it comes to changes in market conditions, and every new investment programme he manages starts with rigorous planning, including a clear definition of success. This, he says, isn’t just important for him — it’s also immensely valuable to his clients.
“We find it's just tremendously revealing. One of the things we do with institutions is we sit down with a committee and really go through a risk waterfall, to prioritise what the risks are.
“Once you get that alignment, then you can really do two things in the programme that are going to increase the likelihood of success.”
Steps two and three: Index core and dynamic asset allocation
“We want to use the All Country World Index as our default, to start with an index core that is global.”
A global core index gives the greatest possible breadth of stocks. Hirtle views performance as a multiplier of skill and breadth: “If you maximise the breadth of your opportunity set, that's a huge mathematical advantage.”
The other factor that Hirtle uses to increase the likelihood of success is dynamic asset allocation, the third step in his process. Hirtle defines this as “asset allocation decisions that can both manage risk and enhance return”. This involves re-weighting the core index to increase exposure to certain sectors, and reduce exposure to others.
This can have the net effect of overweighting certain geographies, but Hirtle emphasises that this reflects sectoral preferences, rather than geographic ones. “We’ve been overweight US for quite a while,” he explains, “Europe has more banks and industrials as a percentage of their business. If you just stripped out the technology and looked at our remaining portfolio of banks and industrials, our performance was right in line with Europe.”
Hirtle has a preference for high growth technology stocks, and as these are disproportionately concentrated in the US, his portfolio has a US leaning.
Step four: Look for inefficiencies
The fourth step relies “heavily on the inefficiencies of private markets”. Hirtle cites a maxim from his time in the Marines: “Never get into a fair fight if you can avoid it.”
He cites venture capital markets as a good example of an unfair fight. “In venture capital, if you're with leading managers, in a lot of ways, it's not a fair fight, because they're getting the first look at all the most innovative companies and ideas.”
Private credit is another market that Hirtle believes to be is rife with inefficiencies, due to “high-quality borrowers taking advantage of the private equity market”.
“You’ve got very strong collateral producing high returns,” he told Opto Sessions.
Trust in tracking error
Finally, Hirtle is clear on being highly selective about the portfolio managers that he works with.
“Never pay active management fees, unless you're paying them to people with the skill and the degrees of freedom to really add value, net of fees.”
While many portfolio managers target a low tracking error (i.e., deviation from a key benchmark’s returns), Hirtle views this mindset as an unintended consequence of the US Employee Retirement Income Security Act (ERISA) of 1974. Ultimately, ERISA encouraged a conservative approach to portfolio management, which in the context of wealth management Hirtle believes “actually destroys value every day”.
Instead, Hirtle prefers “high conviction specialist managers with true skill and a sustainable edge who have real tracking error”.
In fact, Hirtle explains, his process for selecting portfolio managers is the inverse of the traditional approach of many funds.
“Most people look at managers because of their performance. We look at that last,” he says, explaining that ‘people’ (i.e., managers’ personal characteristics), ‘process’ and ‘portfolio’ (and specifically, whether the latter two consistently reflect one another) are assigned greater importance.