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This interview is with Andrew Stewart, the chief investment officer of Exchange Capital Management, with $750 million in assets under management. He specializes in individuals and families of wealth. During this interview, he'll discuss how he manages his staff with radical candor, how he applies his tech background to investment probabilities and portfolio construction, how he approaches due diligence, and risk tolerance.

Christine Giordano Markets Group:

So of course, let's just jump right into it. What do you what is your role at exchange Capital Management?

Andrew Stewart:

To describe my role, I also need to talk about the entire team for a moment. So we are a registered investment advisor. We're therefore fiduciaries, we specialize in doing goals-based financial planning for our clients, most of whom, as you said, are high net worth individuals and families, many of whom know us locally and personally, if you're in southeastern Michigan, we're based in Ann Arbor.

I am our Chief Investment Officer, I am part of a three person team that's responsible for managing the assets inside of our clients' portfolios. We also have a number of advisors who interface with clients directly, and are supported by a financial planning team. We also have administrative folks and marketing folks. But if you think about those, those two different groups, the client-facing advisors who focus on the financial planning aspect of our work, and my team, that focuses on the investment management part of our work, those are two separate and distinct teams. We call ourselves 'an ensemble practice,' which means we're all working together, the clients belong collectively to the firm, and we're all working as a team to service those clients.

And because we think about servicing clients in that way, it allows us to provide uniform and consistent investment management for my team, regardless of which advisor over on the other side of the office is managing the relationship. So that's one of the things that that is a distinction between so many other firms.

We're not the only firm that is ensemble in nature. But there are plenty of other firms that are more siloed based where each advisor might provide a slightly different service offering for their stable of clients versus the other advisor in the office next to them. So my role here is to manage our models, kind of the point on the horizon that all of our clients are steering towards over time.

And I supervise the portfolio manager and the traders who are doing trades on a regular basis in all of our clients' accounts, steering them towards that point on the horizon, while also delivering what our clients expect out of those accounts, when they are drawing down on them and taking distributions raising the cash when needed, or if they are perhaps younger and in the accumulation phase, and are putting cash into these accounts on regular basis getting input to work consistently.

And per our standardized procedures. So my role is both investment manager, reading research, designing the models, doing due diligence on outside managers when we need them. My role is also leadership and operational in nature, because I'm managing this team that is executing day to day on those general ideas of the investment management models that we have for equities and fixed income and municipal bonds alternative so on and so forth.

Giordano:

And in this current economy, what are you seeing take shape?

Stewart:

I know, we're going to talk about what kind of what keeps us up at night. So maybe I'll reveal the headline a little bit there. There are always things to worry about in financial markets, even when you see a whole bunch of assets at all time highs, that still engenders anxiety in a lot of people.

And many of our clients are no different than they, even when things are going quite well over the past 15 months. There's a good amount of anxiety to be processed through. So I think there is worry, both in the retail investors mind and you know, in the market overall, obviously, in an election year.

When you do the research, though, I do think that earnings have kept up, we are seeing there are always some companies that are overpriced, and there are others that are underpriced. But there's still a good amount of value to be had in owning equities, if the long term goal of your portfolio is to generate growth, and since it is clear that the Fed might not be cutting rates as early as many in the stock market would prefer.

It does seem that rate hikes are over. And in a stable rate environment, corporate America can process through their quarterly processes and their balance sheet issues, when they're fairly confident that they can issue debt at these levels, right?

So I see that it's a good thing that rate hikes are over. Of course, and you know, a long duration growth investment person would love for rates to be 100 basis points lower than they are right now.

But stability is better than nothing. So I'm cautiously optimistic that that we should be able to process through a reasonably good economy over the next year or two, I think it's not going to be gangbusters. But things should be okay. And in the meantime, on the lower-risk asset side, you can go buy bonds and earn, you know, well over three, four. And if you take the bet on short duration money market above 5% right now, and that's a heck of a lot better for risk- free rates than you could get three or four years ago.

So that's the silver lining, you know, after the rate, the rising rates, that was a very painful transition. But now here we can make some money at low risk again.

Giordano:

And are your individuals of wealth showing concerns? Are they expecting a bull market?

Stewart:

It really depends on the person, right? When it comes to investing, much of it has to do with your stomach. And how firm it is, as it does the kind of psychological processes of analyzing an economy. That's where actually the work that my colleagues on the advisory and planning side, the work they do on financial planning, helps that a lot. Because if you are working with somebody where they've saved a good amount of money, but you know, it's not so much that they that they can do nothing wrong, they have to plan out the rest of their lives correctly to make sure that they don't run out.

You do high quality financial planning that can lead to a proper asset allocation. And then you also take into account how firm their stomach is, especially if you try to quiz them, like asking, how did you feel in March of 2020? How did you feel in November of 2008?

If you can kind of counsel through that process, you can land on an asset allocation that helps immunize a lot of that stress, right? So if you do find yourself with somebody that has enough that they don't need the portfolio to grow it out, for them, they have enough to make make the financial plan work.

But if they lose a lot, they might be in trouble, well, then you can de-risk the portfolio, don't have too much allocated to stocks. And as I said, in this kind of fixed income environment, earn a fair rate of return on the ballast side, the bond side of the portfolio, then even if you do go into a recession later this year or next year, and a correction or even a bear market on equities comes with it, well, if you don't have too much allocated equities, the portfolio is still going to be okay. And we can prove that through good financial planning both now in advance and when it's happening later.

At the same token, we have clients who are well over 70 years old. And if you looked at one of those articles in AARP and looked at the table of age, you might say, this portfolio should not have a lot of stocks, and it shouldn't have a lot of growth. But we have folks who have saved millions of dollars, and they did it all, sometimes by just spending less than they earned for an entire lifetime.

And that's a really hard habit to break even in retirement. And now they have millions of dollars. And they aren't drawing on those portfolios. And they know that and they recognize that this is money that is going to, in some case, charities, or children or grandchildren, and they are really just stewards of capital, that isn't even theirs. And when a client is in that state of mind, they could be 100% equities. They don't need to have ballast in their portfolio, because it's not money that they're going to be drawing down on. And if they are in a state of mind that can also tolerate the volatility that comes with that growth engine, they can do it.

And again, these are the kinds of conversations that we have in this conference room with our clients, figuring out where they are in terms of the plan, and where they are in terms of their state of mind, to be able to get to a good asset allocation, that services  whatever their goal may be, whether it's their lives, or future generations for charity.

Giordano:

Sounds like you have a very nice process for risk tolerance. And I hope that we're all in that position where we don't have to worry.

So just in talking about that, can you tell me about your investment office? How many do your staff? And your client demographics? 

My investment office is three people. We manage $700 million in assets that's spread across over 300 clients. Each of those clients has sometimes one account more often a handful of accounts, IRAs, and tax trusts, and so forth. All of those accounts are managed individually. But we, the team, is supported by a pretty significant tech stack that allows us to systematize the portfolio management processes.

I think that with a firm this size, with this many clients with the kind of service that our clients are expecting, it would be very difficult for three people to do it if this was 30 years ago and we didn't have the technology tools that we have available today.

Because with proper model software and an order management system and a CRM system to help process instructions, we can have advisors have meetings with clients that lead to, you know, instructions that need to make changes in portfolios, which then gets passed off to our team. And I can build a model that gets coded into our portfolio management system, and then it's applied uniformly to all of the accounts that meet those requirements. And then my team can very easily do searches every morning that says, show me all of the accounts that have a little bit too much cash in them because, you know, perhaps we sold something yesterday or a client makes a contribution or a bond matures and a bunch of cash is delivered or dividends paid out in a large position of stock.

I can do a search that shows me all the accounts that have a little bit too much cash. So now we have that list of accounts that need work done on them. A different search might say, show me all the accounts that are overweight stocks versus bonds and other ballast by more than 3%. And then because we know our client accounts pretty well, [we will often have a sense for when the markets move to make things overweight, like, for example, right now in the technology sector.] So the system shows me all the accounts that are overweight equities. And then I can apply some subjective knowledge of the whole ecosystem and say, 'All right, let's set up a process for all the accounts that are overweight equities, sell this (name) that Andy has identified as something that we'd like to take profits off the table on inside technology, and the system can do that for you. And then the job as the human is to go check the system's work.

But having that tech stack there to do the first two or three parts, do the filtering, set up the automated trade, makes it possible for a three person team to manage the kind of assets and number of accounts that we're dealing with. Incredible technology has really facilitated smaller steps. Yeah, I don't think it's possible to run a firm like this these days without embracing the use of technology. I think it's really inefficient and almost impossible otherwise.

Giordano:

How do you determine when to insource instead of outsource?  What's your process, on what your staff handles?

A lot of our assets here in Exchange Capital Management are invested in individual stocks, and some individual bonds, even in the process of picking those individual stocks as a CFA charter, I've learned how to do the cash flow models on spreadsheets. I could be spending hours of my time doing hardcore analysis on individual companies, but I'm also a generalist, and I have a lot of other things to do with my time. And if I can find high quality research that's done by people outside of our firm that I agree with consistently over time, then that's a good place to outsource, right?

Find a team of analysts that have their specialties, whether it's based on sector or geography or other things, do the due diligence on their research, decide that you agree with it. And then, if you do, pay some money to get access to that research, for the next year, read it, consume it and make decisions based on their work. Let those specialists be those specialists. And I'm the generalist who processes that information.

Giordano:

In your small office, how do you approach due diligence on the investment side? And the operational side?

Well, for the individual stock research, I think it does come down to the fact that there are a number of good ways of thinking about the world. I have to my team, and our advisors have to explain how we think about the world to our clients.  There's a lot of storytelling involved in this work when you're dealing with managing somebody else's money if they aren't bought in with how you think about the world. And if they don't know what they own, then sooner or later, their anxiety when markets go sideways, will keep them from making a high quality decision in that moment. It's still their money, and they can go in and delink you from the account or make trades on their own anytime they want.

So if the client hasn't bought in, eventually you're going to have trouble. It needs to be a thing: that our advisors and I, as the chief investment officer, and my team, when they're in front of clients, can articulate 'this is how we think about the world.'

So in terms of finding research, for the individual stock picking: there are multiple different ways of doing stock analysis and they are all valid in their own right, but you need to find something that fits with how you think about the world consistently so that you can lean on them to make decisions without finding yourself disagreeing with you know, a piece of analysis three, three months later and then throwing the entire process out and having to start from scratch.

So that's part of it: find synergy or harmony with the outsourced team that you've chosen to outsource research to.

Then there are other parts of our clients' portfolios that are not individual stocks, and this is where operational due diligence is important as well. We don't use all individual securities throughout the entire portfolio. Even in the largest portfolio, we use ETFs and parts of equities, right, we might buy a few small cap stocks, but we want a larger weighting towards small cap and mid cap ETFs to make it much easier than trying to build a diversified portfolio of all individual securities. Same thing can be said for international exposure, I believe in currency hedging, and developed international investing, which I know is a bit of a minority view, it's maybe a conversation for another day. But you can't do that on your own, at least not efficiently inside of somebody's million dollar IRA, ETFs can.

Giordano:

I can't resist a quick question. What's your favorite currency to hedge?

Stewart:

I always want to hedge most of the currency risk away in Euro stocks, great British stocks, Japanese stocks, all the developed markets. Real research done by other folks that that you can read will show that over time, it sometimes helps and sometimes hurts performance. over long periods of time, the performance pick up effects effectively turns into zero.

And it always adds volatility.

The only time you want exposure to the currency is if you think that that foreign currency is going to do better than your home currency. And if you live in a developed market, and you're investing in a different developed market, there's no reason to think that that other developed market is going to do better than yours over any long period of time. That whole argument goes away in the world of emerging markets, right?

I think part of the investment thesis and investing in Brazil or China or India, that those entire economies are growing, they're still developing and should be growing faster than the US or Europe or Japan. And in that case, you not only want to have exposure to the stock in that country, but you also want to have exposure to the currency in that country. But in developed markets, you don't want the currency exposure. And ETFs are the only efficient way to do that inside accounts of the size that we're dealing with.

So I'm very much one to outsource some of our investment management. Again, I mentioned a few examples. on the equity side. Certainly in the bond side, we use a lot of ETFs. There are more liquid than individual corporates and munis a lot of the time. So there are benefits of liquidity. But once you've decided to outsource, not just the research, but the entire investment management process, whether it's a passive structure, or an active ETF, you need to learn a lot about how those portfolio managers are doing their jobs.

Folks in our position have been doing that in the active management mutual fund side for many decades. And now that the active ETF is here, I think that that kind of skill set has come back to people sitting in my position. But even in passive ETFs, you need to know what index that portfolio manager is tracking. And is that actually the exposure you want.

In the case of small caps are there are two big indexes, the Russell 2000, the S&P 600. The S&P 600 has a profitability filter that leads to different performance, and, looking backwards and should lead to different expected performance going forwards.

That is an active choice that you have to make as an allocator to an external manager—what index you want, you also need to think about how well it trades, how liquid it is, what the expense ratio is—there is real due diligence to be done even in the most plain vanilla, passive ETF strategies out there. And then, since there are things that are not just plain vanilla, the work stacks on even more if you're dealing with fixed income ETFs. The indices can become very custom and nuanced, which is a good thing.

They've developed high quality products that are useful to our clients and useful for the portfolios we're trying to build, but you better know how those things are built and how they're going to perform and how they fit inside the rest of the ecosystem that you're building for your clients.

And then in the world of active ETFs goes a whole one level further. And for all of this, the operational side, which you alluded to earlier, operational due diligence is important. It has to do with 'Do you know if there high quality compliance? Do they have good market makers so the ETFs are liquid and stay liquid even when markets are tough? If you're doing a big trade, do you have the support of the Capital Markets team at the asset manager to help you find liquidity beyond what you just see in the bid?

There's often hidden liquidity in ETS, but you have to know who to call at the asset manager to find out if that liquidity is actually there today. Or if it might be there tomorrow, and if it's not.

And you need to think about co-investor risk; that there are other people buying this fund as well. And if there's one big decision-maker who has control over 10s, or even hundreds of millions of dollars of assets inside of a particular fund, and then that investment committee changes their mind and decides that, oh, we're not going to use that fund anymore, we're going to use this other one instead. And then suddenly, you see a quarter of the assets of that fund going out the door, and you are owning a larger and larger portion of that fund on behalf of your clients.

You need to think about that, and what you're going to do when that happens, all of those kinds of things fall into the role of operational due diligence in my mind.

Giordano:

Fascinating, thank you for putting it into such a 'digestible' perspective. It just must be such a next level of trust, when a family comes to you with whatever wealth they've accumulated and placed that due diligence in your hands.  I'm curious to know about your background. How did you come to this? 

Stewart: 

I was trained as an engineer in college. And shortly thereafter, graduated looking for my first job in a particular niche of engineering that wasn't very employable without a master's degree. Systems engineering. And you mentioned,  clients putting a lot of trust in us, you're absolutely right.

They do.

Some of them love to hear all of these details about the work that we do. But sometimes I run the risk of kind of going down the rabbit hole too much and getting into the details beyond what they actually wanted. And my weird background is perhaps part of that story, but trained as an engineer, went to Case Western in Cleveland for systems engineering, which was  fairly a young and smaller form of engineering at the time, moved up to Boston, shortly after getting married and spent some time in the nonprofit world doing technology work, but always had an interest in the markets and moved over to the world of investing in finance, went to Boston College, during the Great Financial Crisis, which was a wonderful time to study markets, and then landed at John Hancock a couple years later. 

For those who don't know, John Hancock mutual is a fully self advised mutual fund platform. So there's a whole team of people there, who do sub advisor due diligence mandate, much of the things we've been talking about already today. And I sat alongside that team doing strategy work at John Hancock, right alongside this group of due diligence analysts figuring out who were going to be the portfolio managers for the John Hancock mutual funds.

But again, I'm from the Midwest, I grew up in southeastern Michigan, so my wife wanted to move back here and we made the transition back to Michigan, close to Detroit, at a boutique fund of hedge funds just north of Detroit.

And it was our job to figure out which underlying hedge funds we wanted to invest in, both from a kind of strategy perspective, long term equity, versus global macro, versus credit, and then also inside of those areas, which funds and how much to allocate. So, John Hancock public assets, public markets, stocks and bonds, and then at the fund of hedge funds, spending a lot of time doing due diligence on the hedge fund world alternative asset classes.

I came to Exchange Capital Management in 2017 to lead our investment efforts, where now you can see it's very natural for me to kind of take that due diligence first approach, and decide where does it make sense to use those external managers? Where does it make sense to use individual securities?

Giordano:

Interesting, as far as the systems engineer experience, you can probably also apply that to FinTech. And have you used your engineering mind in behavioral predictive ways or any other kinds of methods? 

Stewart:

So this is a common question. Systems engineering is really a practice that you can take wherever you want. It has to do with analyzing complex systems and complex systems can be markets: that's the dream, right? If you've built a computer program that can actually understand and consistently predict how the stock market is going to behave, you can make a fortune. The trick is that it is a complex system, it probably has a dose of chaos, there's a whole other field of physics and engineering that's chaos theory, that explains that some of these things you can never predict because of chaos. So I think that theoretically, and perhaps intuitively, the world of systems engineering can be applied to how you think about markets. For me, it often falls into what I call probabilistic thinking that actually predicting what is going to happen is very, very difficult, and probably does have a good dose of chaos. But you can lay out a landscape of probability in front of you and allocate likelihoods, even broad likelihoods to different things. 

So a good example is what is the economy going to do over the next year? Right? The two biggest likely examples are that we're either going to be in slow growth or mild recession. Right? Is there a possibility that the US economy is going to grow at 5% over the next year? Yes. But is that a very high likely scenario? No, is there a possibility that we're going to have a really bad recession and we shrink by something more than 2% Over the next year? Yes. But that's also less likely than something like the economy is probably going to be somewhere between negative -1,5 and +3.5 over the next year.

And once you can kind of put some bookends on the most likely scenario that gives you confidence to act inside those bookends, assuming that some of those things are true. And then again, it goes back to the financial planning, right? If financial planning is done wrong, then you have a whole bunch of portfolios that cannot tolerate, oh, what if it is negative 4%? You need the financial planning and the asset allocation to be able to tolerate that unlikely but possible event, without it being disastrous in the lives of your clients.

Giordano:

Make sense. So you're systematically and scientifically reviewing the risk and the parameters around it?

Stewart:

...and then remember that everything is probabilistic. And there are likely things and unlikely things and you shouldn't spend a ridiculous amount of money or time insuring against extremely unlikely events.

We think it's easy to kind of sum it all up real quick, it's as easy as insurance, which plays a real valuable role in people's lives. But would you be willing to spend $100,000 a year for $10 million worth of insurance when your heirs don't actually need it? Is that a good trade off? There are limits to how much insurance people buy in their lives. They apply some reasonableness to that. I think about portfolio management in the same way.

Giordano:

I like that nice analogy. Which brings us to one of probably the most common questions, what keeps you up at night?

Stewart:
So we talked about this a little bit already. Markets are volatile. Unexpected things happen. Low probability events happen. When they do it's stressful. Those are the things that could keep us up at night. But I think that those of us who have chosen to spend our lives being professionals in this space, that's part of the process. You're signing up for that, that anxiety, that uncertainty will exist, and you build a team around yourself when you find systems and tools that help you act rationally, even when things get stressful.

 But I found that the things that keep me up at night, even when markets are being kind to us, has to do with the humans that we work with. We are managing these assets on behalf of individuals, sometimes entire families. To do that properly, we are intimately engaged in, in their lives and their hopes, their dreams, their fears. They talk to us about these things while we're meeting with them so that we can help meet them where they're at, in terms of their goal setting and their emotional state, and do whatever we can to use their money to help solve those problems and reach those goals.

 Furthermore, clients become friends, friends become clients, we care for these people on a number of different levels. And there are so many times when the money can't solve the problem. But we're still in the thick of it with them. They have an aging parent, an ailing parent, or sibling they're worried about, the children are graduating from college and struggling to find their first job. 

These are real human problems that money can make easier, certainly in the case of health care, but they don't make them go away. And we see our clients struggle through that. And because we have spent so much time getting to know them and understanding these things and what they want out of life, I often find myself thinking about these problems that we can't solve. And that's the kind of stuff that keeps me up at night.

It applies to my team as well.  I care about my team a lot. I'm friends with a number of them. I care about the work that they do here for our clients. And I also care about their careers and other parts of their lives. They, they fall in love, they get married, they have children, they have parents struggling, they get divorced, they have children who you know, are graduating from college and having a hard time finding their first job. I really care about these humans that I work with. It's one of the reasons I love coming to this job. And why I chose Exchange Capital Management over seven years ago is because I thought, Oh, these are some humans that I think I might actually want to spend a lot of my time with. I can't say that about all firms. So I care about them, too. And that keeps me up at night.

Giordano:

That's a beautiful thing, you know, to be a human and an Investment Officer at the same time. So I'm guessing that you're sometimes in the conflicted position of grooming your team to actually leave your firm. Can you go into that? 

I alluded to that a moment ago talking about managing their careers. Not always, but a lot of folks, we hire right out of college. We have a couple of financial planning positions we have for people in the financial planning role right now. We have found that it's often very efficient for what we need to hire people right out of college or maybe a year or two after, into that entry level financial planning role, that they work on thinking about the CFP, get some client facing experience. And maybe someday they think about becoming a financial advisor. We also have that same entry level role on my team as a trader.

We don't need somebody with trading experience to hire them as a trader, we've seen somebody good enough at Excel, who's very detail oriented, and has an interest in markets and we will teach you everything you need to know. The tricky part is that if you hire intelligent, ambitious people, there's a very good chance their careers will accelerate faster than the business does to satisfy the hopes and dreams and desires of their career. And so, financial planning, it feeds right into into the adviser work and if we're growing and gaining new clients, there should always be more work to be done there. The trader side is a little bit tougher.

And my thoughts on this apply to all entry level positions and kind of mid level positions, that if we start saying out loud, there might not be the next step for you here at Exchange Capital, when you want it. We don't know exactly what the future holds: there might be the next opportunity when you get there, when you finish that certification, achieve that skill, figure out all the soft stuff around talking to clients and those things, we hope that those that next position does exist.

But if it doesn't, I don't think that the right thing for the firm or the team, let alone that the human that we're talking about is to lie to them about 'oh, yeah, you know, we'll figure out that when you get to it, I'm sure we'll have something good for you just keep your nose down and keep working.'

And then when the time comes, then you give them the bad news, or maybe you obfuscate even more, eventually, and again, an intelligent ambitious person is going to recognize that you've been misleading them for years now. And they will find somewhere else to go, and they'll do so in a disappointed way. And then you leave on bad terms. And they tell the world about that. Right? People talk about their experiences at other firms.

I'd much rather be radically candid with people about the uncertainty and tell them, you know, here's what will probably happen. Here's another thing that is almost as likely. And then here are a couple of low probability examples of what can happen. And I do that in the interview process, just radically candid about the uncertainty and explain to them that I am here for as their mentor, and leader and sometimes even direct manager, and how my door is open, and they should come talk to me.

And this will be a conversation that starts now in the interview phase will continue throughout your entire employment in with Exchange Capital.

 But I have a lot of folks that I know here in south eastern Michigan and beyond, I'm friends with lots of them. Let me introduce you to the firms that I think will might be good fits for you. Because now you've been with us for a few years, I know you well enough that you'd love working for them. And then even if they ended up leaving, it's bittersweet, because obviously they're the high quality employee here, we wouldn't be having these these conversations. And we'll be sad to see them go. But I'll also be happy that they're doing what's right for their career, and they're leaving on good terms. And maybe we'll get them back in the future. When things that at our firm change and things in their career change.

I just I have a lot of examples now over the past seven years where that method of doing things has led to a much higher quality experience for the people who have stayed and the people who have left. And I think that people really appreciate the honesty, even in the uncertainty.

Sometime they kind of see what else is out there and decide  they're going to be patient. They'd rather roll the dice on things working out here then making a big shift.  Radical candor makes managing their careers easier, and it makes the entire process more joyful and collaborative than it is otherwise.

Markets Group

Thank you. That's Andy Stewart. He's chief investment officer of Exchange Capital Management. I want to thank you for your time today, Andy, and it was wonderful to talk with you and hear your insights on how you managed with integrity.

Stewart

Thanks. I appreciate it. As you can see, I'm very passionate about a lot of these things. I appreciate the opportunity to talk to you. Thank you.