Copycat Compliance, Gory Detail, and Patience

To date, the content in The Investment Ecosystem has been primarily made up of longer-form essays (with the exception of these Fortnightlies).  Going forward, there also will be “Four for Friday” postings for paid subscribers.

They will feature shorter items that are clustered around a theme, appearing within the existing posting categories and including a mix of new and historical material you may not have seen.  The postings won’t appear every Friday, but will include “Four for Friday” in the title so that you’ll know what you’re getting.

There’s plenty happening in the ecosystem right now.  60/40 is not doing what 60/40 usually does, freaking out those who have come to rely on it.  The broad-based markets are down and the list of crazy things happening in the risky stuff is very long.  Not much of that here, just good things to read.

Patience

Today’s environment could be described as one that demands patience, making a paper from Permanent Equity very timely.  It begins, “This essay could be a long-winded way of saying ‘good things come to those who wait.’  But the saying isn’t foolproof — waiting can easily lead to decay.”

It lays out “what it takes,” including “the ability to be patient,” which for some is a challenge:

If you don’t have the financial, mental, or emotional discipline to withstand a decline or a period of extreme underperformance, you don’t have the ability to be patient.

In addition, “you can’t lose your mind during periods of success” (but most people do).  The other requirements:  determination, a team, openness, trust — and gratitude, compassion, and humility.

The paper examines how time can twist us in knots.  The first part of it provides a frame for the back half, which uses the themes to set up a comparison between Permanent Equity’s perpetual approach to private equity and the standard industry structure.  In that way, it also illustrates how ideas can be used effectively by asset managers who want to promote their approach but offer something beyond a pitch to the reader in exchange.

Copycat compliance

William Heaston, a Ph.D. student at Wharton, recently issued a paper, “Copycat Compliance and the Ironies of ‘Best Practice’.”  While its subject is general corporate compliance, it has direct implications for investment compliance and other aspects of the industry.

Heaton identifies two “ironies” about “best practice” approaches.

First, there is nothing inherently “best” about them; more often than not, they reflect what is commonly done rather than what is most effective in some empirically validated sense.

And second, taking a formalistic, checklist approach may undercut the supposed goal, “the promotion of ethical behavior.”

Regulated industries like investments have rules that need to be followed, but beyond that, “normative isomorphism” is a powerful force.  What other organizations are doing, what industry organizations are advocating, and what vendors are selling all coalesce into a body of anointed best practices.  But do they really represent the best practices for your organization?

(The theme of isomorphism will be revisited later in other postings, since it helps to explain the profound sameness across a number of industry practices well beyond compliance.)

Gory detail

In “AIMA at work – Contending the contentious,” the CEO of that organization lays out the “gory detail and potential consequences for our industry” from the proposed SEC regulations regarding private funds.  A longer article by Joseph Grundfest calls it “The Most Curious Rule Proposal in Securities and Exchange Commission History.”

Another, even more contentious SEC proposal relates to climate change.  A previous Fortnightly included a description of a paper which argued that the commission was following precedent in putting the rules forward.  The other side of the argument comes from Roger Lowenstein (“The SEC Should Stay In Its Lane”).

Other reads

“Do we speak the same language? A Market Survey on the Future of ESG Ratings,” 2° Investing Initiative.

The majority of survey respondents . . . are in favour of abolishing aggregated ESG ratings that merge environmental, social, and governance issues, and replacing these ratings with individual “E”, “S”, “G” ratings.

“Ever read an article in Bberg or WSJ about a big fraud and wondered how so many professional investors were fooled?” @MarketBricoleur.  A walk through a 2017 Alliance Structured Alpha pitch.

“The Pitfalls of Asset Management Research,” Campbell Harvey, SSRN.  A summary of the issues in academic and practitioner research, including:

As with academic research, investors need to be skeptical of asset management research conducted by practitioners.  Indeed, one company might comb through the academic research and do its own data mining in order to launch many ETFs, fully knowing some will fail.  Nevertheless, the company receives a fixed fee.  Given the large number of funds launched, most remember the winners more than the losers.

Feedback: Information as a Basis for Improvement, with Michael Mauboussin,” Essentia Analytics.  A wide-ranging interview about Mauboussin’s paper (which was the subject of two postings on this site, here and here) and other topics.

“The Work-Life Balance Report,” eVestment and MJ Hudson.  Quoting Richard Taffler and David Cooper:

What came across from our research is that the private equity industry exists on a fundraising treadmill, with all parties being continuously barraged in different ways, so there is always something that needs doing, meaning it is very tough indeed to be able to block out time when it is possible to think.

“How Will You Know A Single Family Office When You Find One?” Marc Sharpe, TFOA.  A basic outline of the attributes and responsibilities of a family office.

“The Four Horsemen of Investing,” Don Phillips, Morningstar.

Complexity, concentration, leverage, and illiquidity are the four horsemen of the investor apocalypse, perennial threats that wreak havoc on portfolios and undermine even the best-laid plans of diligent investors and their advisors.

“Financial Stability Report,” U.S. Federal Reserve.  Everyone is wondering how far (and how fast) the Fed will go; this examines the four categories in its stability monitoring framework.

“IRR is a vanity metric,” Seth Levine, VCAdventure.  “Interim IRR is much too easily manipulated and in some cases incents behavior counter to the long-term benefit of LPs (and GPs).”

“What Are the Odds of Making a Good Investment?” Joe Wiggins, Behavioural Investment.

Why don’t investors like thinking in terms of odds?  There are two reasons — because it’s less exciting than the alternative, which is largely storytelling, and because it is perceived as too difficult.

“The Boston Celtics’ Players-Only Meetings,” The Daily Coach.  Would regular team meetings without “leaders” — in good times and bad — improve organizational health?

Doing it the right way

“I would rather have questions that can’t be answered than answers that can’t be questioned.” — Richard Feynman.

Round trip

MTUM, which “seeks to track the performance of an index that measures the performance of U.S. large and capitalization stocks exhibiting relatively higher momentum characteristics,” is shown since its inception.

Not only is this vehicle of interest because it is one of a vast crop of factor-related ETFs that came into being over the last decade, but because its methodology leads to huge rebalancings of its holdings.  A year ago, the rebalancing caused turnover of 68%, this year’s (imminent) restructuring is estimated to be around 75%.

Given the shift to value, the kinds of companies will have changed dramatically too.  Wells Fargo estimates that technology stocks will go from 31% of the fund to 10%, and financials from 24% to 7%.

The relative performance has done a round trip, and what investors own is likely different than what they think.  The cycles of market momentum aren’t scheduled; the rebalancings are.

Postings

A March posting, “Questions about the Dominance of Indexed Strategies,” was reissued as a Sampler offering, so it’s out from behind the paywall.

The Bond King, by Mary Childs, served as the framework for a series of postings about Bill Gross and Pimco:

“Cult and Culture in the Bond Kingdom.”  Organizational dynamics, Secretariat and the diplomat, pots of gold, and the fall.  Quite a story.

“Hunting for Edges that Others Didn’t See.”  Some of the more notable examples of the firm’s aggressive and unusual moves over the years.

“Challenges and Quandaries in Manager Research.”  Important questions spawned by the book for anyone analyzing asset managers.

Plus:

“In the Belly of the Beast.”  Personal accounts from two people at the nexus of the rise in technology stocks and massive changes in stock research on Wall Street.

Follow us on Twitter to see the Charts of the Day (such as ones on the retrenchment in venture capital, wide variations in REIT performance, and how a high valuation on a stock can disappear quickly) and more.

All of the content published by The Investment Ecosystem is available in the archives.

Published: May 23, 2022

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