Causal Factor Investing, Created Value Attribution, and Numbers That Lie

After a few weeks off, The Fortnightly is back, offering interesting readings from around the ecosystem.  There’s something for everyone.

For the full slate of content, consider a paid subscription (now available at reduced prices).  Check the archives to see what you’re missing.  If you see a posting you’d like to read, send a note to that effect and you’ll get a PDF of it in return.

Causal factor investing

“Virtually all journal articles in the factor investing literature make associational claims, instead of causal claims.”  Thus begins the abstract for an intriguing paper by Marcos Lopez de Prado, “Causal Factor Investing: Can Factor Investing Become Scientific?”  It lays out the “spurious claims” that serve as theoretical support for much of the factor investing that has become prominent across the years.

The author posits that researchers (and firms that offer products based on their research) encourage conclusions that aren’t supported by their methods:

The practical implication of this logical inconsistency is that the factor investing literature remains at a pre-scientific, phenomenological stage, where spurious claims of investment factors are accepted without challenge.  Put simply:  without a causal mechanism, there is no investment theory; without investment theory, there is no falsification; without falsification, investing cannot be scientific.

This does not mean that investment factors do not exist, however it means that the empirical evidence presented by factor researchers is insufficient and flawed by scientific standards.

In the industry, “commercial asset managers require investors to accept disclaimers such as ‘past performance is not indicative of future results’ in direct contradiction with the inductive claims that authors promote and managers sell to customers.”

While the paper as a whole might be a challenge for those who don’t specialize in quantitative analysis, you can skip the details and still see that some widespread assumptions that drive investment practice deserve greater scrutiny.  (A slide deck on the topics is also available.)

Created value attribution

Kroll has published a report, “Created Value Attribution,” which goes beyond the standard “value bridge” of private equity analysis, in an attempt to deal with what it doesn’t demonstrate:

Investments with strong returns are sometimes just the result of timing and market movements, and sometimes weak investment returns hide value creation or value preservation in difficult environments.

By expanding on the current approach, a whole range of possibilities become evident.  A series of graphics accompanies the explanations that are provided, showing how the analysis builds.  (Figure 3 includes an error in the investment value at valuation date that might throw you off; all of the rest of the images foot with the original value bridge.)  The adjustments make evident changes in revenue, margins, cost of capital, growth, and balance sheet items; show clearly the changes in the components due to acquisitions; and put the information in the context of industry and capital market developments and deleveraging actions, all of those adjustments ultimately resulting in something Kroll calls “unique” (think alpha).

It is more work, to be sure, but the breakdown offers insights not available from the current blunt instrument.

The numbers lie

You might not expect an article in the Harvard Business Review carrying the title “How Financial Accounting Screws Up HR” to be of much interest, but it is worth your time.  In the United States, rules prevent the sensible accounting treatment of investments in human capital, causing company managers to make poor long-term decisions and inhibiting analysts from understanding which firms are investing in ways that will pay off over time.  The examples provided — and the questions asked — are thought-provoking.

Other reads

“Submergence = Drawdown Plus Recovery,” Dane Rook, et. al, SSRN.

Smart diversification is a potent weapon against drawdown risk.  Yet appropriate diversification strategies should be rooted in reducing the overlap between the depth and duration of drawdowns (and recoveries) of assets in a portfolio, rather than fixating on lessening the correlation between asset returns (which is the usual emphasis of diversification).

“The Best Stock Research Tools for 2023,” Edwin Dorsey, The Bear Cave.  An eclectic set of sources; a few common ones, but many below the radar, including websites, podcasts, newsletters, presentations, etc.

“The Path to Inclusive Capitalism,” Blair Smith, et. al, Milken Institute.

As the ultimate owners of capital, asset owners have the ability and responsibility to drive DEI within investment management teams and portfolios and across the asset management industry.

“Disruptive Innovations IX,” Citi.  Ten things to “stop and think about,” including a section on professional qualifications, credentialing, and learning — all issues in the investment world.

“Infrastructure investing will never be the same,” Marcel Brinkman and Vijay Sarma, McKinsey.

Revolutions in energy, mobility, and digitization are introducing new dynamics to existing infrastructure investments that previously appeared almost impervious to change.

“Investing Novices Are Calling the Shots for $4 Trillion at US Pensions,” Neil Weinberg, Bloomberg.  Not the Canadian Model.

“Choosing Pension Fund Investment Consultants,” Aleksandar Andonov, et. al, SSRN.  “Overall, our evidence is consistent with pension funds hiring consultants to shift responsibility rather than improve performance.”

“The Illusion of Trust in Asset Management,” Angelo Calvello, Institutional Investor.

If you want institutional money, or if you are a steward of institutional money, you should be willing to accept the most invasive due diligence on the planet . . . . But [allocators] may not do it because the tough questions make them worried they’ll be seen as dumb or rude.

“Asset Management: The Year That Was,” Harriet Agnew, Financial Times.  A look at 2022 through stories and links, a number of which were best followed by the FT.

“Kuhnian thinking and investments,” Mark Rzepczynski, Disciplined Systematic Global Macro Views.  “The old paradigm does not work and cannot explain the facts, so a new paradigm has to take hold and replace the old.”

“Short-term vs Long-term,” Nick Sleep, The I.G.Y. Foundation.

The list is not exclusive (outputs and inputs are often inter-changeable) or exhaustive, but it may be the start of a map away from the worst moat-draining activities and behaviours and toward a more rational and fruitful allocation of time and resources.

“Did Investor Interest In Financial Reporting Peak With Enron?,” Shivaram Rajgopal, Forbes.  “Who reads a 10-K anymore?”

“Should We Listen to Outperforming Fund Managers?” Joe Wiggins, Behavioural Investment.

If a fund manager has a strong track record we listen with rapt attention to everything they say about anything.  If their returns are poor, we disregard their words.  This may sound sensible but it is anything but.

“My 8 Best Techniques for Evaluating Character,” Ted Gioia, The Honest Broker.  Great ideas for the difficult business of understanding others, a critical skill in the investment world.

A storm coming to venture?

“So LPs are looking at a world of inflated fund sizes, bloated teams, very high fees/carry, and very little actual deployment in good new companies over the past 12 months.  They also know that TVPIs are super inflated, gross DPIs are going to be awful, and net DPIs even worse.”  — From a Twitter thread by Gil Dibner.

Capital allocation  In the introduction to “Capital Allocation: Results, Analysis, and Assessment,” Michael Mauboussin and Dan Callahan cite the research that supports this chart, writing that “the vast majority of companies could improve their financial performance by increasing their reallocation [of capital].”

The report covers the sources and uses of capital, alternatives for the allocation of it, and ways to assess management’s capital allocation skills (including a checklist in that regard).  A large number of exhibits are provided.

As was highlighted in the HBR article referenced earlier, not having information available to assess the allocation of human capital as part of an exercise like this is a major shortcoming for analysts.

Postings

Two pieces have been distributed since the break in the action:

“Airbrushed Appearances and Underlying Realities.”  Due diligence encounters are dominated by impression management.  Those doing the work need to be skeptical and employ tactics that will go past the narrative to add value.

“The Pull of Reciprocity in Decision Making.”  From trivial swag to fancy perks, the investment business is full of favors and gifts.  How do they affect what decisions we make?

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

Thanks for reading.  Many happy total returns.