Cat and Mouse Games, the Power Law, and the Most Important Chart

Thanks to all of the new subscribers since The Investment Ecosystem paywall was lifted.  This is the Fortnightly, a curated guide to good readings from around the industry, which you’ll receive every other Monday (U.S. time) if you have subscribed to email updates.

Other essays do not occur on a schedule.  The most recent posting was “The Double-Edged Sword of Manager Selection.”

The most important chart?

The title of a posting from Byrne Hobart calls this “The Most Important Chart in Finance.”

The stylized graphic illustrates “what crowding does to returns.”  The references to publication indicate that the chart comes from quantitative finance; Hobart rightly points out that the general pattern holds for qualitative strategies/fads/movements/regimes too.

Of particular interest is the “gaining popularity” phase.  (An upcoming posting will delve into the effects of popularity to a greater extent.)  As assets flow into a winning idea, the demand affects valuation and performance in a positive way.  That reinforces the emerging belief and draws even more adherents.

Eventually an inflection point is reached and the increased competition and overcrowding come home to roost.  At the bottom of the cycle, the reverse occurs.

Knowing where you are on the chart is impossible, but being aware of the forces at work is essential, which is why Hobart writes that the “picture should be printed out, framed, and hung somewhere prominent.”

Cat and mouse

Natural language processing and artificial intelligence have changed how company managers are analyzed.  Conference calls, annual reports, and other communications are parsed for indications that go beyond the words that are said or written.

Nicholas Megaw wrote an article in the Financial Times about the state of play right now, to which Matt Levine added commentary, including the emergence of this loop:

1. Executives try to trick investors.
2. Investors acquire computers that can spot the tricks.
3. Executives adapt to be able to trick those computers.
4. Investors get new computers.
5. Etc.

VC power law

Stepstone published a report that shows that “a small number of vintage years within venture capital have historically produced most of the returns for the asset class.”  The problem:

In VC, we often observe two behavioral phenomena hindering successful outcomes that are closely linked:  recency bias and the fear of missing out.  Quite simply, investors tend to allocate more heavily to the asset class during periods in which recent performance has been strongest.

That happened again in 2021, when commitments were much higher than they had been running, setting investors up for disappointment — and leaving them overexposed so that they have trouble taking advantage of the retrenchment that has subsequently occurred.

Private credit

Robin Wigglesworth captured the moment with this opener:

In a radical break from their business model of paying fines, lobbying and advising CEOs how to wreck their careers through stupid M&A deals, several banks are looking to break into the hot new phenomenon of lending money to companies.

And puts an even finer point on it to close:

History repeats itself, first as tragedy, second as farce, and third as Citi blowing itself up on the Wall Street fad of the moment.  So we’re sure this will end well.

CalPERS search

Top1000Funds.com reported that the list of applicants for the frequently vacated CIO chair at CalPERS was “55 and counting,” even though it’s early in the search.  The headhunter is quoted as saying the group “is higher quality [than last time].”

“A specially convened CIO selection sub-committee” is involved; an industry newsletter named the members of it and noted their other roles:  Principal Compliance Representative, Franchise Tax Board; Senior Environmental Scientist, California Department of Toxic Substances Control; City Council Member, Palm Springs; President, Service Employees International Union Local 521; and the California State Controller.

The last few selection processes at CalPERS would make for a good case study.

Personal trading

ProPublica published an article with the title “A Top Mutual Fund Executive Made Millions for Himself Trading the Same Stocks His Giant Fund Was Trading.”  The portfolio manager at Dodge & Cox is said to have followed requirements for advanced approval before making the trades, but the scale of the trading and its proximity to activity at Dodge & Cox raises interesting questions about what the best practices for personal trading ought to be.

Other reads

“Navigating The Information Garbage Super Highway,” Shannon O’Leary, LinkedIn.

My information consumption rules:  Go directly to primary information sources; seek out long-form writing; always search for counterpoints or a highly differentiated interpretation; never scroll headlines; and do not consume news or information you need for your day job from social media.

“Why Canadian Pension Plans Succeeded With Some of the Industry’s Largest Deals,” Alicia McElhaney, Institutional Investor.  A summary of a research paper that evaluates “four landmark transactions made by large Canadian pension funds” and how a smaller fund emulates some of their strategies.

“Schonfeld vs. Millennium: ‘Great culture, shame about the tech’,” Sarah Butcher, eFinancialCareers.

For the biggest funds, like Millennium and Citadel, technology is a differentiator in a good way.  For smaller funds, like Schonfeld, technology is also a differentiator, in less of a good way.

“The stones left unturned in the Sam Bankman-Fried trial,” Molly White, Citation Needed.  Quite a list of intriguing events yet to be explained.

“Advisors continue to complain about asset manager websites — time to do something about it?” Pat Allen, Lowe Group.

While a collective industry response may be too much to expect, here’s hoping this report finally lights a stick of dynamite under at least a few digital teams, including their development and design partners.

“Private Credit Fund Diligence — Six Considerations,” DiligenceVault.  Some basic points of evaluation for those wanting to get on the bandwagon.

“Why ESG Investing Has Been Such a Letdown,” Sloane Ortel, Invest Vegan.

Despite the promises of real-world impact, glossy brochures with pictures of solar panels on them, and a substantial weight of evidence indicating that these data can help mitigate financial risk if properly applied, the truth is that ESG investing often fails to deliver on its promises.

“Hard work pays off,” Joachim Klement, Klement on Investing.  A “probably quite flawed” study raises questions about how to measure true effort by fund managers — and how steadfast that effort is.

“Factor Zoo (.zip),” Alexander Swade, et. al, SSRN.

Our findings indicate that about 15 factors are enough to span the entire factor zoo.  This evidence suggests that many factors are redundant but also that merely using a handful of factors, as in common asset pricing models, is insufficient.

Valuable things a hedge fund employer can do for younger analysts, @hfreflection.  Some good ideas to help avoid the “sink or swim” approach that isn’t beneficial for analysts or firms.

“Confirmation Bias Writ Large,” Bob Seawright, The Better Letter.

In essence, the map/territory problem is confirmation bias writ large, whereby we see what we want to see, accept those desires as truth, and act accordingly.  As Annie Duke says, we’re built for false positives.

“We Now Need College Courses to Teach Young Adults How to Make Small Talk,” Tara Weiss, Wall Street Journal.  Will new entrants to the investment workforce come in even less prepared than prior generations when it comes to communication skills?

Be cautious of certainty

“Cherish those who seek the truth but beware of those who find it.”  — Attributed to Voltaire.

Flashback: The best and brightest

A 2018 posting on the original “research puzzle” blog looked back at the Vietnam War for lessons on organizations, culture, and behavior that are of value to those in the investment ecosystem.  One of them:

Don’t automatically believe what the generals tell you; they may not really know, may be conflicted for some reason, or may be putting on a show for your benefit.

The posting drew from David Halberstam’s The Best and the Brightest and Neil Sheehan’s A Bright Shining Lie.  The difference between the real story and the story told is also evident in Dispatches, Michael Herr’s gritty account of correspondents embedded with troops in the field during that war.  He wrote, “I’d never seen any point in asking generals heavy questions about anything; they were officials too, and the answers were almost always what you expected them to be.”

A core principle for those doing due diligence.

Postings

With the removal of the paywall, all 150+ postings are available to read.  One example:  “The Pull of Reciprocity in Decision Making.”

Thanks for reading.  Many happy total returns.

 

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