The series, “Three Books about Capital Allocation,” concluded with postings about The Rebel Allocator (on decision making in companies) and The Counting House (in regards to institutional investing).
No April Fools’ Day material in them — or in this great set of readings for you.
The total portfolio
CAIA Association has released a report on the “total portfolio approach” (TPA). It’s also known as “total portfolio management” — and Future Fund calls it “a joined-up whole-portfolio approach.” By whatever name, the ideas underlying it are put forth in this piece by representatives of CAIA and four organizations that implement TPA.
In John Bowman’s introductory summary, he writes that TPA “is not a monolithic methodology that can be applied off the shelf,” but more a “state of mind.” That state, as described in the report, has several notable features:
“Stepping away from traditional asset class bucketing,” which, having been taken to the nth degree by most organizations, has become “counterproductive.”
Dropping strict mean-variance optimization and strategic asset allocation limitations.
An evolution in governance that involves greater interaction between the governing board and management as opportunities and exposures require consideration and action in ways that are different than the policy and implementation cycles of the past.
A focus on evaluating the best ideas to employ in the context of the total portfolio, not within asset class silos; there is a “competition for capital” in the broadest sense.
The management of factors and risk becomes the essential top-down activity.
The mindset starts with “the premise that it’s impossible to know what investment opportunities will present themselves over time.” In building an organization that can implement TPA, there are new considerations in regards to talent assessment and hiring — adaptability and the ability to see the whole picture should be prized; personal fiefdoms and inflexible thinking need to be avoided. Which is not to say that specialized expertise won’t be important, but it must fit into a new environment. Ultimately, “adopting TPA is a change management process, and one that requires bold leadership and vision.”
Vetting AI claims
Angelo Calvello wrote a column for Institutional Investor titled “Every Allocator Should Ask These Questions Before Hiring a Manager Using Large Language Models.” It stressed the need to deeply understand how those models are being used by managers:
Allocators should make sure that their vetting process goes beyond managers’ demonstrations of slick user interfaces and general claims of success. Integrating LLMs into an investment process is a complex and expensive project with considerable investment and business risks and ethical considerations.
As some managers have found out, the SEC is on the lookout for “AI washing.” Calvello:
As regulated entities, managers must already adhere to a complicated set of domestic and international regulations. Using LLMs amplifies this burden.
But relying on the regulators to police the managers is foolhardy:
All LLMs have technical vulnerabilities and limitations that can taint the model’s output and the firm’s reputation.
Those doing due diligence need to understand in which ways large language models are being used by a manager, the risks and vulnerabilities of the approach, and avenues of inquiry that can lead to the necessary understanding of how these emerging tools are being used. Calvello offers perspective on all of those topics.
Alternative credit
A new monograph from the CFA Institute Research Foundation, “An Introduction to Alternative Credit,” provides a good overview of issues in that red-hot area (more often referred to as private credit). Seven different categories that fall under that umbrella are examined.
The first chapter gives a general overview that includes characteristics and yield ranges for various instruments. Within that chapter is a six-page exhibit on due diligence activities which lists a variety of parameters, noting the prevalence of questions about them. The most common entry in that column is “Nearly all investors ask this.” That provides a rough outline of the basics which asset managers would be likely to include in presentations and questionnaires — the documentation to be expected and therefore widely known. The discoveries beyond should be the goal of due diligence.
Time to get to work
The latest edition of Bain’s global private equity report was released. The lede:
It’s safe to say the private equity industry has never seen anything quite like what’s happened over the last 24 months.
Events “have left private equity hamstrung.” The charts above display the scene; investments and exits plummeted in 2023, while inflows actually moved up to previous highs.
A changed environment has laid bare a longstanding problem:
We’ve talked about it for years: The industry has relied disproportionately on rising multiples and revenue gains to generate returns while margin improvement has contributed practically nothing. That no longer works when rising rates serve as ballast for asset multiples.
A variety of exhibits paint the situation in finer detail. For example, under 40% of portfolio companies had less than three times interest coverage (defined as EBITDA/cash interest) in 2020; now more than 80% are in that situation. And the holding period for buyouts has continued to increase. Last year it was 6.1 years — compared to 3.1 in 2000.
Bain stresses that it is important for managers to tell a better story:
The next step is communicating to LPs how portfolio managers are using all the tools at their disposal to act as a trusted steward of investor capital. GPs aren’t particularly adept at this kind of communication because they haven’t had to be in the past.
After reminding readers of the industry hurdles that have been cleared before, the introductory section ends with a call to action:
This is one of those moments. Time to get to work.
Private equity firms and consultants are already on the case, promoting the strategies by relying on historical performance patterns (including the strong results that followed previous lulls), often without discussing the potential effects of changes in underlying fundamentals. See, for example, “You can’t control the cycles, but you can control your nerves,” the second installment in the “mythbusters series” from Partners Group.
Surveys of asset owners generally indicate plans to maintain or increase their exposure to private equity. Most major institutional asset owners have boosted their holdings dramatically over the last few years, but there are some exceptions.
Robin Wigglesworth wrote an article for the Financial Times about the Norwegian sovereign wealth fund’s hopes to start investing in private equity. Titled “Is private equity worth it?” the article provides some history of the strategy; a “lies, damned lies, and investment return statistics” section; problems with benchmarking; changes in the environment; and questions about whether the “illiquidity premium” has morphed into an “illiquidity discount.” A good summary for the Norwegian fund’s stakeholders to consider — or anyone else.
Richard Ennis has made no secret of where he comes down on these questions. In his latest paper, “Second-Guessing CalSTRS on Investment Strategy: A Case Study,” he addresses its plans to further increase its weighting in alternatives (not just private equity) to around half of the portfolio. Ennis concludes that “CalSTRS’s experience with alternative investments is similar to that of public pension funds in the main: Alternative investments have detracted from performance.” He explains why the CalSTRS custom benchmark (like those adopted by other asset owners) “makes it impossible to determine whether active investing has paid off.” (See earlier postings about Ennis’ work in that regard and his role in the history of the institutional consulting business.)
Untapped indicator?
A surprising paper, “The Financial Statements of Investment Companies,” by James Li, was recently updated. Surprising, because who would think that the boring financials of mutual funds could actually improve prediction of future performance? Investors pore over return and fee information, but Li finds that tips exist elsewhere.
Dividend income is “highly predictive” of future income: “Funds that outperformed their benchmarks by selecting high dividend-paying stocks continued to do so in the future; they also outperformed their peers having lower dividend yields.” In contrast, unrealized gains and losses do not persist but mean-revert. (Unfortunately, the noisy variability of valuation often leads investors to mistake luck for skill in the meantime.) Fee waivers, which “temporarily increase fund performance, and thus fund rankings,” are another way that investors who aren’t careful can be fooled. Li’s analysis shows that investors do not react to changes in the financial statement variables, even though he finds them predictive.
Other reads
“Apples and IRRanges: Peeling Back the Challenges of Performance Measurement in Private Markets,” Phil Huber, Cliffwater (via LinkedIn).
Understanding that IRR and TWR are like apples and oranges for comparative purposes, allocators need a framework to help bridge that gap as they increasingly adopt evergreen structures like tender-offer funds and interval funds.
“Beware Naive Comparisons of Asset Management Fees and Returns,” Byrne Hobart, Capital Gains. Subhead: “Why investors pay 1000x more for a 10% return from Millennium than for a 10% return from Vanguard.”
“Equity Risk Premiums (ERP): Determinants, Estimation, and Implications – The 2024 Edition,” Aswath Damodaran, SSRN.
Given its importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice.
“Too Much Certainty is a Terrible Thing,” Inigo Fraser Jenkins and Alla Harmsworth, AllianceBernstein. Looking at benchmarks from different angles, including within a changed environment:
The new regime creates a tension between two different concepts of risk: risk measured as the ability to maintain purchasing power is now in conflict with risk measured as the standard deviation of returns.
“The Language of Investment Management,” Ryan Bunn, Reference Equity. Do asset managers talk most about fundamental business issues or other transitory factors? Do asset owners compel them to focus unproductively on the latter?
“Recovery rates as a mitigator against default rates,” StepStone.
Entering an uncertain economic environment, default rates often offer valuable insights into current economic conditions. However, they only tell part of the story: Their impact on returns can be offset by higher recovery rates.
“Breaking down barriers with new building blocks,” Deloitte. Benefits and challenges of fund tokenization.
“Decarbonisation Theory vs. Reality,” John Ploeg, PGIM.
In theory, a single, portfolio-level metric is appealing because it is easy to track and compare across portfolios. In reality, though, managing to a single, portfolio-level metric often produces results that are counterproductive to real-world decarbonisation.
“But We Are Long-Term Investors,” Ian Cassel, MicroCapClub. Repeating the mantra of your philosophy as emotions try to pull you away from it.
“Belonging at Scale,” Gapingvoid.
The lesson here applies to leaders in business as well. The trick is to create space for people to develop strong and effective communities that all ladder up to a singular North Star.
For the files
“Our memos always attribute success to something. But I’m not sure if we write memos to convey information or just to cover our tracks.” — The CIO, in The Counting House, by Gary Sernovitz (see the posting about it).
Flashback: Pension fund management
A 1992 paper, “The Structure and Performance of the Money Management Industry,” by Josef Lakonishok, et al., looks specifically at pension funds, then dominated by corporate plans. It concluded:
When all is said and done, we doubt that an industry that has added little if any value can continue to exist in its present form.
In one sense that’s true, because corporate plans are not the key driver of the pension industry as they were then; public funds are. But many of the problematic conditions related to the use of outside managers remain: agency issues, underperformance by asset managers, and performance chasing by plan sponsors.
Of note, the paper cites a jump in indexation at the time. That was the first sizable shift to passive (which would spread to other kinds of investors), although most pension plans have moved aggressively back to active management through the increased exposure to alternatives.
(This pivotal time in the evolution of pension management was the subject of an earlier posting, “The Anthropologists and the Pension Funds.”)
Postings
The archives include all of the previous postings. You can also sort them by category or search by keyword.
For example, check out a short posting on benchmarking from 2022.
Thank you for reading. Many happy total returns.
Published: April 1, 2024
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