Differences of Opinion, the Playbook, and Stylized Answers

If you missed the series “Three Books about Capital Allocators,” you can find a short summary of it (with links to the postings) here.

Other new essays will be out soon.  Sign up if you want to receive them (and these Fortnightlys full of curated readings) when they are released.

Differences of opinion

They say that it takes two sides to make a market.  While that phrase is used to refer to the buyers and sellers of an investment vehicle, it is also true for theories, ideas, and practices.

There are positions staked out on every topic imaginable and ongoing debates between their proponents.  With the rise of “alternative” investing and the varied ways of interpreting the performance of many of the strategies found within that category, the debates seem to go on without end.

Take private credit, which has exploded in popularity since the financial crisis, appearing as an asset class in most allocation schemes only within the last decade.  A new working paper, “Risk-Adjusting the Returns to Private Debt Funds,” by Isil Erel, et al., has gotten a lot of attention.  In it, the authors note the challenge for researchers evaluating a relatively new area of investment:

The academic literature on private debt funds is remarkably sparse.  While practitioners argue that these funds are excellent investments, our knowledge is limited about their returns and whether these returns are sufficient to justify their risk.

Their conclusion?

Our estimates suggest that the risk-adjusted abnormal return on $1 of capital invested in private credit funds is indistinguishable from zero.

Cliffwater begs to differ:

A recently published academic study’s conclusion that private debt produces no after-fee excess return has caught the attention of some familiar naysayers in the business press.  We briefly critique the paper below and, contrary to the authors’ conclusion, find a large and statistically significant 4% after-fee excess return using a different, but more familiar risk measurement methodology coupled with a transparent and contemporary database of private debt performance.

The firm is an investment advisor and manager specializing in alternatives.  It also oversees the Cliffwater Direct Lending Index; another piece argues that its approach meets the criteria for a good benchmark (and that other ones don’t).

(Also of note:  The International Monetary Fund released “The Rise and Risks of Private Credit,” which deals with the macroprudential aspects of “the recent evolution of private credit into a major asset class,” of importance since financial crises typically stem from large increases in new types of leverage in the system.  The report covers credit, liquidity, leverage, asset valuation, interconnectedness, and conduct risks.)

On another front:

Many European and UK asset owners have pulled their allocation to hedge funds in recent years, unsure what multiple strategies with different outcomes are trying to achieve or if hedge funds really do capitalize on bull markets and protect them in a downturn.

That opens an article from Top1000Funds that details the double-digit weighting of TfL Pension Fund to hedge fund strategies, making it “a bit unique.”  Unlike other categories of alternatives, hedge fund allocations have shrunk in many portfolios, even while (as links offered in past postings have shown) some think that the time is right for increased allocations due to changes in the broad economic environment.

The debate is a messy one, because so many disparate strategies are lumped into one category — and goals for their use are all over the map.  It’s past time to discontinue using “hedge funds” as a descriptor, since it doesn’t really mean anything; each strategy should be placed appropriately in an allocation scheme based upon its economic drivers and risk/return characteristics.  (And analyzed on that basis; for example, see research from Rodney Sullivan and Matthew Wey on the decline in risk-adjusted alpha for global macro and managed futures managers.)

The playbook

Ted Seides has a message for asset managers:

New investment relationships start when the manager fits into the allocator’s playbook, not the other way around.  Managers often only see the game from their perspective. What happens on the other side of the field significantly influences the likelihood of a new allocation.

The investment office playbook takes place over four seasons — governance, deployment, optimization, and maturity.  The seasons repeat each time a new CIO takes the helm.  Other rules influencing investment activity include fund flows to the investment office and the CIO’s tenure in the seat.

For the most part, there is a sweet spot that starts a year or two after a new chief investment officer takes over, when most changes take place in the portfolio.  Before that, governance decisions take precedence and there is very little chance for a new allocation.  After the deployment period, prospective managers face limited opportunities, as “any new allocations to managers face severe competition for capital.”  (How should managers consider such implementation cycles when creating their marketing playbook?)

Stylized answers

In a LinkedIn article, Mervin Burton calls public equities “a space where alpha generation seems as difficult and elusive as building an anti-gravity machine.”  Burton offers a clever listing of fifteen “stylized answers” put forth by managers of different stripes (and the clients who hire them), grouped into fundamental, quantitative, tilts, and passive camps.

ETFs for asset owners

This chart illustrates the ownership of ETFs by U.S. and Canadian pensions, endowments, foundations, and sovereign wealth funds.  It comes from the latest quarterly report on such ownership by S&P Dow Jones Indices.  It shows a substantial rise in the usage of ETFs over the five years ending in December 2023.

As noted in the report, the AUM number appears to indicate a decline in appetite for the vehicles over the last couple of years, but in reality the dip is due to market performance, not to reduced exposure.  (A share count comparison is one of more than twenty exhibits provided.)

The increased use of ETFs prompts some questions:  What kinds of ETFs are being used?  In what ways?  For short- or long-term positions?  What strategic decisions are behind the changes?  How have performance patterns changed as a result?

Influencer

These days you shouldn’t be surprised if a young person tells you that they want to be an influencer when they grow up.  Maybe even a finfluencer.

An influencer of a different kind and era — with a lasting effect on the investment world — passed away recently.  Daniel Kahneman won the Nobel Prize in economics for his work on behavioral finance, even though he wasn’t an economist.  Among the notable tributes to him are those from Behavioral Scientist (“A Mosaic of Memories and Lessons”), David Epstein (“The ‘Lesson I Have Learned’ Mindset”), Jason Zweig (“The Psychologist Who Turned the Investing World on Its Head”), and Bob Seawright, (“Crackpots Work Alone”).

AI in the analyst trenches

A New York Times article by Rob Copeland, “The Worst Part of a Wall Street Career May Be Coming to an End,” considers what will happen when the “grunt work” done by investment banking analysts is farmed out to AI bots.  Similar questions are being asked about jobs throughout the investment ecosystem.

Writing for CAIA Association, Steven Novakovic offers an important perspective:

If we use AI to automate these mundane tasks, that means we need fewer fresh-eyed analysts, and that we assign our fresh-eyed analysts to tasks that we haven’t yet figured out how to automate with AI.  And those analysts that we do hire, aren’t going through the same experience-building process that those before them benefitted from.  When the bosses of these fresh-eyed analysts retire, what experiences and practical knowledge will the analysts have missed out on?  Will they be able to absorb all the information provided to them by the AI bots and know what it means, what to do with it, and know when the AI bot is lying?  Will they know what rules to give to AI to help find the next great investment?  Will they actually truly comprehend?

Other reads

“Tunnel Vision: 2024 Inflation and Growth Forecasts in Historical Perspective,” D. E. Shaw.

Historical distributions can’t tell us whether or when rapid disinflation or runaway growth will occur.  But they remind us that such outcomes have happened before, even during periods preceded by notably subdued macroeconomic volatility, and with much greater frequency than recent forecasts might suggest.

“Alternative risk premia: Building blocks for resilient portfolios,” Farouk Jivraj, et al., Fidelity.  This argues for long-short implementation of factor strategies versus long-only “smart beta” approaches.

“Generative AI in Systematic Investing: The Sizzle and the Steak,” Vladimir Zdorovtsov, et al., Acadian.

While excitement about generative AI is certainly warranted, we find that current speculations about its applicability and promise are in some cases misplaced and in others premature — both broadly speaking as well as in the context of systematic investing.

“Unexceptional Endowment Performance,” Richard Ennis.  A look at the fifteen-year returns for a sample of large U.S. endowments against risk-matched passive exposures.

“What is a Compounder, really,” Old Rope.

This is all vernacular nitpicking and possibly sophistry, simply because investment professionals mean whatever they want when they throw around jargon.

“Can Foundation Endowments Achieve Greater Impact?” Bridgespan Social Impact and Capricorn Investment Group.  Perspectives for organizations that want to more closely align their investment approach with their mission.

“Carbon Trading Strategies,” Chris Stevens and Toby Goodworth, bfinance.

Although still a somewhat small niche of the investment landscape, carbon trading is becoming increasingly relevant, particularly for hedge funds:  we’re seeing CTA/managed futures, multi-strategy, global macro and even long-short equity funds with exposure, as well as an emergent cohort of dedicated carbon trading strategies.

“The Alternative Truth of Private Equity and What That Means for Asset Allocation,” Christopher Carrano, Institutional Investor.  On the definition of an “alternative” and “paper diversification versus real diversification.”

“Would an asset manager by any other name still smell so sweet?” Chris Sloley, Citywire Selector.

While the jokes about Abrdn are likely to persist for the foreseeable future, this is another article in the funds industry which references that name.  To quote Oscar Wilde, the only thing worse than being talked about, is not being talked about.

It happens

“My karma ran over my dogma.”  — Attributed to many; the earliest reference on Google comes from a 1996 NYT article.

Flashback: Vague but exciting

It is now thirty years or so since the World Wide Web became publicly available.  It had its roots in a paper written by Tim Berners-Lee in 1989:  “Information Management: A Proposal.”  On it, his supervisor wrote, “Vague but exciting . . .”

Postings

The archives include all of the previous postings.  You can also sort them by category or search by keyword.

For example, “Two Sides of Ambivalence” from 2022 asked:

What is your preference?  Do you favor people and organizations who are highly confident in their positions, or would you rather have them be open about the uncertainties that exist (and their own doubts and concerns)?

Thank you for reading.  Many happy total returns.