Big News and (Always) Great Reads

The paywall on The Investment Ecosystem has been blown up.  All of the postings from the first two years of this site are now free (and all future writings will be as well).

If you have been a subscriber, you should have received an email about the change.  If you haven’t been one, now is the time to sign up to receive emails of postings or to visit the archives to see what you’ve been missing.  It’s all free all the time.

The most recent essay, “When Analysts Throw in the Towel,” looks at the social and psychological pressures that affect sell-side analysts (and other investment decision makers) when things go against them.

A new “flashback” section will now appear at the end of Fortnightly postings (like this one, which features a 2008 Howard Marks memo).

On to the readings.

AI all over

We’re coming up on the one-year anniversary of the introduction of ChatGPT to the broader world, which jumpstarted the current fervor over artificial intelligence.

“Productivity, Democracy, Power, and Truth: The Influence of AI on Markets and Investing,” a report by Inigo Fraser Jenkins and Alla Harmsworth of AllianceBernstein, is big in scope, as the title suggests.  It asks (at the end), “How can strategic asset allocation adjust to the potential for somewhat higher real growth (both earnings and GDP) but also higher long-term uncertainty?”  With higher equity exposure, higher inflation expectations, and a higher risk level overall.  (Also of note, the report includes predictions about changes in how analysts will work and think.)

Around the ecosystem:  Texas Teachers “believes AI can differentiate the fund;” J.P. Morgan Asset Management wants AI to “co-pilot” with portfolio managers, not boss them around; Angelo Calvello thinks recommendation engines will change wealth management; trading desks are gauging the risks and opportunities amid concerns about reliability; and Citywire Selector asks ChatGPT whether it will take over fund selection from humans.  Additionally, meetings are about to get weird.

Portfolio management in PE

A revealing paper, “Portfolio Management in Private Equity,” from Gregory Brown, et. al, looks at a little-explored area of a very popular asset class, revealing important patterns for investors.  According to the authors, “In spite of the centrality of the issue we study in this paper, almost no work to date has studied the GP’s investment decision through the lens of portfolio construction.”  Some of their conclusions:

The largest investments in PE funds typically have the lowest returns on average, but are also the least risky.

Managers take their biggest bets on their “safest ideas” instead of “best ideas.”

Returns within a typical PE fund increase monotonically as the investment size rank increases through the fifth largest investment made by a PE fund.

Funds start with higher-return deals.  That is, the earlier deals in the fund are of higher return and higher risk.

Funds with high-performing deals early in the fund’s life generally experience lower returns in later deals.

These results are consistent with the idea that GPs, motivated by career concerns and the incentives of limited partner agreements, approach fund investment through the lens of portfolio formation.

Given the standard marketing cycles, the changing portfolio composition as a fund ages is especially of note.

ESG

Kroll released its first “ESG and Global Investor Returns Study.”  It covers a lot of ground, but performance drives interest and “proofiness” in the industry, so the return calculations are likely to get the most attention.

The results above are for the respective MSCI ESG categories.  The colors indicate the three groupings (leader, average, grouping) used in most of the exhibits in the document, rather than the full spectrum of ratings as shown.

Advocates will no doubt use these numbers in debates with those who oppose any sort of ESG investing — at investment committee meetings, legislative hearings, etc.  But it’s a relatively short time period, there are sector mix effects to consider (and methodology to understand), and the number of companies included in the analysis doubled from 2013 to 2021.  Plus, this was a period when ESG was becoming more popular, so investor flows into highly-rated companies; reversion could mean that things look different over time.  Use with care.

The techno-optimist

Marc Andreessen got a lot of reaction to “The Techno-Optimist Manifesto,” an article which takes talking your book to a whole new level.  Among the many rebuttals are those from Ezra Klein and The Rational Walk.

Byron Wien

Wien passed away at ninety years of age.  He was widely known for his annual list of “Ten Surprises” of prospective developments unexpected by professional investors — and in later years for his twenty life lessons.

Other reads

“ETFantasmagoria,” Robin Wigglesworth, FT Alphaville.  On the explosive growth of ETFs, including “new-gen” ones far from their “passive roots,” and some thoughts about how their use will continue to evolve in more complex ways.

“CDPQ’s two-way street of efficient external manager relations,” Amanda White, Top1000funds.com.

It is important for our team to understand the knowledge gaps of the organisation, and while we better understand these knowledge gaps we work with partners and funds to see how they can help us fill those gaps.

“The art of keeping it simple, by JPMorgan’s Jan Loeys,” Bryce Elder, FT Alphaville.  An uncommon point of view for a strategist who works within a part of the industry that is paid for complexity.

“2024 Examination Priorities,” Securities and Exchange Commission.  The SEC’s playbook across the range of entities it monitors.  One interesting priority:

Adherence to contractual requirements regarding limited partnership advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.

“Sharing Names and Sharing Information,” Omri Even-Tov, et. al, SSRN.  Do CEOs offer more information to analysts who share their name, especially if it’s uncommon?  Fascinating conclusions.

“Diverse Managers Are Stuck. Can Changes to Seeding and Anchoring Deals Help?” Julie Segal, Institutional Investor.

Existing diverse manager and emerging manager programs were two of the least helpful sources, in part because they take a check-the-box strategy to due diligence and their requirements often make some problems worse, including working capital.

“Wind of Change: A Favorable Environment for Hedge Funds,” Zhe Shen, TIFF.  A much different view than that expressed by Michael Rosen of Angeles in the last edition of the Fortnightly.

“We are All Quants. The New Era of Systematic Investing,” Campbell Harvey, Research Affiliates.

The machine, obviously, does not have direct behavioral biases and will not fall prey to human emotion.  Indeed, the best algorithmic strategies will observe, learn from, and profit from others’ emotional choices.

“Reality Of Working At A Hedge Fund — An Insider’s Guide,” Buyside Hustle.  Myths and realities for those trying to get their foot in the door.

“Heterogenous Discount Rates and Optimal Portfolio Diversification,” Theia Finance Labs.

The market portfolio only represents the optimal portfolio in the particular case that the investor’s discount rate is identical to that of the market, i.e. that discount functions are homogenous.

“Private credit returns are great (if you believe the marks)” Robin Wigglesworth, FT Alphaville.  Subtitle:  “A rolling loan gathers no loss.”

It’s a social science

“All investing is behavioral, psychological, social, etc.  So a lot of big investing mistakes are not because investors don’t understand finance — it’s because finance is all they understand.” — Morgan Housel.

Flashback: Marks in 2008

In thinking about 2008, the mind goes to September, when Lehman failed and other major firms were on the brink — and parts of the bond market seized up.  But things had been building beforehand, as shown by the title of a piece by Howard Marks on March 18 of that year:  “The Tide Goes Out.”

He detailed parts of the “virtuous circle” of booms and then wrote:

With things working increasingly well and investors becoming more and more excited, processes like this one seem destined to go on forever.  Of course, they cannot.  But people forget that, satisfying one of the key prerequisites for a cycle that goes to excess.  Overestimating the longevity of up legs and down legs is one of the mistakes that investors insist on repeating.

On the other side of the cycle, “Unquestioning euphoria gives way to full-blown depression.”

More than fifteen years later, it is worth rereading.  Among the topics covered:  “What’s an asset’s price?” (a question being asked about many private holdings today); when things that “should happens” turn into things that “should have happened”; how safe assets become unsafe with leverage; the problem with copying the previous success of others as conditions change; and those “high reported IRRs” — are they skill or luck or just “well-timed risk taking”?

Postings

As mentioned before, all prior postings are now open, so check out the archives and search some of the categories.  For example, if you’re interested in how investment organizations work, you’ll find a wealth of insights in this series.

Thanks for reading.  Many happy total returns.